Equity, adjusted gross income, stocks, bonds, current ratio, operating cash flow, assets, liabilities, net worth -- it's easy to get lost in the jungle of financial terms out there when you're trying to manage finances. Whatever happened to just measuring income and expenses? Well, when you ask yourself "how much am I worth?" it's not just a question of how much money you have in your wallet, or even your bank account, at that moment. It turns out that, depending on how and when you invest, spend or save your money, your worth varies. Liquid assets make up just one special category of your worth. Understanding it will help you get a better idea of your own financial situation.
Liquid Assets in Personal Finance
Each of our bodies is 60 percent water; we all know we need to drink it to live. But how much of your finances should be liquid? If your boss called you into his office today and fired you, how long could you get along comfortably without a job? This is when the importance of having liquid assets will hit you like a ton of solid bricks. Many financial planners suggest that individuals keep easily accessible funds that will carry you through three to six months of comfortable living [source: McWhinney].
So it's probably a good idea to take stock of what you have right now in liquid assets. But what counts as a liquid asset really? Perhaps appropriately, the definition of a liquid asset is not fixed in stone, but can vary. Some people maintain that it must be able to sell at a fair market price within a week, and others say within a month. And some consider an item liquid even if it will suffer at least a little loss of value in a quick sale.
Here's a list of typical things to include in your list of liquid assets:
Stocks, bonds and bond funds are often considered as liquid, even though they may lose value when you sell them [source: Gentry]. Think of liquidity on a spectrum -- cash is inherently the most liquid on one side. Stocks and bonds are on the liquid side, but not as liquid as cash or bank accounts.
Assets that take more time to sell without losing value, like real estate, are more illiquid and fall on the other side of the spectrum.
If you have valuable personal items that you'd like to include in your grand total of liquid assets, understand that these are usually less liquid than the items included on the above list. However, if you have valuable enough items that you wouldn't mind selling, perhaps they're worth considering. These might include collectibles -- anything from valuable baseball cards to stamps or mint-conditioned original Star Wars action figures, jewelry, music CDs in good condition, movie or TV show DVDs in good condition and antiques.
You may even go as far as putting electronics or clothes in this list. Be realistic and think honestly of what your used stuff is worth. Remember that they aren't worth the same as when you first bought them. Unless you have a barely worn designer dress that's still in season, you probably can't depend on getting a significant payoff for used clothing.
Certainly, in this age of eBay and Craigslist, getting a good deal is becoming easier and faster. When you need money fast, no longer do you have to host a yard sale to trade a mint-conditioned original Beatles vinyl for five bucks, to an undeserving neighborhood youth. Now you can auction it off to a wider selection of bidders who appreciate its value.
You're not the only one concerned about a low level of liquid assets. On the next page, we'll learn how corporations must keep an eye on liquidity to live up to their obligations.
Liquid Assets in Business
To keep a business running, it usually takes on a lot of financial obligations, including paying employees salaries and paying off loans and debts. To appease the various stakeholders, an organization must keep a healthy balance of liquid assets. People will be more likely to invest in, or lend to, a company that has enough liquidity to keep up its payments. However, a company can have too much liquidity, which may be a sign that it's holding onto cash that could be invested.
Examples of liquid assets for a corporation are similar to those of an individual:
- Funds in the bank
In a sense, even borrowing money is another typical source of liquidity for businesses. To meet its obligations, the ability to take out loans will be a factor in its liquidity.
Companies like to keep things in perspective to understand the big picture. For instance, they keep an eye on their net liquid assets, which is the amount of liquid they'd have if they paid off their current debts and liabilities using liquid assets. They also want to divide the situation into varying time frames. For instance, a company pays attention to the amount of quick assets, which are assets readily convertible to cash. It also calculates how much it has in current assets, which are all the assets it can sell within a year's time.
Using these concepts, businesses compare these factors in ratios to understand liquidity from different angles. For instance, here are two common ratios relating to liquidity:
- Current ratio: The figure you get when you divide current assets by current liabilities or debts due within a year.
- Quick ratio: Quick assets (which are sometimes calculated as current assets minus inventories) divided by current liabilities. Also called the acid test ratio. It is a measure of a company's more immediate financial situation.
This is where the idea of liquidity differs between personal finance and corporate finance -- a year's time is relatively long-term for an individual's financial obligations, but not for a company's. However, the idea of liquidity gets even more muddled in the corporate world. Whether an asset is liquid depends when the business's obligations are due. The time period for what makes a current asset, for instance, could be a year or the duration of the company's operating cycle. On the other hand, the company's willingness to sell off assets early (forcing itself to accept a discounted price) also plays into whether it can be counted as liquid.
A business also takes into account current market conditions when considering its own liquidity. In a liquid market, assets can consistently sell quickly and without a loss of value. On the other hand, during a thin market, the values of assets change rapidly, and selling assets at a profitable price becomes harder. Many factors influence how easy it will be -- such as inflation and interest rates. This can be understood in terms of the bid-offer spread, which is a comparison between the prices at which things are sold and later bought in a market. If the difference is slight, it makes for a reliable, liquid market. Conversely, if there's a big discrepancy, the market is thin. The foreign exchange, also known as Forex, is usually a reliable market for liquid assets [source: Investopedia].
For more on investing and finances, take a look at the next page.
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More Great Links
- "Liquid Asset." Investopedia.com. (July 22, 2008)http://www.investopedia.com/terms/l/liquidasset.asp
- Gentry, F. Bruce, et al. "The Compete Will Kit." John Wiley and Sons, 2001. (July 22, 2008)http://books.google.com/books?id=9zr8tKBfc9gC
- Loth, Richard. "Liquidity Measurement Ratios: Introduction." Investopedia.com. (July 22, 2008)http://www.investopedia.com/university/ratios/liquidity-measurement/default.asp
- McWhinney, Jim. "Build Yourself An Emergency Fund." Investopedia.com. (July 22, 2008) http://www.investopedia.com/articles/pf/05/EmergencyFund.asp