When an asset or investment cannot be quickly and easily converted into cash at the current fair market price
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What Does Illiquid Mean?
Illiquid is a term commonly used to describe assets or investments that cannot be quickly and easily converted into cash at the current fair market price. An individual, a company, or other entity may also be described as illiquid if they are cash poor and primarily hold only illiquid assets.
Note that there are two aspects to liquidity. The first is the ease or speed at which an investment or other asset can be converted into cash. The second aspect is price – can the asset be sold relatively quickly without having to offer it at a substantial discount to the current market price or sell it at a loss (for less than the price at which it was purchased). Both aspects can be summed up in the question, “Does the seller have immediate access to ready and willing buyers?”
In addition to cash, the most liquid assets are typically financial securities with consistently high trading volumes, such as blue-chip stocks, government bonds, and major commodity futures.
For individuals, liquid assets usually consist of cash, money in a regular checking, savings, or money market account, and liquid investments such as stocks, bonds, or shares in a mutual fund or exchange-traded fund (ETF). More illiquid personal assets may include real estate, jewelry, and art, or other collectibles.
Structure of Market and Depth of Market
A seller’s access to ready and willing buyers may be determined by the structure, or nature, of the market in which an asset is bought and sold, or it may be determined by the depth of market (DOM) – that is, by how many potential willing buyers exist in the market for the asset.
Real estate is an asset that is considered illiquid primarily because of how the real estate market operates or is structured. Before a property is bought or sold, there are time-consuming procedures required, such as inspections and appraisals.
In addition, real estate purchases are commonly financed, and the financing usually takes some time for the buyer to secure. Thus, even if a buyer willing to pay the seller’s initial asking price when the seller offers a real estate asset for sale, it usually still takes a significant amount of time for the sale to be finalized and for the seller to receive the proceeds of the sale.
Depth of the market is an issue that is chiefly considered in the buying and selling of financial securities through an exchange or in an over-the-counter (OTC) market. The depth of a market refers to the number of readily available buyers or sellers.
The market for a popular, widely traded stock such as Amazon (NASDAQ: AMZN) is typically very deep. In contrast, the market for a little-known, thinly traded stock may be very shallow or thin. If there is only a small amount of open interest in a security, or there is very low trading volume, it is usually more difficult for a seller to obtain their desired selling price.
Low open interest or trading volume usually translates into wider bid and ask spreads that make both buyers and sellers settle for less than ideal or desired prices. With some stocks or other securities that are only bought and sold in over-the-counter markets and with a very thin depth of market, sellers who need to liquidate an investment immediately may have to accept a selling price that is far below the fair market price or true value of the investment.
Illiquidity in Business
In business accounting, companies divide their assets into liquid assets, also referred to as short-term assets, and fixed, or capital, assets, which are considered illiquid.
Examples of liquid business assets include cash on hand, accounts receivable, and short-term securities investments (“short-term” is defined in this context as investments that a company plans to sell within one year). Other assets that are less liquid but are considered part of current assets are inventory and prepaid expenses.
It is crucial for a business to maintain adequate levels of liquidity to ensure the ongoing, smooth operation of the business. A company that becomes illiquid may not be able to pay its creditors or suppliers on a timely basis.
Unless the illiquid condition of the business is remedied in fairly short order, its financial troubles may eventually lead to bankruptcy or the need for a costly financial reorganization. Even a company with millions of dollars of assets, if those assets are primarily fixed relatively illiquid assets, may face disruption of its daily business operations, or even insolvency and bankruptcy, if it is unable to find a solution to its cash flow problems.
Related Readings
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