Liquidity is the ability to convert assets into cash immediately. It’s also a useful tool as an indicator of financial health.
If a business is applying for finance from a bank, one of the factors that will be assessed is liquidity. As a lender, the bank will be interested in ensuring that it recoups all of the money it loans, along with interest. In doing this, the bank will want to avoid risk as much as possible. Part of this means being highly discerning about the kinds of businesses it approves for finance. One of the key deciding factors is liquidity.
For SMEs, the importance of liquidity cannot be underestimated. It can often be measured with the use of liquidity ratios such as the current or quick ratio. A good ratio score here means that the company isn’t likely to rely on too much credit, which bodes well for it in terms of operations as well as with regards to credit applications.
As an investor, it’s always prudent to make sure that you diversify your investments. This is a risk management measure that ultimately protects you. Some of your investments should be easily converted into cash. An important step is consideration of how you will access your wealth where necessary. For example, if most of your net worth is tied up in your home, it won’t be easy to tap into its value.
In the financial crisis of 2008, many investors had illiquid assets trapped at a time when they needed money the most. As the ripple effects of the situation began to hit home, more people realised that they had invested in ways that left them exposed when some banks shut down. There is no doubt that there is also inherent risk in keeping liquid assets in the form of cash. (Putting it under the mattress isn’t advised!) Despite this, it can come in handy in times of emergency.
