What is Liquidity, And Why Does it Matter in Financial Planning?

Liquidity refers to the ability to convert an asset or investment into cash or cash equivalent quickly without significantly impacting their value. Some assets, like cash in the bank, units of mutual funds, certificate of deposits, etc. are known as liquid assets. These can be quickly turned into cash in hand. Hence these investments and assets are said to have high liquidity.

On the other hand, assets like buildings, land plot or equipment are not easily convertible to cash and selling them quickly could result in a loss of value. So, such assets are said to have low liquidity or are considered as illiquid assets.

Personal financial planning requires you to allocate some funds in asset classes that are highly liquid so that you have money in hand for emergencies. While investing the remainder in longer term assets that might have relatively low liquidity. The main drawback of liquid investments/assets tends to be the relatively low short and long term returns they tend to offer.

Liquidity can be divided into two categories: market liquidity and accounting liquidity. These two types of liquidity provide valuable insights into the stability of assets, companies, and markets.

• Market liquidity: Market liquidity means the level to which any market permits buying and selling of assets at stable and transparent prices. In simple words, it refers to how simple it is to buy and sell assets in a specific marketplace. For example, stock markets are very liquid as people buy and sell various stocks in significantly high numbers in most cases. On the other hand, fixed assets such as residential property can be quite illiquid. It can take a significantly long time to sell because not many people are interested, and the prices change frequently.
• Accounting liquidity: Liquidity in accounting means that an individual or business has sufficient money on hand to pay short-term debts immediately. It all comes down to being able to complete your responsibilities without feeling stressed. Accounting liquidity is commonly measured through the current ratio or cash ratio. The current ratio calculates the amount of accessible assets you can sell to pay off your debts from the current year, whereas the cash ratio calculates the cash flow needed to meet immediate financial obligations.

When it comes to financial planning, understanding the liquid assets meaning is important. Liquid assets are the assets that can be quickly converted into cash with minimal or no impact on their market value. Examples of assets that are considered to have high liquidity include:

• Cash
• Marketable Securities – stocks, bonds, units of mutual funds
• Treasury Bills s (T-Bills)
• Money Market Instruments – TREPS, CBLO, Certificate of Deposits (CDs), etc.

Imagine that all of your savings are invested in long-term investments, and you urgently need money. What will occur? Either you have to take on debt in the form of a personal loan or sell off the long-term investments at a loss or with minimal profit to overcome the immediate emergency.

That is where having cash on hand such as a dedicate emergency fund is crucial. Hence, knowing what is liquidity and having sufficient assets/investments of high liquidity can help you during both planned and unexpected situations. The following are some key reasons why liquidity is a key factor to consider as part of your overall financial planning strategy:

• Emergency preparedness: Assets with high liquidity ensure quick access to funds during emergencies such as unexpected medical bills, sudden job loss, or urgent home repairs. It reduces the need to take costly loans or redeeming long-term investments prematurely.
• Financial flexibility: Assets with high liquidity provide the flexibility to act quickly in response to changing market situations, this can give you a competitive edge in financial decision-making.
• Debt management: Liquidity helps reduce dependence on personal loans and credit cards during emergencies. Overall, minimising debt can help improve your financial health.
• Better goal alignment: Matching liquidity with long-term and short-term goals ensures availability of a balanced portfolio. It allows you to fulfill your immediate needs while ensuring that relatively illiquid long-term investments have sufficient time to grow.
• Reducing financial stress: Knowing you have access to cash through liquid assets and/or investments eliminates the possibility of stress about how to handle financial emergencies or cover unexpected bills. This peace of mind can help in maintaining focus on financial growth.

There are various techniques you can use to measure the liquidity of an organisation’s or an individual’s finances. The following are the most common methods:

• Current ratio: The current ratio technique provides a quick overview of the company’s or individual’s financial statements. Also, it measures the company's ability to pay off short-term debts within a year by comparing its present assets and liabilities. The following is the formula:
  
  Current Ratio = Current Assets/Current Liabilities
• Quick ratio: The quick ratio method is similar to the current ratio, except it only takes into account only the most liquid assets, such as cash and cash equivalents, marketable securities, accounts receivable, etc. This measurement evaluates how financially able the company is to settle its outstanding debts.
  
  Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
• Cash Ratio: This measurement assesses the company's ability to meet short-term obligations with cash and cash equivalents, which are considered high liquidity assets. It is calculated as follows:
  
  Cash Ratio = Cash/ Current Liabilities
  In all three liquidity calculation methods discussed above, the higher the ratio, the better is the company’s ability to fulfill its financial commitments.

Understanding the meaning of liquidity in finance is important to build a strong financial plan. The role of liquidity in financial planning is to ensure that you always have access to funds whenever you need them. Moreover, having investments or assets are liquid and can be readily converted to cash gives you peace of mind and financial security. Below mentioned are key roles that assets of different levels of liquidity play in overall financial planning:

• Emergency Fund: Assets and investments that feature high liquidity are ideal for maintaining an emergency fund. As per many financial experts, one should considering maintaining the equivalent of 6 months’ expenses as an emergency fund in a mix of liquid assets such as savings accounts, units if liquid funds/money market funds, short-term FDs, etc.
  This is only a basic guideline, and the exact amount can vary for different people depending on their specific circumstances. In the event of an emergency, these can easily be converted to cash to overcome urgent financial needs that may arise.
• Medium Term Goals: Your medium-term goals, which are over a year out but need to be achieved within the next five years, might need investments with less liquidity that can potentially offer moderately high return. Fixed Deposits with tenure up to 3 years, corporate bonds are examples of instruments with moderate liquidity that can offer higher growth in this period to help you reach your financial goal easily.
• Long Term Investments: Long-term investments are designed to offer low liquidity but can potentially offer significantly high returns that can help you reach various long-term financial objectives. Examples of such investments are NPS (National Pension System), ULIPs (Unit Linked Insurance Plans) , PPF (Public Provident Fund), equity mutual funds, etc. These might offer low liquidity, but have the potential to provide inflation beating long-term returns. These investments are ideally suited for long-term financial goals such as retirement, your child's education, buying a house, etc.

In summary, to make smart financial planning, understanding the meaning and importance of liquidity is a key element that every individual should know. This can help you choose between different types of assets and investments with varying degrees of liquidity in order to create a portfolio mix that is ideally suited to your short, medium and long-term financial goals.