The YourMoneyNumbers: Liquidity topic is the third in the YourMoneyNumbers (YMN) series. For more information on the YMN series, click here.
As I write this, we are in the midst of major economic disruption due to COVID-19. It is during times like these that we realize the importance of having some emergency funds or liquidity in our personal finances.
If you are still earning your normal income, this post will describe how to check on how prepared you are for an emergency — it is always better to check before you are having an issue. Generally having 3-6 months of household expenses is recommended — more if you are the sole household earner. If you find you have less, it might be worth trying build up those emergency funds by working to spend less or redirecting money you are saving for other goals.
For those of you whose income is effected by the Coronavirus shutdowns, I am hoping that you are finding the support you need during this time. If you do have some emergency fund savings, this post may provide you some insight on how long it might last. If you do not have savings, this article could be a reference for building up your financial liquidity once your income returns.
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What is Liquidity?
If you have stuck with me through the YourMoneyNumbers (YMN) journey, you will have already created a Net Worth statement and documented/balanced your Budget. The good news is — the hardest steps are behind you. You are aware of all your assets and liabilities, and you have found a budget that at a minimum will not put you further into debt. The remaining steps are intended to give you some clarity about these aspects of your financial life of which you should be aware and pay attention to as you make decisions to prioritize financial goals and help make routine financial decisions. So from here, we move onto the next topic: Liquidity. Liquidity can be considered as a measure of how prepared you are to absorb changes that can impact your financial life.
Liquidity refers to how many liquid assets you have available. For an asset to be liquid, it either is cash or an asset that can be easily converted to cash without a major impact on its value. Examples include cash, savings bonds, and non-retirement investment accounts (stocks, index funds, mutual funds, etc). In contrast, something that may not be able to be sold quickly for cash (example: real estate) or for which you would pay a penalty for withdrawal (example: 401K retirement funds) would be examples of non-liquid assets.
An important note: just because you have liquid assets does not mean that those assets are not subject to risk or fluctuations. For this reason, I like to calculate a couple of different values associated with liquidity — my total liquidity ratio and my emergency fund liquidity ratio.
What is a Liquidity Ratio?
A liquidity ratio gives you an evaluation of how many months of typical expenses your liquid assets would cover. This measure is useful to assess because it would tell you how many months your liquid assets could support you in the event of a personal income disruption (example: job loss, career transition, etc.).
How do I calculate my Liquidity Ratio?
Remember— I said you already did the hard part. We are going to use the Net Worth Statement and Budget that you have made in our first two YMN topics.
First, for every Cash/Asset line item in the net worth statement, determine if it is a liquid or non-liquid asset. The Total Value of Liquid assets is just the sum of all the account values that you have determined to be liquid.
Next, in your budget, you estimated your average monthly expenses.
Total Liquidity Ratio = Total Value of Liquid Assets/Average Monthly Expenses
A value less than one indicates that you have less that one month of liquid assets saved. If you calculate a 3.5 — it means you have three and a half months of your average monthly expenses in liquid assets.
I also indicated that I calculate an Emergency Fund liquidity ratio. To calculate this ratio you look through your Net Worth statement cash/asset list and sum the total of anything you consider an emergency fund— something you would not touch unless an emergency unexpected expense happened. Typically, emergency funds are held in very low-risk asset classes (example: a savings account or money market).
You then can calculate your Emergency Fund Liquidity Ratio.
Emergency Fund Liquidity Ratio = Total Value of Emergency Fund/Average Monthly Expenses
Why look at the liquidity ratio in two ways?
I look at it this way for two reasons:
1) I really would prefer to only have to touch my emergency funds if an emergency happened. If I spent all of my liquid funds in the event of a job loss, I would be left with only non-liquid funds at the end of that period. But — until you have built up a substantial emergency fund, knowing how much you have available to cover unexpected expenses or income disruptions can be helpful.
2) Remember even having liquid assets doesn’t eliminate risk. If the emergency isn’t simply personal but is more societal (example: stock market correction) you may not want to convert all your assets to cash at that time. The total value of your total liquid assets will fluctuate more over time than your emergency fund.
I look at the Emergency Fund Liquidity Ratio as how many months of expenses I am prepared to cover in the event of a personal emergency and the Total Liquidity Ratio as my worst-case backup contingency.
How much is enough?
Only you can determine the answer to that question. It is dependent on many factors including your monthly average expenses and your tolerance to risk.
The Quantify Financial take on prioritizing this in a general way would be:
- Emergency fund $1000
- Total Liquidity Ratio of at least 1 (this could be a buffer in a checking account).
- If you are in debt, make a debt repayment, savings and investing strategy based on the type and interest rate on your debt. (Will be discussed in the next post: YourMoneyNumbers: Debt)
- Emergency Fund Liquidity Ratio to 3-6.
- Over time, Emergency Fund Liquidity Ratio to 12-24 (especially if you are a single earner in the household, work for yourself, or are nearing retirement).
- Grow your Total Liquidity Ratio to meet your personal financial goals. Personal goals like early retirement may require having liquid assets off which you can live until your able to use the non-liquid retirement accounts.
Things to remember
If your budget doesn’t include a lot of contingency expense saving, your emergency fund balance may end up fluctuating a lot as you have “emergencies” that you need to cover. If you notice that you are dipping into your emergency fund frequently for expenses you probably could have anticipated (examples: car maintenance, taxes owed, routine medical bills, etc.) you should re-evaluate your budget to see if some sinking funds should be developed to cover periodic expenses.
Your liquidity ratio doesn’t guarantee you will be “fine” for that number of months under every circumstance. If you incur a large expense outside of your typical average monthly budget — or if your expenses are not evenly distributed throughout the year— you will still need to be diligent to ensure that your cash flow will be sufficient each month. I look at this as a tool to see how well we are positioning ourselves to handle some unexpected financial changes.
You can improve your liquidity ratio by increasing your liquid assets, but also (and more importantly) by reducing your monthly expenses!
Make it a game!
I track my Emergency Fund Liquidity Ratio and my Total Liquidity Ratio every month. Once you are checking on your net worth and doing a budget, this is a simple addition that can give you some perspective. My goal is to try to keep the liquidity ratios increasing each month. If an unexpected expense causes me to use my emergency fund, I would just work hard to build it back up and reduce my monthly expenses where I could. Setbacks happen!
Also, anytime I receive a raise or windfall (bonus, tax return, etc.), I try to designate a part of it to increase my emergency savings balance.
Peace of mind
Taking measures to build up an emergency fund and maintain some level of liquid assets can help give peace of mind when you hit upon uncertain times. Having these funds can also prevent you from ending up falling into costly debt or needing to take more dramatic actions like selling a house, not paying on commitments or reducing your credit score.
Have any questions on why liquidity is important in personal finance? Let me know in the comments below.
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