Definition - What does Liquidity mean?
Liquidity is the ease of converting tangible assets into cash and it has different connotations for different situations and contexts. However, in general, high levels of liquidity give more flexibility to an investor or company to meet their financial obligations. In addition, high levels of liquidity means less risk because the existing assets can be easily converted to cash at any time.
Divestopedia explains Liquidity
Liquidity means something different in varying situations. From an organization's or individual's point of view, liquidity is the extent to which an organization or person can meet their short-term obligations with their existing assets. These assets that can be quickly converted into cash are called liquid assets. When a company or an individual has higher amounts of liquid assets then their chance of defaulting is low in the short-term.
From an accountant's perspective, liquidity is the ability of the current assets to meet the current liabilities. The existing current assets should be large enough to meet the liabilities; to measure whether there are sufficient current assets, a ratio called liquidity ratio is used. This ratio is calculated as:
Liquidity Ratio = Current Assets / Current Liabilities
This ratio should be 1:1 or greater as this value signifies that the company has enough current assets to meet its current liabilities. At the same time, this value should not be too high because it means the company is losing money by way of returns when much of its assets is liquid. In other words, assets with high levels of liquidity offer only lower returns on investment because the risk is also lower. When a company or an individual has more liquid assets then they are settling for a lower return on their investment. This is why the liquidity ratio should be around 1:1 in order to ensure that the current liabilities are met.
Finally, from an investor's standpoint, when he/she is able to convert assets into cash within a short time frame and without any loss in value or cash, then that investment is said to be liquid.
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