Liquidity in finance is all about how quickly an asset or security can be converted into cash.
If an asset has high liquidity, it means it can easily be cashed out without losing its value, like a stock.
If an asset has low liquidity, it can be difficult to unload quickly, such as real estate.
Companies or individuals can run into trouble with creditworthiness if they have too much tied up in illiquid assets because they run the risk of not being able to sell enough assets to meet financial obligations.
An example of this might be if an individual buys a commercial property and relies on lease payments from renters to pay their bills. If the market for renting commercial space dries up – as it did in many areas during the COVID-19 pandemic – the property owner finds themselves in a predicament where they cannot find renters or sell the property in enough time to make their house or car payments, and they default.
The same concept applies to firms. Companies with too much money tied up in assets that cannot be converted to cash are seen as less attractive to investors and lenders.
However, it is important to remember that liquidity is a balancing act. Holding too much cash means a company or individual is not investing excess funds – and that extra cash is sitting around doing nothing.