What is Liquidity?

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DEFINITION:

Liquidity refers to the speed and ease with which you can buy or sell an asset – essentially convert it into cash – without changing its price.

Understanding liquidity

A liquid asset is cash – or an asset that you can convert to cash quickly and at a reasonable price. Stocks and bonds are liquid assets, but real estate and investments are not. The liquidity of an investment is critical if you want to buy or sell it on short notice. A company must have a certain level of liquidity to meet short-term financial obligations, such as upcoming bills. Solvency, on the other hand, refers to a company’s ability to pay long-term debts. There are various formulas for assessing the liquidity of a company.

EXAMPLE

Stocks have different levels of liquidity. Large-cap stocks (typically companies with a market value of at least $10 billion) tend to be more liquid than small-cap stocks (typically companies with a market value between $250 million and $2 billion). This is because there are more buyers and sellers for large-cap stocks. Apple, for example, is a very liquid stock – you can buy or sell it quickly at the market price. There are many Apple shares traded every day (more than 25 million on average), so it’s easy to find a buyer or seller. If you want to buy or sell a stock with a lower trading volume, such as Freddie Mac, it may take more time. As a result, the stock is considered less liquid.

Takeaway

To understand liquidity, think about water…

Water is a liquid ready to drink – you do not have to turn it into something else first. But you cannot drink an ice cube as it is. You have to wait for it to melt and become water. In the same way, with cash you can buy something

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