Definition: The ability to sell something you own (ie: an Asset) quickly and without having to drop the price below its fair value to get it sold.Example: Areeb owns 100 shares of the publicly-held LIQD Corporation. The shares are held for him by his brokerage firm. The last trade price for a share of LIQD stock was $40. Buyers continue to enter orders showing that they’re willing to pay $40 per share. Areeb can log into his brokerage account, click a few buttons, sell his shares, and receive $40 for them in no time. Therefore, shares of LIQD are said to be highly liquid.
On the other hand, we have Kayla, owner of a home whose fair value is $500,000. If wants to receive that much for it, she’ll likely have to advertise it for sale, show the house to several potential buyers, accept an offer, allow time for the buyer whose offer was accepted to borrow a good portion of the purchase price, etc. This could take months, and it is the reason why a home is an illiquid asset!
Investeach explains: One of the major advantages of investing in large publicly-held companies is that their shares are liquid. The reason is that with millions of their shares outstanding, there is an enormous number of owners. At any time, a certain portion of them will want to sell their shares. At the same time, there will be many investors intending to become owners. A vibrant exchange between buyers and sellers means that any owner wanting to sell her shares will find buyers ready to purchase them.
Penny stocks: Shares of penny stocks, the smallest of publicly-held companies, can be very illiquid. This is one more reason why they are risky. Based on the last price at which a trade took place, you may believe that you can sell your shares and make a nice profit. You may be surprised that no one is lining up to buy shares of the company at anywhere near this price!
Private companies: Investments in private companies can also be very illiquid. With no market on which their shares are traded, a person wanting to sell his or her ownership interest would first have to figure out where to find someone who might be interested in buying. Once one or more of those people were found, the value would have to be negotiated between the seller and the potential buyers directly.
Stock split: While one of the advantages of a company splitting its stock is to get the price down to a level where investors feel that it is more affordable, another advantage is to increase the number of shares outstanding. If recipients of the new shares that result from a stock split sell some of them, this will enlarge the number of owners, thereby enhancing liquidity.
Accounting: On a company’s Balance Sheet, assets in the Current Assets section are shown in order of higher liquidity to lower liquidity. This means that Cash is shown first, Accounts Receivable (which for most companies should be collected in a month or less) next, followed by Inventory.
Riddle me this:
1. What are the two conditions that make an asset liquid?
2. Identify an asset that is highly illiquid.
3. How are assets ordered in the Current Assets section of a company’s Balance Sheet.
4. What type of publicly-held company has the poorest liquidity?
5. Why is an investment in a private company illiquid?