Blog

One of the most critical concepts in finance and investing. ‘Liquidity’ means ‘the ease with which an asset or security can be converted into ready cash without impacting its market price.’ Simply put, liquidity is how quickly you can turn an asset into ready cash.

Understanding Liquidity

Let us understand this concept with an example. Hemant has bought a car for Rs 5 lakhs. He has also invested Rs 10 lakhs in stocks of bluechip companies. He has a medical emergency and needs Rs 3 lakhs for an immediate surgery. In this case, Hemant can sell stocks worth Rs 3 lakhs and get the money in his bank account in maximum one day. He cannot get these funds at such a short notice by selling his car.

So in our example, stocks are the more liquid asset as these can be converted to cash easily anytime. The car on the other hand is an asset which offers very low liquidity as it may need an indefinite time period to get sold.

The Curious Case of Liquidity

Liquidity is important for businesses, investors, traders and for the common man alike. It is one of the most important concepts of finance which is many a times ignored. Let us now look at two interesting cases on ‘Liquidity’.

The collapse of Lehmann Brothers (2008)

On September 15, 2008, the 164 year old bank, Lehmann Brothers Holdings Inc. filed for bankruptcy triggering a global financial crisis. Though the root cause of the financial crisis was sub-prime mortgages, it did not cause the collapse of Lehmann Brothers. In 2008, Lehmann had $639 billion in assets which were sufficient to cover the $613 billion in debt. However, these assets were difficult to sell. Lehmann couldn’t sell them to raise funds or ready cash. It was this liquidity problem that led to its bankruptcy.

Berkshire Hathaway & Warren Buffett (2008)

At the end of 2008, another famous financial company, Berkshire Hathaway had $24 billion in cash or cash equivalents. It had an additional $27 billion in fixed maturity securities of which half were government securities. It was this large cash balance which insulated Berkshire from the market turmoil and global melt-down.

Warren Buffett, the legendary investor and Chairman and CEO of Berkshire Hathaway invested $5 billion in Goldman Sachs shares in 2008 to bail out the bank. Berkshire made a profit of $3.7 billion when it redeemed those shares in 2011. So the large cash reserves helped Berkshire Hathaway make strategic investments at the right time and reap massive profits from these.

Why is liquidity important?

• Liquidity is super critical for the common man. In these times of uncertainty, it is very important for the common man to build and keep a cash reserve (ideally a six month reserve for all monthly expenditures). This would help a person in difficult situations like job loss, unexpected healthcare costs and any personal financial emergencies.
• Liquidity is important for investors and traders as they need to have access to the wealth that they are building. If the money is invested in highly illiquid investments or locked in long term investments, they may have a cash crunch and may not be able to book profits. There is also a possibility of losing out on good investment opportunities as there was no liquid cash or funds available to invest.
• Liquidity is important for businesses to be able to borrow money from banks, to make strategic business decisions relating to expansion and to tackle emergency and unforeseen situations like 2008 recession, COVID lockdown etc.