Liquidity vs. Liquid Assets: An Overview
Liquidity means a person or company has sufficient liquid assets to pay the bills on time. Liquid assets can be cash or possessions that could be converted into cash quickly without losing a substantial amount of their value.
For example, if a person earns enough income in a month to pay all of the bills due without sacrificing any other immediate necessity, that person has achieved liquidity. Liquid assets consist primarily of cash in a checking or savings account.
If an unexpected expense comes up, the checking account balance may fall short. At that point, the person may have to dip into a savings account, pawn a gold watch, or cash in a few bond shares. Liquidity has been maintained. The person has sufficient liquid assets to pay the bills on time. No great harm has been done if the same problem doesn't arise month after month.
If, however, the person has no other liquid assets to tap, liquidity has not been maintained. The only options left to meet the bills are borrowing at a high rate of interest, selling a possession at a probable loss, or failing to pay the bills on time.
- 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.
- Illiquid or fixed assets are possessions of value that are held long-term, such as a home, land, or equipment.
Ideally, an individual or a business has sufficient liquidity to meet all regular expenses plus a bit extra for unusual demands.
For example, a bank's liquidity is determined by its ability to meet all of its anticipated expenses, such as funding new loans or fulfilling customer account withdrawals, using only liquid assets. The anticipated expenses can only be an estimate of how much customers may withdraw from savings or how many new mortgages may be issued advantageously.
For a consumer, a lack of liquidity can mean borrowing at a high rate of interest, selling a possession at a probable loss, or failing to pay the bills on time.
Banks particularly have to err on the safe side, maintaining liquidity at all times without fail. The bigger the cushion of liquid assets relative to anticipated liabilities, the greater the bank's liquidity is.
The accounts receivable, or payments owed to the company, are part of the company's liquid assets for that period as well.
No company wants to keep a lot of cash sitting in a checking account, so some of its liquid assets may be in marketable securities. Treasury bills or bonds, for example, can be turned into cash on short notice and with little or no financial loss involved.
Like individuals, businesses also have illiquid, or "fixed," assets. Property, buildings, equipment, and supplies all are fixed assets.
Should stocks be considered liquid assets? Not necessarily. They can be bought and sold instantly. But if they are bought at a high price and a need for cash arises when they have sunk to a low price, the stocks have been converted into cash only at a high cost to their owner.
That fails to meet the standard of liquidity: The assets must be either cash or property that can be turned into cash without a substantial loss in value.
A company or an investor with a highly diversified investment portfolio can count some or all of its holdings as liquid assets. That is, all or parts of the portfolio can be sold at any time without a substantial loss in value overall. A person with a modest number of stocks is wiser to hold onto them until it's the right time to sell.
For individuals or companies, liquidity brings a certain amount of stability. Using illiquid assets to meet routine financial obligations is problematic.
A company that sells off real estate to meet a financial obligation, for example, could be in trouble. If the money is needed in a hurry, the company may even have to sell the property at a discount. In any case, the company has permanently lost a valuable asset.
Liquidating fixed assets to pay debts can have a detrimental impact on the ability to function profitably down the road. A clothing manufacturer that has to sell some of its equipment to pay off loans will have difficulty maintaining consistent production levels.
Liquidating fixed assets is usually a last-resort solution to a short-term problem.
Well-run companies keep a little more in liquid assets than the bare minimum necessary to maintain liquidity.
Percentage of total anticipated expenses for a 30-day period that U.S. banks must maintain as liquid assets.
This is especially true in the banking industry. During the financial crisis of 2008, it became clear that U.S. banks were not maintaining the liquid assets necessary to meet their obligations in all cases.
Many of the banks suffered a sudden and unexpected 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 U.S. government had to step in to prevent a total economic collapse.
As a result, a liquidity coverage ratio rule was developed to ensure that banks keep enough cash on hand to avoid a repeat performance of 2008. Under this rule, all banks must maintain liquid asset stores that equal or exceed 100% of their total anticipated expenses for a 30-day period.
That is, in the event of a sudden dip in income or an unexpected liability, the bank can meet all of its financial obligations without having to take on new debt or liquidate fixed assets. That is designed to give them time to resolve the issue before it turns into another financial disaster.