What is liquidity?

Liquidity describes how easily something can be converted into cash without losing value. It applies to an asset, which is liquid when it can be sold quickly at a fair price, to a market, which is liquid when many buyers and sellers keep prices steady, and to an organization that has enough cash to pay what it owes. Running short of it is how otherwise healthy businesses fail.

How it works

A business can be profitable and still run out of cash, because the money it is owed arrives later than the bills it must pay. Liquidity is the buffer that covers that timing gap. Cash and bank deposits are fully liquid; stock in a warehouse, equipment and property are less liquid because selling them takes time or forces a discount.

The trade-off is that liquid holdings usually earn less. Holding more cash lowers the risk of a shortfall but leaves less money working elsewhere. A common measure is the current ratio: current assets divided by current liabilities. A value below one suggests short-term bills exceed short-term resources.

Example

Say a small retailer holds 20,000 in cash and 60,000 in unsold stock. It owes suppliers 50,000 due in 30 days. The current ratio is (20,000 + 60,000) / 50,000 = 1.6, which looks comfortable. But only the 20,000 in cash can pay bills right now. If stock sells slowly, the retailer must sell it at a discount or borrow to cover the other 30,000. The ratio looked healthy while the actual liquidity was thin. These numbers are illustrative.

How to model it in Machinations

Draw a cash Pool and a stock Pool. Connect a Source of customer payments through a Delay to the cash Pool, and a Drain of supplier payments out of it. Add a Register for the current ratio and an End condition that stops the Play when cash falls below zero. Play many times with varying sales speed, and change the Delay length to see how payment timing alone can drain the cash Pool.