Liquidity

The liquidity of an asset refers to the ease with which that asset can be converted into cash. Two main characteristics enter into the liquidity of an asset. One is the ability to sell the asset on short notice, and the other is the ability to sell the asset without significantly discounting the price. Both of these characteristics must be present for an asset to be considered highly liquid. Money or cash is the most liquid of all financial assets. Ninety-day U.S. Treasury bonds and shares of corporate stock can both be sold on short notice, but the treasury bonds are considered much more liquid. Treasury bonds can be quickly sold at a price close to the price paid for them. The corporate stock can only be sold on short notice at the current market price, which may be significantly below the price paid for the stock. A parcel of real estate is likely to be less liquid than shares of corporate stock. Finding a buyer for a piece of real estate on short notice can be difficult, and the price that buyers are willing and able to pay for real estate varies with economic conditions and interest rates.

The liquidity of an asset does not reflect its soundness. A sales person may find that investing a sizable sum of cash in a nice wardrobe can be a wise investment, one that pays off handsomely in higher sales commissions. If that sales person turns up jobless, however, and needs to sell the wardrobe, that person will likely recover only a small fraction of the original investment. Often highly profitable investments are illiquid.

In the case of financial investments, the liquidity of the asset is not related to the prospects that the investment will pay off. A parent may grant a ten-year loan to a studious, overachieving child with perfect assurance that the loan will be repaid. If the parent, however, tries to discount that loan to a third party for cash, they will find it very difficult. On the contrary, if the parent purchases a ten-year corporate bond, essentially loaning funds to a corporation, that parent can easily sell that bond before it matures. For an asset to be liquid, there has to be a market for it.

Liquidity confers certain advantages. Cash does not earn interest, but it enables its holder to take advantage of bargains and speculative opportunities. Interest earned by financial assets can be interpreted as a reward that must be paid to overcome a preference for liquidity. Usually, but not always, long-term bonds pay a higher interest rate than short-term bonds. The higher interest earned on long-term bonds is partly because liquidity is given up for a longer period of time.

Most business firms face a trade-off between liquidity and profitability. This trade-off is easily seen in the case of banks. If a bank took all of its depositors’ money and never loaned it out, the bank would be highly liquid but would report zero revenue. On the other hand, the bank cannot loan out all of depositors’ money and remain capable of honoring requests for withdrawals on demand.

Banks must strike a balance between liquidity and profit maximization, keeping cash holdings as low as possible without jeopardizing the ability to redeem deposits. Other businesses may have to choose between holding cash and holding inventories. Holding cash guarantees that the business can meet its short-term obligations. A business may increase its profits by trimming its cash holdings to a bare minimum and investing in more inventories. Such a strategy can increase profits, but it also increases the risk that the firm will be left unable to meet its short-term obligations. A firm with relatively large cash holdings has greater chance of remaining solvent in the event of sudden and unexpected adversity.