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Liquidity Meaning & Importance of Liquidity in Financial Planning

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What do you mean by Liquidity?

Liquidity is the degree to which a security can be quickly purchased or sold in the market at a price reflecting its current value. Liquidity in finance refers to the ease with which a security or an asset can be converted into cashat market price.

Why is liquidity important to financial planning?

It is vital to factor in liquidity while planning your investments to ensure that your current needs do not eat into your long-term investment goals.

Following are some of the reasons why liquidity is essential for financial planning:

  1. Provides provisions for cash reserves

    Irrespective of the amount you invest in non-liquid assets, it is advised to keep a small amount aside for emergencies. The ideal amount for such reserves may vary from person to person based on their short-term needs. However, as a thumb rule, it is usually advised to keep at least three months’ income as cash reserve.
  2. A balance for liquid and non-liquid securities

    Ideally, liquid assets such as mutual funds, stocks, bonds, and other alternative investment allocations should be basis your age. For instance, if you are 25-years old, you should allocate reasonable corpus to liquid funds and the remaining to non-liquid assets.

How to Measure liquidity?

Companies use liquidity ratios to gauge their liquidity and measure their financial health. The three most important ratios to measure liquidity are:

  1. Current Ratio

    This calculates a company's current assets against its current liabilities. It determines whether a company can pay off all its short-term debt with the money received from selling assets.

    Current Ratio = Current Assets / Current Liabilities
  1. Quick Ratio

    This is similar to the current ratio but only considers accounts receivable, cash, and bonds/stocks as assets.

    Current Assets = Current Liquid Assets / Total Liabilities
  1. Cash Ratio

    This ratio amounts to cash divided by current liabilities. This is helpful when a firm can only use its cash to pay off debt. If the cash ratio is 1 or greater, the business has plenty of liquidity and would probably face no problems paying its debt.

    Cash Ratio = (Cash and Cash Equivalents + Short-term Investments) / Current Liabilities

Examples of Liquid Assets

In terms of investments, equity funds, as a class, are among the liquid assets.

Cash, by default, is the most liquid asset since it doesn’t need to be traded or converted. Bonds and stocks can typically be converted into cash in about 1-2 working days.

Role of liquidity in investments

Liquidity plays a crucial role in balancing your portfolio with tradeoffs between risk and return.  Let’s understand this better:

  1. Liquidity of assets helps accelerate transactions

    g liquid assets `reduces the time you need to spend on finding a buyer for the asset. Stocks are an excellent example of liquid assets that can be easily traded on the stock exchange on any working day.
  1. Liquidity simplifies the selling process

    It is easier to discover a buyer for a liquid asset than for a non-liquid asset. However, this does not mean that you should not have non-liquid assets at all. Instead, it would be prudent to not depend on non-liquid assets for emergencies.
  1. Liquidity is an overlooked attribute

    The significance of liquidity in the investment realm is utterly underrated. In their race to secure the future, several investors skip making provisions for unforeseen events. Thus, not possessing liquidity can force you to dig into your investment plans or your savings, thus crushing their very purpose.
  1. Liquid assets maintain their value
    Unlike various non-liquid assets, liquid assets manage to retain their value, to an extent, when they exchange hands.

Understanding your financial assets and their liquidity levels is essential to having a fool-proof investment plan. Also, note that high liquidity could mean substantially lower returns than those from long-term investments. Investing in all sorts of asset classes might help keep your finances more stable. Happy investing!