In the business and corporate world, liquidity is a frequently used term. But do you know what the definition of liquidity in finance and what aspects of it are very important? Keep reading, because in this article we will tell you everything about it.
Whether you want to learn to better control your personal expenses, or you are starting a new venture, understand more about economics concepts it will be of great use to you. With the knowledge that you will find here, you will be able to plan a strategy that allows you to achieve the goals you set for yourself.
What is the definition of liquidity in finance?
Liquidity is a concept of great importance in finance, both personal and in a company or business. This refers to the capacity we have to convert our assets into cash quickly and without losing its value, to be able to face financial responsibilities that arise in the short term.
The degree of liquidity of an asset will depend on two fundamental elements. The first is the opportunities to sell it, which is related to the demand and supply of the market. And the second is the simplicity or complexity of the purchase process as such.
So when we say that an asset is very liquid, this implies that your sale will be easy to carry out, fast and that you do not risk much when selling it, because its value will not change. Due to these characteristics, cash is the most liquid asset that a company or person can have.
Cash would be followed, for example, by the balance in a savings account, which is easily accessible. In contrast, life insurance or even gold are illiquid assets, as it takes a long time to find a buyer willing to pay their market value.
You may also be interested in:
Terms with which liquidity is often confused
There are some terms associated with finance and economics that could cause confusion when it comes to understand correctly what liquidity is. Then we will leave you their definitions, so that you can contrast them with the definition of liquidity and that you do not have any doubts:
- Solvency: it is the ability of a company to generate funds with which to meet its payment obligations agreed with third parties at specific terms (generally, long-term). It has a lot to do with the organization’s reserves.
- Profitability: it is the measure that compares the level of profit obtained with the resources used to obtain it. This is something you should keep in mind if you want to dig deeper into the theory of loanable funds.
Important aspects of liquidity in finance
To better understand the importance of liquidity, you should keep in mind that every company needs liquid assets, but also illiquid assets. The former will allow you to solve any crisis in the short term, while the latter will allow you to obtain profits and greater return on capital.
Thus, the liquidity of a company becomes more important in times when bank credit is scarce. In this situation, and depending on the state of universal banking, it is extremely useful to have highly liquid assets on hand to be able to solve any unexpected inconvenience, or process a last minute transaction.
Just in those moments, it is essential that you are able to calculate the liquidity of your company. This can be done quickly and easily, dividing current assets (which is the sum of the company’s most liquid resources) by current liabilities (set of debts that must be paid in the short term).
When performing the previous calculation, if the result is less than one, this means that your company does not have enough liquidity to face the debts it has at any given time. Even if you have a capital much greater than the debt, you need this to be liquid to be able to pay it quickly.
You may also be interested in:
The ability of a company to pay its debts and increase its capital and reserves is essential for it to survive in the market. Therefore, it is important for a company to establish clear objectives and plan the most appropriate marketing and business strategies to achieve them.
I'm sorry this content was not useful for you!
Let me improve this content!
Tell me, how can I improve this content?