Liquidity: Meaning, Types, Importance & Examples (2024)

What is Liquidity?

Liquidity refers to the ability to convert an asset into cash quickly without affecting its market value. In simpler terms, liquidity is how easily an asset can be sold or bought in the market. It helps investors and traders to convert assets into cash quickly, without any major impact on the market value of the asset.

Liquidity can arise from either the inherent nature of the asset or the market conditions. For example, fixed deposits are accessible investments that can be withdrawn whenever you need them. You can withdraw money in an emergency even before the maturity tenure, by paying a premature withdrawal charge.

Liquidity example

Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its value. Here's a breakdown of different assets and their typical liquidity levels:

1. High liquidity

• Cash:The most liquid asset, as it's already usable for spending.
• Savings accounts:Easily accessible, though may have limits on withdrawals.

2. Moderate liquidity

• Stocks:Can be sold quickly on stock exchanges, but prices fluctuate based on market demand.
• Bonds:Traded on markets, may take a bit longer to sell, especially less common bonds.

3. Low liquidity

• Real estate:Takes time to find a buyer and complete a sale.
• Collectibles (Art, Antiques):Finding the right buyer willing to pay a fair price can be a lengthy process.
• Private business ownership:Selling a stake in a private business is complex and time-consuming.

Importance of Liquidity

• Liquidity allows investors to manage their cash flows and make timely investment decisions.
• Without liquidity, investors would be unable to purchase or sell assets quickly, leading to delayed investment decisions and lower returns.
• Additionally, companies that have access to liquid assets can better manage unexpected financial obligations like paying off debts or meeting payroll requirements.
• Liquidity accelerates the entire process of a transaction by maintaining a balance between the risk and returns.

Types of Liquid Assets

1. Currency

Currency is the most liquid asset in the world. It can be easily converted into any other currency or used to buy other assets like stocks or bonds.

2. Cash

Cash is the most liquid of all assets. It can be used to make purchases, investments, or pay off debts instantly.

3. Savings Accounts

Savings accounts are considered liquid as they are easily accessible and can be withdrawn without significant penalties.

4. Fixed Deposits

Fixed deposits with their flexible tenure (12 to 60 months with Bajaj Finance) and payout options (monthly, quarterly, half-yearly, and yearly), can be beneficial for both short-term and long-term goals.

5. Government Bonds

Government bonds are highly liquid as they are issued by the government and are considered a safe investment option.

6. Marketable Securities

Marketable securities like stocks and bonds can be sold easily on the market, making them liquid assets.

Also read:What is Liquidity Asset

Methods of measuring liquidity

Market Liquidity:It refers to market conditions that allow fast purchases or sales of assets. Particularly noticeable is this liquidity in the real estate or finance markets. In economics, the conversion of assets into cash takes place across marketplaces and is known as liquidity.

Accounting liquidity:It is the simplicity with which a business or person can meet its financial commitments utilising liquid assets. It entails comparing the company's or an individual's liquid assets to their current liabilities over a fiscal year. The current ratio and cash ratio are two ways to gauge accounting liquidity.

Working capital is another name for the current ratio, which accounts for current assets that could be converted into cash throughout a fiscal year.
Current Ratio = Current Assets ÷ Current Liabilities

The cash ratio, on the other hand, gauges the amount of cash flow needed to cover present obligations. It frequently serves as a measure of short-term liquidity.

Cash Ratio = Cash and Cash Equivalents ÷ Current Liabilities

Role of liquidity in investments

The importance of liquidity lies in its impact on financial flexibility and risk management. It allows investors to react quickly to market opportunities or emergencies, making it a key consideration when building a portfolio. Illiquid investments, on the other hand, can lock up capital and limit an investor’s ability to respond to changing financial needs.

Key points on the role of liquidity:

1. Quick access to cash:Liquid assets can be easily converted to cash, ensuring financial flexibility in emergencies.
2. Market stability:High liquidity tends to stabilize prices, minimizing the risk of drastic price fluctuations.
3. Investment strategy:Liquidity influences portfolio composition, balancing between short-term and long-term goals.
4. Risk management:A liquid portfolio helps mitigate risks by allowing timely exit from underperforming assets.

Also read:What is Liquidity Trap

FD Laddering: Enhancing Liquidity in Fixed Deposits

FDs are meant to stay invested for their fixed tenures. The longer the tenure, the better the returns. Though there are options for withdrawing funds in case of an emergency that attracts premature withdrawal penalty from the bank or NBFC. To make the most out of a fixed deposit investment, investors opt for laddering to increase liquidity. Laddering deposits is a strategy for spreading out your investment across several fixed deposit accounts to achieve high yields and receive liquidity regularly.

Let us look at an example:

Consider a scenario in which you have a lump sum of Rs.5 lakhs and you want to invest it in afixed depositthat is less risky and pays interest at a rate of about 8.35% p.a. for 36-60 months. To ensure that you have liquidity at regular periods, you should start by scheduling your deposits. You put Rs.1 lakh into a one-year FD (7.40%), another Rs 1 lakh into a two-year FD (7.55%), and so on, up to a fifth FD of 1 lakh rupees with a five-year maturity. This indicates that you have all of your money invested in five distinct fixed deposits with well-timed maturity tenures.

Next, you receive a return of Rs. 1.07 lakh after the 1-year deposit matures. All is well thus far. The sixth step or rung of the ladder is effectively created by investing this sum in a 5-year deposit. You repeat the process, adding a seventh step, for the 2-year deposit. By doing this, you have made sure that your long-term deposits won't be at risk while you consistently have enough liquidity for emergencies. Another significant benefit is that by timing your investments, you may remain on top of rate changes.

For individuals, businesses, and markets alike, liquidity is essential. All these entities risk experiencing a liquidity crisis despite owning valuable assets if those valuable assets can't be turned into cash quickly enough. Hence, it is important to consider the liquidity of an asset before investing in it, as it can impact the ability to buy or sell the asset at a fair price.

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