What It Is:

The term "liquid" refers to the ability to transfer hard assets to cash or the state of being in a position where one has sufficient cash on hand to accommodate any and all necessary financial obligations.

How It Works/Example:

There are many varieties of being liquid, including market, accounting, and bank liquidity.

Market liquidity is a financial phrase that describes the possibility of converting an asset to cash within a short period of time with minimal transaction costs while not affecting the price integrity of the asset itself.

Accounting liquidity is very similar but references the ability of a business to meet its ongoing obligations by having sufficient cash on hand to meet the demands of its creditors.

Bank liquidity refers to the ability of a bank or banks to meet the demands of its depositors. As the banking system is highly leveraged, it does not have on hand all of the cash deposited in its system.  Rather, the bank has its capital invested or on loan elsewhere, which is how the bank generates its income. Called fractional-reserve banking, banks loan out money based on the amount of deposits they have. What they keep in the physical bank to meet the normal demands of depositors is called the reserve, which is only a fraction of what the bank lends out. Maintaining the reserve at optimal levels is referred to as bank liquidity. Without safeguards for liquidity in place, a "bank run" can incur, which any banking system wants to avoid at any cost.

Why It Matters:

Any entity which needs to generate and use capital, whether it be a bank, a household, or a business, must have the proper balance between income producing assets and liquid assets such as cash which produce no income. Holding illiquid assets can be a problem when cash is quickly needed.  The consequences can be having to sell valuable assets at a time when the market is not liquid and income or value will be lost.