Importance of Liquidity in Finance

Liquidity is the quality of assets which makes it easily convertible into cash.  Not all the assets have this quality.  It would take some considerable time to sell fixed assets like building, land etc. Hence those are not liquid assets.  Also, long-term investments which have a lock-in period cannot be converted into cash easily.  Only upon holding the investment till the end of lock-in period one would be able to withdraw the money.

Take the example of cryptocurrency trading using apps like Bitcoin code.  Investment can be withdrawn very easily once you feel it is enough. Check this out for knowing more about liquidity.

Even if the total assets owned are huge, liquid assets are needed to meet urgent expenses. Also, to meet day to day expenses, may it be an individual or a company, cash and other liquid assets are certainly required.

Liquidity in case of business:

In the case of businesses, current assets determine the liquidity level.   Current assets are those which are held for a shorter period like the stock of inventories, cash, and bank balances, short-term debt bills etc.  The liquidity health of a company is determined by its current ratio i.e current assets/ current liabilities.  Ideally, this should be between 1 to 2.  A higher current ratio shows too much liquidity.  It may be an indication of overstocking or too much credit sales etc.  This must be rectified.  When a business approaches banker for a loan, the banker will analyze liquidity before funding the working capital needs.  Suppose if liquidity is not adequate, the business will be able to sell its assets to make payments to creditors which results in the liquidation of the business.

Also, liquidity level varies depending on the working capital cycle for a business.  Suppose if a company sells goods with 15 days credit period, only at the end of 15 days inflow of cash from debtors is more likely.  But the company will need cash to make payments for stock purchase, wages etc. throughout the 15 days.  So liquidity has to be maintained correctly.

Liquidity in the case of individuals:

Liquidity is equally important for individuals.  Liquidity is needed up to that level to support the family expenses till an emergency gets normalized.  If all the funds are locked up in fixed assets, the person will not have funds to meet daily food, transport expenses and emergency expenses like hospitalization.

Too much liquidity will lead to loss as it is a clear indicator of idle funds lying without utilization.

 

Importance of Liquidity in Finance