Difference Between Liquid and Illiquid Assets

Edited by Diffzy | Updated on: April 30, 2023

       

Difference Between Liquid and Illiquid Assets

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In the investment world, it is imperative to know about assets and their types. An asset is anything that provides a current, future or potential economic benefit for an individual or any other entity. There are different types of assets ranging from current and non-current assets to liquid and illiquid assets. Current assets refer to those assets that can be used up before the accounting year ends, while non-current assets are those assets which do not get used up in a single year, they last longer. However, the concept of liquid and illiquid assets is a little challenging. Liquidity can be defined as the amount of cash in the form of ready cash or assets available to be used to fulfil financial responsibilities. It plays a vital role because liquidity ensures you have enough cash in emergencies. This article attempts to describe the concept of liquid and illiquid assets and draw the significant differences between them. A liquid asset can be quickly sold without a substantial loss in value. On the other hand, an illiquid asset cannot be resold soon without a significant loss in value.

Liquid Assets vs Illiquid Assets

The critical difference between liquid and illiquid assets is that liquid assets may be converted into cash quickly during any emergency without incurring a significant loss, while illiquid assets are those assets that cannot be readily converted into cash during an emergency except by incurring a considerable loss. Liquid assets have high financial security, while illiquid assets have low financial security. Liquid assets are easily accessible to investors, while illiquid assets are not easily accessible to investors. Liquid assets tend to suffer from high instability, especially during inflation in the country (consistent increase in the general price level of an economy). Illiquid assets enjoy more stability than liquid assets. Liquid assets are generally financed through short-term borrowings, while illiquid assets are funded through long-term borrowings. Liquid assets are usually held for less than a year, while illiquid assets are held for more than a year. Examples of liquid assets are cash, mutual funds, certificate of deposit, shares etc. Examples of illiquid assets are machinery, vehicles, land, intangible assets, etc.

Difference Between Liquid Assets and Illiquid Assets in Tabular Form

Parameters of Comparison Liquid Assets Illiquid Assets
Definition Liquid assets are assets that can be quickly comverted into cash that is, they can be quickly sold without a significant loss in value. An illiquid asset are assets that cannot be quickly resold without a significant loss in value.
Convertibility into cash Liquid assets may be easily converted into cash quickly during an emergency. Illiquid assets cannot be easily or quickly converted into cash during emergencies.
Financial security Liquid assets have high financial security since they can easily convert into cash. Illiquid assets have low financial security since they cannot be easily converted into cash.
Accessibility to investors Liquid assets are easily accessible to investors. Illiquid assets are not easily accessible to investors.
Stability Liquid assets lack stability as they are prone to price fluctuations during inflation. Illiquid assets enjoy more stability than liquid assets.
Loss on sale Liquid assets may be converted into cash without incurring any significant loss on the sale of the investment. Illiquid assets cannot be converted into cash without incurring any significant loss on the sale of the investment.
Financing A firm finances its liquid assets through short-term financing. A firm finances its illiquid assets through long-term borrowings or deferred payments.
Holding period Liquid assets are generally held for less than a period of one year. Illiquid assets are generally held for a period of more than a year.

What are Liquid Assets?

Liquid assets are assets that can be quickly converted into cash (by selling) without a significant loss in value of the asset. The formula for calculating the liquid assets of a company is Liquid assets = Marketable Securities + Cash – Current Liabilities.

Features of liquid assets:

  1. The asset should be present in the organised market
  2. The investment should be able to generate interest among many customers
  3. The ownership of a liquid asset must be easily transferable.

Types of Liquid Assets:

  1. Cash-It is the ultimate liquid asset. Besides physical currency, ATM withdrawals, and bank deposits, cash also includes money received via peer-to-peer payment apps.
  2. Treasury bills- A Treasury bill is an instrument of short-term borrowing issued by the Government of India, and it matures in less than one year. They are also referred to as Zero-Coupon Bonds. They are issued by the Reserve Bank of India on behalf of the Central Government to meet its short-term requirement of funds. Treasury bills are always issued in the form of a promissory note. They are highly liquid, have assured yield and negligible risk of default. Thus, they can instantly be sold for cash on the secondary market if you need their value before they mature.
  3. Certificates of deposit-Certificates of deposit are unsecured and negotiable, short-term instruments in bearer form. They are issued by commercial banks and development financial institutions. They are issued to individuals, corporations, and companies during periods of tight liquidity when demand for credit is high, despite the slow rate of deposit growth in banks. They help mobilise large amounts of money for short periods.
  4. Bonds-Some companies buy bonds and hold them till their mature. However, the secondary market for trading bonds is vast, meaning that many types of bonds are relatively liquid investments.
  5. Stocks-Equities may be sold on stock exchanges almost instantly, and publicly traded stocks are considered very liquid. Sale from cash is usually received within a few days.

Analysing liquid assets:

It is vital that a business organisation manages external reporting as well as internal performance. An organization that has more liquid assets has a massive capacity to repay debts as they become overdue. Businesses have strategic methods for maintaining the amount of cash on their balance sheet that is used to pay bills and necessary expenses. Banking industries must maintain reserves to abide by industry norms.

Liquid assets can be analysed using several ratios. The most common ones are solvency ratios. The most important ratios among solvency ratios are current ratio and quick ratio. The current ratio checks whether current assets are sufficient to pay its current liabilities. A quick, on the other hand, is to check whether the company's current liabilities can be paid with liquid assets alone. To cover the company's current liabilities only with the liquid assets. Accounts receivables are included in liquid assets while calculating the quick ratio.

What are Illiquid Assets?

An illiquid asset can be defined as an asset that cannot be quickly resold without a significant loss in value. It may be challenging to sell illiquid assets quickly as there is low trading activity or interest in the issue. There is often a lack of willing investors and speculators to both purchase as well as to sell the asset. Therefore, illiquid assets are characterised by low trading volume, wide bid-ask spreads, and a high level of volatility in their prices.

Types of illiquid assets:

  1. Intangible assets- Intangible assets are assets that cannot be seen or touched. Their benefits can only be felt by the company. Intangible assets include assets like corporate goodwill, brand recognition, intellectual property, and reputation. It can be challenging to assign a market value to intangible assets, and they are highly illiquid.
  2. Land- Land is a fixed asset whose value keeps appreciating. This is because the supply of land remains the same over the years, but its demand is ever increasing. Since the sale of land requires a lot of documentation and is generally not sold within a year, it is an illiquid asset.
  3. Building and infrastructure- Building and infrastructure are fixed tangible assets that cannot be converted into cash immediately. Hence, they are illiquid assets.

Why are illiquid assets associated with increased risk?

Illiquid assets carry higher risks than liquid ones, known as liquidity risk, which often becomes true in situations of market turmoil when the ratio of buyers to sellers is thrown out of balance. In such times, holders of illiquid assets may find themselves unable to unload them at all or unable to do so without incurring a loss.

Illiquid assets also demand a liquidity premium added to their price to compensate for the fact that they may be difficult to dispose of later. During times of financial panic, markets and credit facilities may seize up, causing a liquidity crisis, when sellers of even marketable securities find it extremely difficult to find eager buyers at fair prices.

Benefits of investing in illiquid assets:

  1. Illiquid assets can be worthy investments for those looking for long-term investments. They give a high yield in the future. This compensates for their illiquidity.
  2. Assets like real estate properties grow in value over time, reducing the impact of inflation.
  3. Sometimes, the investment in illiquid assets gives better returns than investments in liquid assets, as the former comes at a significant bargain.

Limitations of investing in illiquid assets:

  1. Liquidity risk-Liquidity risk is a cash crunch for a temporary or short-term period, and such situations generally harm business organisations as well as other profit-making organizations. Unable to meet short-term debt or liabilities, the business corporation tends to end up with negative working capital in most cases. 
  2. Illiquid assets come with more risks for their investors.
  3. The liquidity premium offered on an illiquid asset is too low.
  4. Provisions created against these investments tend to take away a significant portion of their value.

Main Differences Between Liquid Assets and Illiquid Assets (In Points)

  • A liquid asset is an asset that can be quickly sold without a significant loss in value. Illiquid assets are assets that cannot be resold soon without a substantial loss in value.
  • Liquid assets may be easily converted into cash during emergencies, whereas illiquid assets cannot be easily converted into cash.
  • Liquid assets tend to have high financial security since they can be easily converted into cash. Illiquid assets do not enjoy high financial security since they cannot be easily converted into cash.
  • Liquid assets are easily accessible to investors, while illiquid assets are not easily accessible to investors.
  • Liquid assets have low stability as their prices may fluctuate during a period of inflation in the economy. Illiquid assets have more stability.
  • Liquid assets can be sold quickly without incurring a significant loss during the sale. Illiquid investments cannot be sold soon except at a substantial loss in the value of the asset.
  • Liquid assets are financed through short-term sources of finance. Illiquid assets, on the other hand, are funded through long-term sources of finance.
  • Liquid assets are generally held for a period of less than one year. Illiquid assets are typically held for a period of more than one year.

Conclusion

A liquid asset can be defined as an asset that can be quickly sold without a significant loss in value. An illiquid asset can be defined as an asset that cannot be resold soon without a substantial loss in value. It is essential to understand that a firm requires both illiquid assets and liquid assets to run its operations smoothly. Both these groups have different functions within the business, and they are also valued by the investors using other methods. This article has attempted to explain the critical differences between liquid and illiquid assets in a tabular form and in points. It has described the concept of both liquid assets and illiquid assets in detail.

Any enterprise needs to have the right sort of mixture of these asset classes to sustain its activities on a long-term basis. Owning liquid as well as illiquid assets may prove to be beneficial for the company. Possessing a more significant number of liquid assets may guarantee financial capital and security for the company while keeping a greater amount of illiquid assets minimizes portfolio losses when the market is down.  

It is essential to maintain the apt balance between liquid and illiquid assets as owning more of either of them can prove to be damaging as they possess their disadvantages. Thus, it is advised that companies diversify their investments to minimize the loss to be faced in the long run.   

References

  • www.yieldstreet.com
  • www.wallstreetmojo.com

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"Difference Between Liquid and Illiquid Assets." Diffzy.com, 2024. Mon. 20 May. 2024. <https://www.diffzy.com/article/difference-between-liquid-and-illiquid-assets-594>.



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