What is Liquidity And Why It’s Important

According to a recent CNN poll, 75% of US voters believe we are already in a recession. That may not be the case, especially with the current low unemployment of 3.7%, but that can change as economic uncertainty persists with more companies pruning their workforce. Should a recession come in 2023, households will have more significant liquidity needs to continue to pay their bills and fixed monthly expenses.

David Edmisten, CFP, Founder, Lead Advisor at Next Phase Financial Planning, said, “To prepare for the possibility of a recession next year, households should make sure their emergency funds equal 12 months, and liquidity is at optimal levels.”

What Is Liquidity?

What is liquidity, and why do we need it? Liquidity is the speed and ease of converting an asset into cash with little or no loss in value. High liquidity means a household or a business has funds free from financial risk. Monetary assets are closest to money, more liquid, and readily accessible for bill payments, emergencies, and living expenses. The current ratio is a benchmark that businesses and households can use to measure its liquid nature.

Being asset-rich and cash-poor can be uncomfortable. It means you have considerable assets you can’t easily convert into cash.  The often-mentioned quote, “Cash is King,” reflects the recognition that cash is a more valuable resource than other convertible assets that differ in their ability to provide liquidity.

Bank savings and checking accounts are liquid assets representing ready money you can access easily. You may have a beautiful home or a vintage watch collection, but it will take time to sell those assets, potentially at a significant discount from their appraisal value.

If you needed $15,000 for an emergency, would it be easier to take out the money from your savings, assuming you have it, or sell your land? Most assets other than cash have some liquidity risk.

Why Is Liquidity Important?

You may only realize how essential liquidity is once you don’t have it or lose it. The inability to pay your bills on time, face an emergency, or pass on an opportunity that requires funding, results from liquidity risk. Without liquidity, you may pay for your needs with credit cards that carry toxic interest rate costs. 

The downside of cash is that you won’t earn a return unless you can put it into high-yielding savings accounts, which provided meager income until recently. 

Few landlords will accept rent payments by bartering your tangible assets like a bicycle, a watch, professional skills, or labor. Your landlord would prefer your monthly check of $1,200 to a hardly used hybrid bike valued at the same amount.

Having cash has always been important, especially during uncertain times. Liquidity is essential, especially during economic downturns when job losses rise the most. Having liquidity is valuable when markets fall and you want to take advantage of market turbulence. Someone you admire invites you to consider becoming a partner in their start-up is an opportunity you hoped to find, but you happen to be illiquid and need help accepting the offer.

Your Financial Plan Should Make Room For Liquidity 

Households should review their financial goals with their financial advisors, adjusting their financial plans to provide liquidity. Whether households have  5% or 20% of their net worth in liquid assets depends on their circumstances. We spoke with several financial experts about the importance of liquidity and protecting assets. 

Dwight Dettloff, CFP, Founder of Winding Trail Financial, advises, “If someone is concerned that we’re going into recession and that they will be negatively affected, it’s a good idea to funnel dollars into a cash emergency fund whether that’s a separate checking or savings account. Now is a good time to check your spending, make adjustments to either decrease spending, increase savings, and reevaluate any pending purchases.”

Devin Faddoul, Founder of Adda Financial, said,”Generally speaking, portfolio liquidity should not change based on stock market volatility, an economic downturn, or geopolitical events. Instead, you should build up or maintain liquidity in the good times to ride out the scary times. So that you can “sleep at night, your emergency fund should be held in the most liquid asset, cash, and ignore other ‘liquid” accounts like CDs, treasuries, and money market funds, and not anywhere near growth assets like equities and real estate.” 

Market Liquidity

Financial markets are where financial assets or securities, such as stocks and bonds, are bought and sold. Market liquidity refers to the ease of selling financial securities at relatively efficient prices in their respective public markets.

Although financial securities are more liquid through electronic exchanges than selling other household assets, they vary according to factors like a bid/ask and daily trading volumes.

Most Liquid Assets

Assets vary in their ability to convert into cash. The most liquid assets are cash, and interest-bearing accounts, including savings, checking accounts, and cash-equivalent or money market securities. High-yield savings, money market accounts (MMA), and money market mutual funds are relatively liquid but may have minimums or fees if not maintained.

Bonds

Bonds vary in liquidity, with those with more frequent trading and at high volumes having more substantial liquidity than bonds that trade less frequently. US Treasury securities have active secondary markets and are among the most liquid securities. Series I government savings bonds are liquid, but after you hold the securities for the first year.

Municipal and high-grade corporate bonds are less liquid than treasuries but benefit from active secondary markets. High-yield corporate bonds have less liquidity and higher credit risk.

Stocks 

When investing in stocks, the daily trading volumes vary and can indicate greater liquidity. Large-capitalized stocks trade with high volume providing greater liquidity. For example, a large-cap stock like Apple typically trades over 100 million shares daily, allowing investors to buy and sell their shares more efficiently. Small-cap stocks trade with lower trading volumes, with stocks that only trade daily volumes of 100K or below presenting liquidity challenges. 

The bid-ask spreads can also provide clues about liquidity. The bid price is the price the purchaser is willing to pay for a specific security, while the asking price at which the seller is willing to sell. The spread between the bid and ask is the transactional cost between the highest price a buyer is willing to pay and the lowest price the seller will accept. The bid-ask spread measures market liquidity, with smaller or tighter spreads, like for large capitalized stocks reflecting higher liquidity.

The cash value of your life insurance policy is relatively liquid but may have fees and take up to a month to get your money.

Least Liquid Assets

The least liquid assets are investments with longer-term horizons, like real estate or tax-advantaged retirement and college savings accounts for your household’s financial future.

Real Estate

Real estate investing, outside of REIT stocks, is less liquid. Selling your home or investment property can be challenging and is often hurt more by rising mortgage rates, tempering buyers’ enthusiasm. 

Investing in a real estate syndication is less liquid, with your money tied up and an average holding time for the project being about five years. 

Retirement and College Savings Accounts

Don’t count on your retirement or 529 college savings accounts for liquidity. They are long-term assets designed for your financial future. Unless you are 59.5 or older, withdrawing money from your 401k or IRA plans will result in 10% penalties and potential tax liabilities while losing some compounding benefits. Similarly, you can impact 529 College Savings accounts with those costs unless you withdraw money for qualified education costs. 

Differences Between Net Worth and Liquid Net Worth

Net worth is a standard benchmark of your financial health at a point in time. It’s simply the difference between total assets and total liabilities. However, it needs to consider the liquid nature of your assets.

Typically, your net worth will be more than your liquid net worth, which only counts your liquid assets and provides a more realistic snapshot of your available cash position.

Using a net worth statement, you can calculate your liquidity position with a few financial ratios.

Liquidity Ratios

A liquidity ratio indicates the number of months a household has to meet its fixed monthly costs, monetary assets/fixed monthly expenses.

For example, if you have $6,000 in monetary assets and $3,000 in fixed monthly expenses, you can cover two months, a relatively short time, with six months preferable.

Emergency Ratio

To determine your cash cushion for unexpected events like a job loss or leaky roof, multiply three or six months times your monthly fixed expenses. You should use a higher number, six or more, if there are expectations for an upcoming recession. Alternatively, the emergency fund ratio helps you target how much you need to save over specific months.

Current Ratio

The current ratio measures a household’s ability to repay a short-term debt coming due within one year with current assets by dividing your current assets by current liabilities. Your current liabilities may hold credit card balances and any debt due within a year. 

Final Thoughts

Having liquidity is valuable for emergencies, opportunities, and financial health. Balance your short-term and long-term investments to access readily available liquid assets when you most need them while assuring you are building up your wealth for your financial future.

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