Liquidation is the process of selling assets to generate cash, both within an investment portfolio and for a business that needs additional capital.
Simply put, liquidation is selling something to create free cash that you can do other things with – from growing your business to finding new investment opportunities to just paying bills.
The word itself comes from the Latin root lique, which means to melt or be fluid. So think of liquidation as the process of merging a complex investment portfolio or business transaction into the simplest measure of value we have: gross dollars and cents.
It should also be noted that in accounting terminology, “liquid” is a common adjective used to refer to an asset that trades easily and efficiently. Assets that are already quite liquid are naturally easier to turn into cash.
If the assets in question are widely traded and there is persistent demand, liquidation is a fairly straightforward process. If the assets are difficult to value or if there are simply not many qualified buyers in the market, liquidation is much more difficult.
Going back to the earlier merger analogy, some assets require a lot more energy and time before they are fully liquid.
Cash in any major currency is the most liquid asset because its very purpose is to enable easy and efficient transactions. Assets that can be easily and quickly turned into cash are almost as good and are also considered highly liquid.
For example, blue chip stocks can be sold during any trading session. You can’t sell them on weekends when Wall Street is closed, and you can’t buy groceries with your inventory. But in a day or two, you can easily turn those shares into cash. Stocks and other “marketable securities” – including bonds and exchange-traded funds – are often considered almost as good as cash for accounting purposes.
Illiquid assets come in all shapes and sizes, but are generally difficult to value or difficult to sell effectively. Consider buying or selling immovable, a process that often takes weeks or even months. Even though you can find the approximate value of your home on the internet, turning that asset into cash is not a simple process.
Another class of illiquid assets includes goods that are much more difficult to value, such as works of art by a famous painter that are one of a kind. There are also illiquid assets that have tangible value, but only to a small, specialized group of potential buyers, such as expensive industrial equipment or a business jet.
If you’re running a business, liquidity is important to keep the lights on. An automaker can’t just trade in new vehicles to build a factory or pay the power company, after all. Similarly, a full-time investor may have a multi-million dollar portfolio but will not be able to pay the mortgage unless he holds some of those assets in cash.
Anyone with illiquid assets should therefore plan to avoid becoming “cash poor” and ending up in a situation where you are trying to solve real problems with wealth that only exists on paper.
Liquidation can involve simple profit taking or a strategic desire to redeploy the value of an asset elsewhere. Forced liquidation is another story. When you run out of money, whether as a business or a consumer, you have to sell certain assets whether you like it or not.
Liquidating assets can be good and natural in some cases, such as when an investor intentionally exits a position to make a profit or when a company liquidates assets to redeploy their value in an area it deems strategically important.
However, forced liquidation is almost always a bad thing. First, it is normally the result of creditors demanding payment when there is simply no money to do so. This in itself is a bad sign. If you are short on cash and are in this situation, you may be forced to unload an asset quickly at a lower price rather than when it reaches full value. This makes the cash crunch even worse. If you hold strategic assets and then sell them just to generate emergency cash, it could ultimately undermine your long-term plans.