Illiquid (Asset) - Explained
What is an Illiquid Asset?
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Table of ContentsWhat is an Illiquid Asset?How Does an Illiquid Asset Work?Selling Illiquid ItemsExamples of Illiquid AssetsExamples of Liquid Assets
What is an Illiquid Asset?
Illiquid indicates those assets or securities that cannot be sold easily or converted into cash due to shortage of buyers or without loss in its value. A firm may be identified to be illiquid if it lacks the cash needed to meet its current debts or obligations. A business can survive without profit but not without cash. That is why illiquidity is one of major causes of business failure.
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How Does an Illiquid Asset Work?
In a business, illiquidity refers to a company that does not have enough cash flows to make required debt payments. The company may still have other assets like fixed assets (land, buildings, machinery), which have their own value. However, they are not easily sold to convert them into the cash required for debt payments. Selling of the illiquid asset is not part of company's core business. In times of financial crisis or need, the company may choose to liquidate its other assets to avoid bankruptcy. If this is not done on time, it can lead to selling the assets at a much lower price than regular market price. This is also known as fire sale.
Selling Illiquid Items
Due to lack of available buyers, there tends to be increasing discrepancies between price demanded by the seller and the price bid by the buyer. This leads to larger bid to demand spreads than in a normal and orderly market. Hence, the seller fails to realize all available value, especially if the sale needs to be done rather quickly. The liquidity of assets may change overtime due to certain market influences. Typical examples include collectibles that are valued based upon an items popularity. This may fluctuate overtime and can lead to highly volatile pricing.
Examples of Illiquid Assets
Examples of illiquid assets include penny stocks, microcap stocks and nanocap stocks; ownership interests in private companies; collectibles like art and antiques; partnership shares in hedge funds and alternative investments; certain types of options, futures and forward contracts; and some types of bonds and debt instruments. Since these assets are not commonly traded, it is difficult to find the true market value specially when it must be sold on an urgent basis.
Examples of Liquid Assets
Some examples of liquid assets include securities such as stocks, EFTs, mutual funds, bonds and commodities listed at major exchanges. These are very liquid and can be sold almost instantaneously at market prices during the regular market hours. In addition to these, precious metals like gold and silver are also considered as fairly liquid. Trading these assets other than regular market hours may lead to illiquidity as most of market participants are not active during that time.