Understanding Liquidity And Liquid Assets (2024)

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Understanding Liquidity And Liquid Assets (1)

Liquid assets include cash and other assets that can quickly be turned into cash without losing value. You always want some of your assets to be liquid in order to cover living expenses and potential emergencies. But in a larger sense, think of liquidity as a spectrum: Some assets are more readily convertible into cash than others. At the far end of the spectrum are illiquid assets, which are very hard to value and sell for cash.

What Is Liquidity?

Liquidity describes your ability to exchange an asset for cash. The easier it is to convert an asset into cash, the more liquid it is. And cash is generally considered the most liquid asset. Cash in a bank account or credit union account can be accessed quickly and easily, via a bank transfer or an ATM withdrawal.

Liquidity is important because owning liquid assets allows you to pay for basic living expenses and handle emergencies when they arise. But it’s important to recognize that liquidity and holding liquid assets comes at a cost.

In general, the more liquid an asset is, the less its value will increase over time. Completely liquid assets, like cash, may even fall victim to inflation, the gradual decrease in purchasing power over time.

To protect against inflation and save for long-term financial goals, you’ll probably want to sacrifice some liquidity and lock assets into investments that grow your wealth over time, like investment securities or real estate.

But assets like real estate, as well as art and jewelry, may be considered highly or even exclusively illiquid. This doesn’t mean that you will never receive cash for them, only that it can be more challenging to value assets like this and then turn them into cash.

What Are Liquid Assets?

Liquid assets are assets that can easily be exchanged for cash. While assets are valuable possessions that can be converted into cash, not all of your assets can be sold for cash right now, or without taking a loss on the sale. Common liquid assets include:

  • Cash. Cash is the ultimate liquid asset. Besides holding physical currency and ATM withdrawals, cash can be accessed via your checking account and peer-to-peer payment apps.
  • Treasury bills and treasury bonds. T-bills and T-bonds are highly stable—and highly liquid—investments, backed by the full faith and credit of the United States government. As a consequence, they can instantly be sold for cash on the secondary market if you need their value before they mature.
  • Certificates of deposit. CDs can earn you higher APYs than checking or savings accounts, but they also come with tougher withdrawal restrictions. To access the money held in a CD before its maturity date, you may have to pay a penalty, typically a few months of interest. No-penalty CDs are an exception here, and they earn lower APYs.
  • Bonds. Some investors buy bonds and hold them to their maturity date. But the secondary market for trading bonds is vast, meaning that many types of bonds are relatively liquid investments. Like any security, you may end up selling bonds for less than you paid for them.
  • Stocks. Equities may be sold on stock exchanges almost instantly, and publicly traded stocks are considered very liquid. You usually receive cash from the sale within a few days. As noted above, you may end up selling a security like stock for less than you paid for it.
  • Exchange traded funds (ETFs). ETFs are investment funds that trade like stocks on public exchanges, making them fairly easy to sell quickly. While they are less risky than individual stocks and bonds, you still may end up having to sell ETFs at a loss if you need your money quickly. You will generally receive cash within a few days.
  • Mutual funds. While they provide easy diversification, mutual funds only trade once a day, at the market close. This makes them slightly less liquid than stocks and ETFs. You generally receive proceeds from a sale the next business day.
  • Money market funds. Money market funds are a type of mutual fund that only owns highly liquid assets, like cash, CDs and government-backed debt. Because their components are highly liquid, their value is highly stable. Like mutual funds, you generally receive proceeds from a sale the next business day.
  • Precious metals. Precious metals can be both liquid and illiquid. In some states, certain gold and silver coins can be used as currency, meaning it’s hypothetically as liquid as cash. Physical precious metal can also be exchanged for cash via dealers. But depending on where you store your precious metals, they may be less accessible.

Liquidity and Your Financial Accounts

Beyond individual asset classes, you should also understand the liquidity offered by the different accounts where you hold your assets. Certain account types are more liquid than others:

  • Banking accounts. Banking accounts are the closest to cash, in terms of liquidity. You can pay for things directly with a debit card, write a check or withdraw cash.
  • Savings accounts. Everyone should maintain both a banking account and a savings account, but it’s important to understand that savings accounts are designed to be slightly less liquid. To encourage less frequent transactions, According to the Reserve bank of India, banks are required to provide four transactions minimum for free of charge. You can get around this limitation by conducting transactions in person, by mail or by ATM.
  • Taxable investment accounts. These investment accounts are available via brokerages, and are designed to hold stocks, bonds, ETFs and mutual funds. They are fairly liquid and, when you sell assets held in a demat account, cash proceeds are transferred to your account within days of a sale. There’s a big potential downside, however: Depending on market conditions, you may have to sell your investment assets at a loss, and you may incur trading commissions or sales fees.
  • Tax-advantaged accounts. Tax-advantaged accounts, like national pension scheme (NPS) are less liquid than taxable investment accounts. They may hold similar investment assets, but their preferential tax treatment comes with major limitations, such as penalties for their use before retirement age or when they are used for non-qualified purposes.
  • Trusts. Trust accounts can be fairly liquid, depending on how they’re set up and how they’re managed. However, some trust structures are designed to make it harder to access and control the assets, so consult a trust attorney before setting up this type of account.

What Are Illiquid Assets?

Illiquid assets are not easily sold or converted into cash. Some examples of illiquid assets include:

  • Real estate. It can take weeks or months—or even years—to sell real estate. While it’s possible to access the equity you have built up in a home or an investment property through a home equity loan, home equity line of credit or a reverse mortgage, setting up these arrangements takes time and effort.
  • Collectibles. Antiques, artwork, baseball cards, jewelry and other collectibles can be difficult to value and hard to sell.
  • Stock options. Many companies—not just tech start-ups—offer their employees stock options as part of a larger compensation package. Typically a new employee is promised a set amount of stock in the company that employs them if they remain with the company for a given period of time. Stock options can be very valuable, but they are highly illiquid assets, as you must remain with the company for years before you own the stock promised to you.
  • Private equity. If you can invest in private equity assets, like venture capital or funds of funds, you have the potential to achieve big gains. However, private equity funds often come with steep restrictions on when you can sell your shares.
  • Estates. Before you can access the assets in an estate, debts must be paid and taxes assessed. It can take years to fully benefit from an estate.
  • Intangible assets. Intangible assets are concepts or ideas that have value—in some cases a very great deal of value. Intangible assets include things such as corporate goodwill, brand recognition, intellectual property and reputation. It can be very difficult to assign a market value to intangible assets, and they are by nature extremely illiquid.

How to Build Your Liquid Assets

Holding some of your total net worth in the form of liquid assets is a key part of sound long-term financial planning. Above and beyond your checking account, you should hold some liquid assets so you can rapidly get cash when you need it most.

For instance, many financial advisors recommend that you have at least three to six months of expenses in liquid assets in an emergency fund, should you lose your job or experience financial hardship.

If you don’t have enough (or any) money set aside in an emergency fund, take a survey of your assets. If you have a high amount of illiquid assets tying up your money, consider liquidating some of them to finance your emergency fund. If you don’t have illiquid assets you can or want to liquidate, aim to set aside at least a portion of your paycheck to grow your emergency fund.

One of the best places to keep an emergency fund can be a high-yield savings account. Once you have a solid emergency fund in place, you can begin to use less liquid assets to achieve your longer-term financial goals.

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Miranda MarquitContributor

Miranda Marquit has been covering personal finance, investing and business topics for almost 15 years. She has contributed to numerous outlets, including NPR, Marketwatch, U.S. News & World Report and HuffPost. Miranda is completing her MBA and lives in Idaho, where she enjoys spending time with her son playing board games, travel and the outdoors.

Benjamin CurryEditor

Ben is the Retirement and Investing Editor for Forbes Advisor. With two decades of business and finance journalism experience, Ben has covered breaking market news, written on equity markets for Investopedia, and edited personal finance content for Bankrate and LendingTree.

Understanding Liquidity And Liquid Assets (2024)

FAQs

Understanding Liquidity And Liquid Assets? ›

Key Takeaways. Liquidity is sufficient cash on hand to meet financial responsibilities. Liquid assets may be cash or property that can readily be converted to cash without a substantial loss in value. Maintaining liquidity above the bare minimum is considered wise to guard against unexpected expenses.

What is the most liquid asset and why explain your response? ›

Balance Sheet Accounting

A company's current assets are assets a company looks to for cash conversion within a one-year period. Current assets have different liquidity conversion timeframes depending on the type of asset. Cash on hand is considered the most liquid type of liquid asset since it is cash itself.

How do you understand liquidity? ›

Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. The most liquid asset of all is cash itself.

What answer best describes liquidity? ›

Answer and Explanation:

A firm's liquidity indicates the ability of a company in meeting its current obligations using its liquid assets.

Why is it important to understand liquidity? ›

By evaluating a company's liquidity position, investors can see the company's ability to meet immediate financial obligations. This is important when trying to reduce the risk of default and ensuring the safety of investing in only healthy companies.

Which asset has the highest liquidity? ›

The most liquid assets are cash and accounts known as "cash equivalents," like savings, checking and money market accounts. Even certificates of deposit (CDs) and I bonds could be considered liquid, slightly less liquid than a checking or savings account, but fairly easily accessible.

Which of the following is the best example of a liquid asset responses? ›

An example of a highly liquid asset is cash. Cash is considered highly liquid because it can be easily and quickly converted into other assets or used for transactions. It is readily available and generally accepted as a form of payment. Other examples of highly liquid assets include stocks and money market funds.

How do you determine good liquidity? ›

Ideally, you want your net working capital to be growing consistently alongside your business. Sales and assets should be going up as this will increase net working capital. On the other hand, if your working capital is declining, this indicates a lack of liquidity.

What is liquidity in real life? ›

At its core, liquidity describes how easily an asset can be converted into cash without affecting its market price. It's the financial world's measure of readiness, the ability to meet obligations when they come due without incurring substantial losses.

How do you determine the liquidity of an asset? ›

The current ratio (also known as working capital ratio) measures the liquidity of a company and is calculated by dividing its current assets by its current liabilities. The term current refers to short-term assets or liabilities that are consumed (assets) and paid off (liabilities) is less than one year.

What is the best example of liquidity? ›

For example, cash is the most liquid asset because it can convert easily and quickly compared to other investments. On the other hand, intangible assets like buildings or machinery are less liquid in terms of the liquidity spectrum.

What two things does liquidity measure? ›

Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. A liquid asset can easily and quickly be converted to cash, whereas an illiquid asset is difficult to convert to cash. By converting we mean selling.

What is the meaning of liquid assets? ›

Liquid assets refer to cash on hand, cash on bank deposit, and assets that can be quickly and easily converted to cash. The common liquid assets are stock, bonds, certificates of deposit, or shares.

What is an example of liquidity? ›

Cash is considered the most liquid asset because it's readily available to use. Cash can be paper money, coins, or checking or savings account balances. Cash is very useful for immediate needs and expenses, such as daily spending, rent and building an emergency fund.

What is an example of a liquidity decision? ›

The main goal of a liquidity decision is to ensure that a company has enough liquid assets to meet its short-term obligations. For example, paying bills, salaries, and other operating expenses as they become due. At the same time, the company must also ensure that it does not hold too much cash or other liquid assets.

Is liquidity good or bad? ›

Financial liquidity is neither good nor bad. Instead, it is a feature of every investment one should consider before investing.

What is a liquid asset? ›

Liquid assets refer to cash on hand, cash on bank deposit, and assets that can be quickly and easily converted to cash. The common liquid assets are stock, bonds, certificates of deposit, or shares.

Why is cash said to be the most liquid asset? ›

Cash on hand is considered to be a liquid asset because it can be readily accessed. Cash is a legal tender that a company can use to settle its current liabilities. The money in your checking account, savings account, or money market account is considered liquid because it can be withdrawn easily to settle liabilities.

What is your most liquid asset How can you protect it? ›

Cash is the most liquid asset of an agency. Because of its liquidity, it is so attractive, that it is most susceptible to theft and misappropriation. [1] To guard against the loss of cash through theft or fraud, adequate cash management mechanisms and controls must be in place.

Which is the most liquid asset Quizlet? ›

Cash in hand is considered to be the most liquid type of liquid assets because it is money itself.

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