Liquidity

Liquidity

What is Liquidity?

Liquidity is a word used in finance and accounting. It means how quickly and easily you can turn something into cash.

Cash is the most liquid asset because it is already money. You can use it immediately to pay for things.

Why is Liquidity Important?

Businesses and people need liquidity to pay bills and buy things. If you have money in your bank account, you have good liquidity. If all your money is in a house or a painting, you have poor liquidity because you cannot use it immediately.

Good liquidity means you can pay your bills on time and deal with emergencies.

Liquid and Illiquid Assets

Liquid Assets are things you can quickly turn into cash:
• Cash in your wallet
• Money in a bank account
• Shares that you can sell easily
• Government bonds

Illiquid Assets are things that take a long time to turn into cash:
• Houses and buildings (property)
• Land
• Expensive paintings or antiques
• Machinery and equipment

For example, if you need £1,000 tomorrow, you can easily take it from your bank account. But you cannot sell your house by tomorrow - it might take months.

Liquidity in Business

Businesses must manage their liquidity carefully. They need enough cash to:
• Pay staff wages
• Pay suppliers
• Pay rent and bills
• Buy stock and materials

A business might own valuable things like buildings and machines, but if it doesn't have enough cash to pay its bills this month, it has a liquidity problem.

The Liquidity Crisis

Sometimes a business has a "liquidity crisis". This means it doesn't have enough cash to pay what it owes, even though it might own valuable assets.

Imagine a shop that owns the building it trades in. The building is worth £500,000. But this month, the shop only has £1,000 in the bank and must pay £5,000 in bills. The shop is rich in assets but poor in liquidity.

Measuring Liquidity

Accountants use special ratios to measure liquidity. Two common ones are:

Current Ratio = Current Assets ÷ Current Liabilities This shows if a business can pay its short-term debts.
Quick Ratio = (Current Assets - Stock) ÷ Current Liabilities This is stricter because stock takes time to sell.
A ratio above 1 is usually good. It means the business has more assets than debts.

Personal Liquidity

Liquidity is important for people too, not just businesses.
Financial advisors often recommend keeping some "liquid savings" - money you can access quickly in emergencies. This might be 3-6 months of living expenses in a bank account.

You might have money invested in property or pensions, but you cannot access this quickly. So you also need liquid savings for emergencies.

Liquidity and the Economy

Banks and the whole economy need liquidity too. During the 2008 financial crisis, many banks had a liquidity crisis. They owned valuable assets but couldn't turn them into cash quickly enough.

The Bank of England and other central banks help by providing liquidity to the financial system when needed.

Summary

Liquidity means how quickly you can turn something into cash. Good liquidity is essential for paying bills and dealing with emergencies. While it's good to own valuable assets like property, everyone needs some liquid assets too - money they can use immediately.

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Vocabulary Task
Match the words with their meanings:
1. Liquidity
2. Asset
3. Cash
4. Crisis
5. Ratio
6. Debt
Meanings:
• A) Money you owe to someone
• B) A serious problem or dangerous situation
• C) Physical money (notes and coins) or money in the bank
• D) How quickly you can turn something into money
• E) Something valuable that you own
• F) A comparison between two numbers
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Comprehension Questions
1. What is the most liquid asset?
2. Give two examples of liquid assets.
3. Give two examples of illiquid assets.
4. Why might a house be considered illiquid?
5. What is a liquidity crisis?
6. In the shop example, why does the shop have a liquidity problem even though it owns a valuable building?
7. What do financial advisors recommend keeping for emergencies?
8. What does a current ratio above 1 mean?
9. Why is liquidity important for businesses?
10. In your opinion, is it better to have all your money in cash or all your money in property? Explain your answer.
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Answers to Vocabulary Task
1-D, 2-E, 3-C, 4-B, 5-F, 6-A
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Answers to Comprehension Questions
1. Cash is the most liquid asset.
2. Any two of: cash in your wallet, money in a bank account, shares that you can sell easily, government bonds.
3. Any two of: houses and buildings (property), land, expensive paintings or antiques, machinery and equipment.
4. A house is illiquid because it takes a long time to sell - it might take months to turn it into cash.
5. A liquidity crisis is when a business (or person) doesn't have enough cash to pay what it owes, even though it might own valuable assets.
6. The shop has a liquidity problem because although the building is worth £500,000, the shop only has £1,000 in cash but needs to pay £5,000 in bills. The building cannot be turned into cash quickly enough.
7. Financial advisors recommend keeping 3-6 months of living expenses in liquid savings (in a bank account).
8. A current ratio above 1 means the business has more assets than debts / the business can pay its short-term debts.
9. Liquidity is important for businesses so they can pay staff wages, pay suppliers, pay rent and bills, and buy stock and materials on time.
10. (Answers will vary) Sample answer: It is better to have a mixture of both. Cash gives you liquidity for emergencies and daily expenses, but property can increase in value over time. Having only cash means missing opportunities to invest. Having only property means you cannot pay for things quickly.