A:

A company's liquid assets can easily be converted into cash to meet financial obligations on short notice. Liquidity is the ability of a business to pay its debts using its liquid assets.

The most common types of liquid assets for all businesses, from banks to electronics manufacturers, are funds in checking and savings accounts and marketable securities, such as stocks and bonds. Highly liquid securities can be bought and sold quickly and easily without affecting their price. Liquidating a stock investment is as simple as placing an order, which almost instantly triggers the sale of shares at the current market price.

A bank's liquidity is determined by its ability to meet all its anticipated expenses, such as funding loans or making payments on debt, using only liquid assets. Ideally, a bank should maintain a level of liquidity that also allows it to meet any unexpected expenses without having to liquidate other assets. The bigger the cushion of liquid assets relative to anticipated liabilities, the greater the bank's liquidity.

To understand the importance of liquidity to a bank's continued solvency, it helps to understand the difference between liquid and illiquid, or fixed, assets. Illiquid assets cannot swiftly be turned into cash, including real estate and equipment that provide long-term value to the business. Using illiquid assets to meet financial obligations is not ideal. Selling off real estate to meet financial obligations, for example, is inefficient and potentially expensive. If funds are needed in a hurry, the company may have to sell the property at a discount to expedite the liquidation,.

In addition, liquidating these types of assets to pay debts can have a detrimental impact on a business's ability to function and generate profit down the road. A clothing manufacturer that has to sell its equipment to pay off loans will have difficulty maintaining consistent production levels and will likely need to take on new debt to purchase replacements. Liquidating fixed assets is a last-resort solution to a short-term problem that can have devastating long-term consequences.

During the financial crisis of 2008, it became clear that banks were not maintaining the stores of liquid assets necessary to meet their obligations. Many banks suffered the sudden withdrawal of depositor funds or were left holding billions of dollars in unpaid loans due to the subprime mortgage crisis. Without a sufficient cushion of liquid assets to carry them through troubled times, many banks rapidly became insolvent. In the end, the banking industry was in such a poor state that the government had to step in to prevent a total economic collapse.

The liquidity coverage ratio rule was developed as a means of ensuring that banks maintain a level of liquidity sufficient to avoid a repeat performance of 2008. Under the new rule, all banks must maintain liquid asset stores that equal or exceed 100% of their total anticipated expenses for a 30-day period. In the event of a sudden dip in income or an unexpected liability, banks can meet all their financial obligations without having to take on new debt or liquidate fixed assets, giving them time to resolve the issue before it turns into another financial disaster.

RELATED FAQS
  1. What affects an asset's liquidity?

    Learn about what affects an asset's liquidity, including examples of liquid and fixed assets, and how a company's liquidity ... Read Answer >>
  2. Is liquidity calculated by flow?

    Read about the differences between economic liquidity, financial liquidity and asset liquidity and how each respective type ... Read Answer >>
  3. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ... Read Answer >>
  4. What items are considered liquid assets?

    Learn what a liquid asset is, some examples of liquid assets, what a non-liquid asset is and what determines whether as asset ... Read Answer >>
  5. Are a bank's current assets counted as liquidity?

    Find out how bank assets are defined and how the Federal Reserve controls the definitions of, requirements for, and availability ... Read Answer >>
  6. What is the impact of inflation on liquid assets?

    Find out why inflation is particularly problematic for liquid assets, and learn what holders of liquid assets can do when ... Read Answer >>
Related Articles
  1. Insights

    What is Liquidity Risk?

    Liquidity risk is the risk of being unable to sell an asset fast enough to avoid loss.
  2. Investing

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
  3. Investing

    Understanding Liquidity Risk

    Learn about the two types of liquidity risk: funding liquidity risk and market liquidity risk.
  4. Investing

    Financial Analysis: Solvency vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health.
  5. Insurance

    Explaining the Liquidity Coverage Ratio

    The liquidity coverage ratio requires banks and other financial institutions to hold enough cash and liquid assets on hand to weather market stress.
  6. Financial Advisor

    What Is The Quick Ratio?

    Find out about this liquidity indicator and how it's used.
  7. Managing Wealth

    What Does Liquidation Mean?

    Creditors liquidate assets to try and get as much of the money owed to them as possible.
  8. Financial Advisor

    Small Cap Investing: How to Think About Illiquidity

    Do your homework, have a long term view, exercise patience, you'll find that investing in small market capitalization stocks is no riskier than investing in large stocks
  9. Investing

    Using The Current Ratio

    Find out more on how this liquidity ratio is used to measure a company's ability to pay short-term obligations.
RELATED TERMS
  1. Liquid Asset

    An asset that can be converted into cash quickly and with minimal ...
  2. Liquidity Cushion

    A reserve fund for a company or individual made up of highly ...
  3. Flight To Liquidity

    A situation where investors attempt to liquidate positions in ...
  4. Liquidity Crisis

    A negative financial situation characterized by a lack of cash ...
  5. Liquid Market

    A market with many bid and ask offers, low spreads and low volatility. ...
  6. Liquidity

    The degree to which an asset or security can be quickly bought ...
Hot Definitions
  1. Risk-Return Tradeoff

    The principle that potential return rises with an increase in risk. Low levels of uncertainty (low-risk) are associated with ...
  2. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  3. Aggregate Demand

    The total amount of goods and services demanded in the economy at a given overall price level and in a given time period.
  4. Fixed Cost

    A cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses ...
  5. Blue Chip

    A blue chip is a nationally recognized, well-established, and financially sound company.
  6. Payback Period

    The length of time required to recover the cost of an investment. The payback period of a given investment or project is ...
Trading Center