Liquidity is a measure of how easily an investment can be sold and converted into cash.
Liquid assets are those that can be converted into cash without any change in the asset value.
Liquid assets are much more difficult to convert to cash and may decrease in value when converted.
Before investing in the stocks, investors will often weigh a stock's liquidity with its potential for gain.
WHY IS LIQUIDITY IMPORTANT?
Liquidity allows investors to quickly convert their investments into cash in order to reinvest or spend on goods and services. Additionally, it gives investors the flexibility to react to the ups and downs of the market, ultimately reducing risk.
TYPES OF LIQUIDITY
Market Liquidity - is liquidity that applies to markets. The stock market is considered very liquid since the bid price and ask price for a share are usually pretty close, meaning investors do not have to forfeit unrealized gains in order to sell quickly. On the other hand, the real estate market is considered to have low liquidity. This is particularly true in a buyer’s market where sellers will have to give buyers deep discounts in order to sell property quickly.
Thus, liquidity is important for a number of reasons, but primarily because it impacts how quickly you can open and close positions. A liquid market is generally associated with less risk, as there is usually always someone willing to take the other side of a given position. This can attract speculators and investors to the market, which adds to the favorable market conditions.
Accounting Liquidity - a measure of how easily an individual entity can sell their assets in order to pay their debts. Continuing with the example of paintings, a fine art collector would not necessarily be able to get the full value for their paintings in a short time period compared to someone with an equivalent amount of cash. Accounting liquidity is usually expressed as some type of ratio comparing liquid assets to current liabilities, meaning financial obligations that are due within one year.