Liquidity refers to the ability to convert assets to cash without significant impairment.
An asset which can be sold quickly without impairment is said to be highly liquid. An asset which cannot be sold quickly, or which can only be sold quickly at a significant discount to the asset’s fair value, is said to be illiquid.
Assets are listed on the balance sheet in order of liquidity. Thus, cash and equivalents are listed as the first asset on the balance sheet. Other liquid assets include traded securities and money market instruments. Trade receivables are also considered to be highly liquid. These assets can be sold in a matter of days or even hours. Other assets, however, such as specialized machinery and real estate, may take many months to sell and often involve significant transaction costs.
The term liquidity can also refer to the general state of the business. When a business is highly liquid, the business has ample current assets which can be used to satisfy liabilities. There are several ratios which can be used to determine the general liquidity of a business. The most widely used liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio compares the company’s current assets to its current liabilities. The quick ratio compares the company’s current assets, excluding inventory, to the company’s current liabilities. The cash ratio compares only cash and equivalents to current liabilities. These ratios will lead to a result of greater than 1 when the assets in the numerator are greater than the liabilities in the denominator. The greater the result of these ratios, the higher the degree of liquidity.
