What is Liquidity

Liquidity is how quickly you can turn an asset into cash without losing much value. Money is the most liquid asset, as it is already cash, while stocks, bonds, and other financial securities also have a high level of liquidity. Real estate, private company stock, collectibles, and online businesses are illiquid assets because they require time and money to convert to cash.

In the context of digital real estate, liquidity applies to a business’s ability to pay its short-term debts (accounting liquidity) as well as how easily the entrepreneur can sell the company (market liquidity). Companies prioritize having cash on hand if they value flexibility and accounting liquidity. Having cash reserves helps during market fluctuations and is beneficial in the event of sudden growth opportunities, so that the company does not have to rely on loans. 

The market liquidity of a company is influenced by factors such as high demand from potential buyers, ease of valuation, and the depth and activity level of the marketplace. 

High market liquidity also has its downsides. Easily traded liquid assets, like stocks and bonds, are bought and sold on a whim which enables emotional investing, for example out of fear and greed. This can create large, rapid swings in the market, otherwise known as market volatility. Illiquid assets, like digital businesses, often come with liquidity premiums – extra returns that compensate investors for the risk of holding such assets. By avoiding illiquid assets and the windfall that comes from selling an online business, investors miss this return on investment (ROI) and have lower overall profits.

Key Points About Liquidity

• Liquid vs. illiquid asset pricing: Liquid assets generally trade at a premium, while illiquid assets trade at a discount to expedite their sale, assuming all other factors are equal.
• Liquidity vs. solvency: Solvency refers to an individual or company’s ability to meet long-term financial obligations, which determines whether they can continue operations over a long period. This is in contrast to liquidity, which relates to metrics of near-term financial health, such as the ability to pay next month’s bills.
• Operating Cash Flow Ratio: This financial metric shows a company’s ability to cover current debts with cash from its core operations. It’s a popular measure of a company’s accounting liquidity. You can calculate it using the Operating Cash Flow Ratio = Cash Flow from Operations / Current Liabilities.
• Liquidity vs. profitability: While often conflated, these are distinct but related concepts. Having money on hand (liquidity) can help you make more money because you can quickly convert your assets into cash to pay debts or invest in other assets. Conversely, making a lot of money (profitability) can raise liquidity because it provides the resources to invest in assets that you can quickly turn into cash.