An asset's liquidity is a function of how easily it can be converted into cash.
In corporate finance, liquid assets are those that can be used to pay off debts in a hurry. The most common examples of liquid assets are cash – on-hand or deposited in a bank – and marketable securities such as stocks and bonds.
If a debt suddenly becomes due, the simplest way to meet that obligation is with cash. Physical currency is the only truly liquid asset, since it represents capital in its most accessible form. Because funds deposited in checking or savings accounts can generally be accessed almost immediately, they are also considered a liquid asset.
Stocks and bonds require a slightly more complicated transaction to convert the investment into cash but are still considered highly liquid. The open market provides ready access to both buyers and sellers for these types of securities, so they can be easily sold on short notice without impacting their value. (For related reading, see "Common Examples of Marketable Securities.")
The things a business owns that contribute to its profitability but are not easily converted into currency are called fixed assets. Common examples of fixed assets include real estate, vehicles and equipment. If a shipping business needs to pay off a creditor on a short deadline, selling its fleet of delivery vans or pieces of large packaging equipment would not be the most efficient way to generate funds. Fixed assets represent a long-term investment of capital with the goal of adding ongoing value to the business.
There are some assets that are neither fixed nor totally liquid. These types of assets are included in the current asset total on a company's balance sheet. In addition to cash and other liquid assets, this category includes inventory and accounts receivable. While these assets cannot be liquidated on a moment's notice, they generally are turned into cash within a year or less.
A business's liquidity is important for many reasons. It directly affects the company's appeal to investors. If a company has $1.5 million in assets, of which $1 million are liquid, that is a sign it is financially healthy. The company's capital is not tied up in burdensome fixed assets that depreciate over time, and it is better positioned to weather any potential financial storms.
Liquidity in an Economic Downturn
In the event of a decrease in revenue or an economic downturn, a company that is highly illiquid would have to deal with selling off, or liquidating, fixed assets to meet its financial obligations. This could mean selling property or equipment that is essential to the day-to-day operations of the business, limiting its ability to generate revenue down the road. A company with large stores of cash would be able to pay off creditors easily without having to liquidate fixed assets that are necessary to keep the business running.
A company's liquid asset total also impacts a number of key financial ratios. Companies use metrics such as the cash, current and quick ratio to assess how well the business manages its money. Financial institutions look at these ratios when evaluating a business as a candidate for a loan. Investors look at these liquidity ratios as indicators of a company's financial health and stability.
(For related reading, see "Understanding Financial Liquidity.")