The ease and speed with which an asset or investment can be turned into cash without materially depreciating in value is known as liquidity. In simple terms, it’s how easily your money is available when you need it. Cash in your hand or at your bank account, for example, is highly liquid, while real estate or long-term investments are less liquid because it takes time and effort to transform them into funds available.
Whether you are a consumer planning for the unexpected, a business covering day-to-day expenses, or an investor selling or buying assets efficiently, liquidity is a critical factor in making decisions. It ensures financial stability, allows flexibility during uncertain times, and helps you react promptly to new opportunities or threats. Liquidity is not a financial jargon term but a solid tool for achieving greater financial well-being.
Types of liquidity in finance
1. Market liquidity
Market liquidity means the simplicity with which an asset can be sold or purchased quickly and easily in the financial markets at a price that is very close to its intrinsic value. It is useful for both investors and businesses.
- Liquid markets lower transaction costs and reduce price volatility for investors.
- For businesses, it can raise capital more efficiently by selling shares in an orderly market.
Highly liquid markets consist of numerous participants (buyers and sellers), in that:
- You can sell your asset almost instantly.
- You will not have to sell it at a large discount.
Example:
| Asset | Liquidity Level | Reason |
| Cash | Very High | Universally accepted and ready for instant use |
| Publicly traded stocks | High | Large volumes are traded on the exchange. |
| Mutual Funds | Medium to High | It is calculated based on NAV and can be sold even after a short duration |
| Real estate | Low | It has high transaction costs and takes a longer duration to sell |
| Art/Collectables | Very Low | It has Niche buyers, is difficult to sell, and the value is subjective. |
2. Accounting Liquidity
Accounting liquidity is about an entity’s ability to meet a firm’s short-term obligations using current assets. It serves the following functions for managers, investors, and creditors:
- To creditors: Offers terms for the settlement of immediate debts.
- To investors: Refers to the health of the company’s operations and cash.
- To managers: Used to schedule daily and monthly expenses.
This measure of liquidity is taken primarily in terms of financial ratios that equate current assets (like cash, inventory, and receivables) to current liabilities (like bills, wages, and payables within one year).
Key ratios:
| Ratio | Formula | Meaning |
| Current Ratio | Current Assets ÷ Current Liabilities | Liquidity position of the company |
| Quick Ratio | (Current Assets – Inventory) ÷ Current Liabilities | Liquidity position, but without relying on selling inventory |
| Cash Ratio | Cash and Equivalents ÷ Current Liabilities | The most conservative view of liquidity |
3. Funding Liquidity
Funding liquidity refers to the ability of an institution, firm, or individual to raise cash to meet its obligations, especially under stress. Unlike accounting liquidity, which focuses on the snapshot of the balance sheet, funding liquidity is about having cash available over time. It is particularly important for big businesses, banks, and other financial institutions.
A company could be endowed with assets but still experience a cash shortage if the assets are illiquid. During a crisis, banks and firms may fail not because they are insolvent but because they cannot sell assets to convert them to cash fast enough (a liquidity crisis).
Why Liquidity is Important in Finance
Liquidity is relevant to know for individuals as well as businesses. Here’s why:
For Individuals:
- Emergency needs: Savings or fixed deposits in liquid funds are needed for medical needs or unexpected expenses.
- Investment planning: The development of a diversified portfolio with a good return is possible through investment planning.
For Organizations:
- Solvency & Operations: A financially liquid business is able to pay its suppliers, its staff, and operational costs without delay.
- Credibility: The company’s creditworthiness is enhanced due to high liquidity and improved access to loans.
- Risk Management: Liquid reserves act as a buffer in the event of a business downturn or flat sales.
How to maintain good Liquidity?
Maximum liquidity is obtained through an investment-cash combination in a strategic manner. This is how:
1. Diversify Assets in Terms of Liquidity
- Invest some portion of your portfolio in cash or a cash equivalent, like savings accounts or short-term fixed deposits.
- Balance with moderately liquid securities like a mutual fund or ETF.
- Long-term investments (like property), which reduce the ability to have money available.
2. Utilize Liquidity Management Tools (for Companies)
- Develop a cash flow projection to monitor receipts and payments.
- Maintain a line of credit available to draw against during brief cash deficits.
- Review liquidity ratios regularly and establish minimum levels.
3. Set up an Emergency Fund (for Individuals)
- Save 3–6 months’ worth of costs in an easily accessible savings account.
- Invest in liquid mutual funds to earn relatively good returns with good liquidity.
Final Thoughts
Liquidity is not merely having money in hand but having your financial arrangement, personal or corporate, such that it can accommodate unforeseen needs. Too much liquidity can cause you to miss out on investment opportunities, while too little liquidity can drive you into a financial crisis.
By effective liquidity management via smart asset allocation, ratio analysis, and monitoring of cash flows, individuals and companies can keep their financial situation robust in the face of prosperity or adversity.
Written by: Tanya Kumari
