The Importance of Liquidity in Financial Planning

What is Liquidity?

Before we talk about its importance, we need to understand what liquidity is. In essence, liquidity is the ability to convert any asset or investment to usable cash and pay off any short-term liabilities. Short-term liabilities are payables that will come due in a year or less.

Accountants represent liquidity in the form of a formula called the quick ratio. Quick ratio is the value of a business’ efficiently liquefiable assets divided by its existing liabilities. An asset is liquid if it can be easily converted to cash in 90 days or a quarter.

All assets have a variety of liquidity, depending on several factors. Cash is simply the easiest, the most liquid asset you can have, primarily because you can immediately use it to purchase new assets or pay off debts.

What Factors Affect Liquidity?

The numerous factors affect how easily an asset or investment converts into cash. Some elements are external and easily changeable, while others are internal and harder to manage.

External factors include the overall economic conditions in the market. This consists of the inflation rate, interest rates, and the availability of capital. Internal factors such as the profitability or loss of the business and the current and projected level of cash flows and revenues also impact the available funds.

However, the most significant factor that hinders liquidity as you build wealth is time. As liquidity is the ease of converting assets to cash, the more time it takes to convert the investment, the less fluid it is. You want assets that you can easily convert at a moment’s notice.

As your assets become larger, they are less likely to be converted quickly. Assets like real estate, for example, take much longer to sell or transfer than a bank account or a stock.

Besides physical size, the expense of selling or transferring the asset is another critical factor. A special deed, payment of capital gains tax, and legal fees all add costs to the process.

Why Liquidity is Important

As we’ve already discussed, the difficulty in turning illiquid assets and investments into money is a significant factor in planning for the future. You want a good balance of short-term assets that you can convert without much time or cost and long-term investments that you can’t touch.

Here’s a situation: you might have invested many resources in long-term investments. These take several months or even years to grow and pay dividends. It can be complicated to convert them when you want to sell due to several factors.

That inability to turn your investment into immediate, ready money is one of the main reasons investors become illiquid. In emergencies, you want to have a way to boost your cash flow. Identifying liquidity can be challenging if you are asset rich but cash poor.

Having fewer, smaller, and more portable assets are better for preserving your liquidity. If the market falls and you suddenly need to sell, it will be easier to have smaller assets you can sell to keep you afloat. It’s easier to get a buyer for a smaller share of a larger property than it would be for half the asset.

How Much Liquid Asset Do You Need?

It is recommended that you maintain liquid assets equal to six months' worth of expenses. This will help you stay liquid and protect your way of life in emergencies. Personal finance and financial planning experts recommend keeping a portion of your emergency funds in hard cash.

Savings accounts provide easy access to cash in case of an emergency. One clear evidence of this is the COVID-19 crisis, where people found themselves in need of urgent cash.

Many put much of their money in stocks, trusts, or long-term investments, which were impacted by job loss, salary cuts, and medical emergencies. A liquid asset or emergency fund can be beneficial during times of crisis.

Boosting Your Liquidity

There are many ways to improve your ability to be financially flexible. For individuals, focusing on building an investment portfolio that includes a mix of bonds, mutual funds, and stock can provide a higher return on investment.

Businesses can consider borrowing for working capital, essentially the money required for operations. It helps keep the company running smoothly and meeting daily obligations.

For businesses, the primary way of improving liquidity is simple. Working towards increasing your sales and lowering your overhead can create cost savings for the company. It can be a different challenge for individuals looking for better financial planning.

Improving Personal Financial Health

The easiest way to improve liquidity as an individual is to pay off liabilities as fast as possible. Liquidity ratios reflect assets and debt due within the next 12 months. You can improve your liquidity ratios by paying down debt.

Be careful not to dip too far into your savings to pay off all debts. Plan for and anticipate unforeseen expenses.

If you can’t pay off your debts immediately, it’s best to refinance them instead. Where appropriate, transition from short-term to long-term debt. This gives you greater flexibility to manage your short-term financial obligations by lowering your interest rates and resulting in smaller monthly payments.

Manage all your payables properly. You can also improve your liquidity by effectively managing accounts payable. You should take advantage of early payment discounts when they're available and negotiate longer payment terms with your regular suppliers when they're not.

Make sure you don't pay suppliers early when this isn't financially beneficial. Keep your business running by paying key suppliers first if necessary.

The Bottom Line

When it comes to financial planning, understanding the value of liquidity is important. Having enough liquid assets on hand allows you to manage your financial needs. In an emergency, you or your business will have enough to weather emergencies.

Being in control of your finances means you have the flexibility of making calculated decisions. Having a solid plan gives you the freedom to choose what actions to take next.