What is liquidity?

Liquidity is the ease for an asset to be converted into cash without significant loss of value. This concept refers to the agility with which an investor can have an investment to have money in his hands again without, therefore, having to have losses.

When making an investment, an investor exchanges an amount of money for an asset. This asset can be a government bond, a savings account, company stock, or property, for example.

If that investor has some unforeseen circumstance and needs the return of the money, he will have to get rid of the asset or right that he acquired. However, some of these investments are more liquid than others, meaning it is easier and faster to convert them into cash than others.

Investment liquidity

An example of a highly liquid investment is the savings account. If the investor needs to redeem what he has deposited in savings, he can do so immediately. A property, on the other hand, is a low-liquidity investment, as it can go on sale for months without anyone being interested in buying.

To sell your property quickly, the investor would need to price it lower than the market. That is why liquidity is said to encompass both the agility dimension in cash conversion and the loss of value in its meaning. Liquidity risk is the possibility of not being able to trade an asset without affecting its price.

Unless you are certain that your money will not need to be redeemed in the short term, it is recommended that you consider highly liquid assets for investments. If you have other resources to use in the event of a financial emergency, it may be interesting to invest in low-liquid assets, if they have a higher return prospect in the long term.

Liquid trap

In monetary economics, the  liquidity trap  is a process identified by economist John Maynard Keynes in which an economy, after successive cuts in interest rates to stimulate consumption, would reach rates close to zero.

With such low interest rates, economic agents would have no incentive to make long-term investments, preferring to keep their funds in cash or make short-term investments, which would contribute to exacerbating the recession.

Credit liquidity analysis

Liquidity can also be understood as the measure of the resources that a company has to settle its obligations with third parties. To measure this liquidity, indicators such as current liquidity, dry liquidity, immediate liquidity and general liquidity ratios are used.

You may also be interested in liquidity ratios, to learn more about the indicators that measure the financial health of a company.