Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value. In other words: the ease of converting it to cash.
Cash is universally considered the most liquid asset, while tangible assets, such as real estate, fine art, and collectibles, are all relatively illiquide. Other financial assets, ranging from equities to partnership units, fall at various places on the liquidity spectrum.
There are three types of liquidity:
- Asset liquidity: The liquidity of an asset refers to how easily that asset can be converted to cash when it is bought or sold. Cash is the highest liquidity asset because it can be traded easily and quickly without any effect on its market value. Stocks and bonds are also considered highly liquid assets, although their liquidity can vary depending on the popularity and reliability of the stock. Examples of illiquid assets include real estate and high art, as although they’re highly prized they can be more difficult to sell and their price fluctuates with the market.
- Market liquidity: Market liquidity refers to the conditions of a market in which an asset can be bought or sold. If market conditions support a high number of buyers and sellers, the market has high liquidity because it is easier to buy or sell your asset at the price you want. Illiquid markets are financial markets in which there are fewer buyers or sellers—for example the market for rare collectibles—which makes it harder to sell assets at your desired price. During periods of financial crisis, stock markets become less liquid.
- Accounting liquidity: Accounting liquidity refers to a company’s ability to pay off financial obligations such as marketable securities, cash, inventory, and accounts receivable. Investors looking at a company’s stocks often consider the company’s accounting liquidity, because this can convey the state of a company’s financial health.