Quite often, you may have heard people say, “Oh, I have liquidity problems right now. I cannot really buy this house.” If you are wondering what they mean by this, let us help you understand. Read on!
What is liquidity?
Simply put, liquidity is the ease with which an asset can be converted into cash without losing its market value. Think of cash—it is the most liquid asset. Similarly, short-term securities and other financial instruments are also highly liquid assets because they can be sold for cash.
If you were to imagine a liquidity spectrum, cash would be on one end, and on the other end, you would find illiquid assets like property or an estate. These are relatively more difficult to convert into cash.
Why is liquidity important?
For an asset to be deemed liquid, it requires a ready market. There is always a market for cash, and therefore, it is the most liquid asset today. If this was not the case, and if markets were not liquid, then selling or converting your assets or securities to cash would be an ordeal that you would not want to go through.
Let us assume that you are in need of cash and want to sell your securities in the market. If you had no buyers, then the value of your securities would be of no relevance because there would be no one willing to pay that particular value. In other words, your securities would be illiquid.
Whether you are an individual or a business, it is imperative that you hold a sufficient value of liquid assets so you can cover your short-term dues like bills and other overheads. If you fail to do so, you may face a liquidity risk, which if gone unattended, may even lead to bankruptcy.
What is financial liquidity?
Financial liquidity indicates the effort it takes to convert your assets into cash. Like we already discussed, if you hold liquid assets like bonds and stocks, these can be converted into cash in a matter of a few days.
On the other hand, if you are an individual or a business with large assets like property and plant and machinery, then you must be prepared to wait before you get their value in cash.
When you are planning an investment, you must always consider its financial liquidity. This is because you do not want to put all that you have into illiquid assets and expose yourself to liquidity risk.
At the same time, you must also hold assets that can be used to raise funds (through a bank loan) or sold later, for instance, during your retirement. A balance of both liquid and illiquid assets is always better. Now, let us look at this in detail.
Importance of liquidity in financial planning
As we mentioned earlier, you must factor in the liquidity of your assets during financial planning. This will ensure that you easily meet both your short-term and long-term needs.
At the same time, you will not need to rely completely on your long-term investments when you know that you have liquid assets to fall back on. However, here are two rules to follow.
Have a cash reserve
No matter how many assets you have, it is important to have some cash that you can instantly access. Moreover, when you hold cash, the value of these funds stays intact unlike with other assets where there is a loss in value during conversion.
Now, you might wonder how much cash you must hold. While this is a personal decision and may differ from one individual to another, we recommend that you have at least three months of your take-home salary.
However, if you need to use this for an emergency, remember to reload or restore the amount.
Keep a healthy split
It is advisable to maintain a 60:40 ratio between your liquid assets and illiquid ones. The former could comprise bonds, stocks, or other liquid funds.
In essence, these will help you in times of emergencies and when you need something to encash quickly. If you are considering other investments, especially those that are publicly traded, then go for the long term because that will have a minimum impact on the price.
If you are going for private investments, then consider keeping a portion of it easily accessible.
You might wonder how to differentiate between these liquid assets and illiquid assets. Well, it’s quite simple. Read on to know more.
What are liquid and illiquid assets?
As the name suggests, liquid assets can be easily converted into cash. Some liquid assets’ examples are cash itself, treasury bills, certificates of deposit (CDs), bonds, stocks, exchange-traded funds (ETFs), liquid mutual funds, and even some precious metals like gold and silver.
On the other hand, illiquid assets cannot be easily converted into cash. Examples of these are real estate, some employee stock options, private equity, collectibles or artwork, and intangible assets.
Individuals and businesses alike must be able to cover their short-term obligations through their liquid assets. In fact, this relationship between the two is known as the liquidity ratio.
Understanding liquidity ratio
Businesses, both big and small, need to be able to meet their short-term financial obligations (typically one year) and the liquidity ratio of a firm usually is an important parameter to judge their ability to do so. A ratio of one and over is considered quite good.
Liquidity ratios are of three types: Current ratio, quick ratio, and cash ratio. We will learn how to calculate these ratios further.
So, it is safe to assume that liquidity is as crucial for the short-term requirements of a business as it is for an individual. It is also equally important when you are investing.
How important is liquidity in investments?
Liquidity provides a balance between risk and return. You may find that highly liquid assets are low in risk, but they are also low in return.
On the other hand, illiquid assets may offer a higher return at the cost of liquidity. Stocks or equity mutual funds may offer higher returns but with a higher degree of risk as well.
Liquidity is important while investing because of the following.
It helps make sales quicker and accelerates transactions
If you want to sell a money market instrument, you are likely to find a buyer and sell your asset quickly too.
Liquidity is underrated
Businesses and individuals do not understand the power of liquidity and end up not keeping reserves for unforeseen events. As a result, they are sometimes forced to dip into their long-term investments to meet urgent fund requirements.
Finally, it is never too late to realize its importance. You can always revise your investments. To begin with, measure your liquidity, especially if you run a business.
Methods of measuring liquidity
Earlier we looked at various liquidity ratios to measure the financial liquidity of a business. Here are the formulas to calculate each of these ratios.
This ratio measures current assets against current liabilities. It is the simplest to calculate. The formula for the current ratio is Current Ratio = Current Assets / Current Liabilities
Also known as the acid-test ratio, it is similar to the current ratio but excludes inventories, accounts receivable, and other assets that are not as liquid as cash.
Quick Ratio = (Cash and Cash Equivalents + Short-term Investments + Accounts Receivable) / Current Liabilities
If you are to calculate the exact amount of cash and cash equivalents your business has in order to cover current liabilities, you may use this formula for liquidity. It excludes everything that does not come under the purview of cash.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Examples of liquidity
In addition to cash, some forms of equity too can be highly liquid. For instance, in the stock exchange, you will notice that a few shares have a bigger market. They usually trade in large numbers and are popular among investors.
Sometimes hundreds of thousands or even millions of these shares might be traded. This high volume of trade contributes to the high liquidity of these shares.
You already know that money markets or certificates of deposit (CDs), or time deposits are also highly liquid. You may invest in these for a short period, and these can be easily sold off too.
The same is the case with exchange-listed stocks and bonds. Moreover, in precious metals, gold coins can also be exchanged for cash quickly and readily.
Liquid assets maintain their market value
When you withdraw from your savings account, your cash is likely to hold the same value as against raising funds by selling your illiquid funds.
For instance, if you are trying to sell your house to meet a sudden financial need, there are high chances that you might have to settle for a price that is much lower than its appraised value.
To sum it up, your financial planning is incomplete if you do not dedicate 60% of your investments to liquid assets. They are an integral component of your portfolio and are unbeatable when it comes to meeting short-term financial obligations.
Therefore, you must avoid digging into your long-term investments and plan for the short-term by investing in some of the best liquid funds.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/understanding-financial-liquidity/