To understand the notion of liquidity, look at the company in the following manner: at a given point in time, the balance sheet shows the company’s assets and commitments. This is what the company has done in the past. Without planning for liquidation, we nevertheless attempt to classify the assets and commitments based on how quickly they are transformed into cash.
When will a particular commitment result in a cash disbursement? When will a particular asset translate into a cash receipt? A company is illiquid when it can no longer meet its scheduled commitments. To meet its commitments, either the company has assets it can liquidate or it must contract new loans. Of course, new loans only postpone the day of reckoning until the new repayment date.
By that time, the company will have to find new resources. Illiquidity comes about when the maturity of the assets is greater than that of the liabilities. Suppose you took out a loan, to be repaid in 6 months, to buy a machine with a useful life of 5 years.
The useful life of the machine is out of step with the scheduled repayment of the loan and the interest expenses on it. Consequently, there is a risk of illiquidity in the event the investment is not very profitable. Similarly, at the current asset level, if you borrow 3-month funds to finance inventories that turn over in more than 3 months, you are running the same risk.
The risk of illiquidity is the risk that assets will become liquid at a slower pace than the rate at which the liabilities will have to be paid, because the maturity of assets is longer. In a sense, liquidity measures the speed at which assets turn over compared with liabilities.
