Liquidity Defined

If you run across the term "liquidity" in your financial reading, know that it has several meanings. With companies, liquidity refers to their cash, as well as assets that can be quickly converted into cash, such as certificates of deposit, money market funds, and investments in stocks and bonds. Companies with high liquidity are less risky, but they might also grow slowly, since assets that could be put to work increasing sales are instead kept easily available.

Liquidity matters because, ultimately, a company's value is based on how much cash its operations generate. Why buy shares of Acme Explosives Co. (ticker: KBOOM), for example, if people aren't clamoring for products that blow up roadrunners? It's not a company likely to generate much cash.

When you're discussing a stock, liquidity refers to the market's ability to handle a large volume of trading without significant price swings. Major investors, such as mutual fund managers, care about this because if they want to buy a million shares, they don't want their purchases to drive up the stock price too much. For example, if Acme Explosives has only 2 million shares outstanding at $10 per share, there's only $20 million worth that the market can buy or sell. Compared with companies like Microsoft (Nasdaq: MSFT  ) that trade several billion dollars' worth of shares per day, KBOOM is tiny and volatile. It's illiquid.

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