Financial Liquidity – Why you should know your Liquidity position

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Financial liquidity refers to how easily assets can be converted into cash.  An asset is anything of value that can be converted into cash. Individuals and companies own assets. Assets like stocks and bonds are very liquid since they can be converted to cash within days. However, large assets such as property, plant, and equipment are not as easily converted to cash.

In a rapidly changing world where life and business can be totally unpredictable, it is wise to have an emergency fund which can be quickly used to tide over an unforeseen difficulty. Personal Loan can be a good option to handle a sudden crisis if your credit rating is good and liabilities are manageable. When your assets can’t be converted conveniently or stand the risk of being undervalued, a Personal Loan would appear to be the best choice. In such a scenario it is advisable to approach a credible Franchise of a renowned bank.

The most liquid asset of course would be hard cash. It does not require any conversion and will not lose any value. Unless, of course, a situation like demonetization arises. Keeping cash in hand would be not so advisable due to other reasons as well. A Savings Account with a reasonable interest rate would be an ideal place to park funds which can be easily retrievable through an ATM or the Cheque at a local branch.  But you have to decide on some investment and tax saving instruments to ensure that your money is not idle. It should be put to good use. But the planning for investment should be done with a clear view of the desired liquidity. There are few ratios to determine the ideal liquidity based on different parameters.

For a Business, Liquidity can be assessed using the Current ratio, also known as the working capital ratio.

The formula for calculating the current ratio is as follows:

Current Ratio = Current Assets / Current Liabilities

It measures the business’ ability to pay off its short-term debt obligations with its current assets.

So, if the current assets amount to ₹400,000 and current liabilities are ₹200,000, the current ratio is 2:1.

Current assets are liquid assets that can be converted to cash within one year such as cash, cash equivalent, receivables, short-term deposits and marketable securities. The current liabilities refer to the business’ financial obligations that are payable within a year.

Obviously, a higher current ratio is better for the business. A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts.

A current ratio below 1 means that the company doesn’t have enough liquid assets to cover its short-term liabilities. A ratio of 1:1 indicates that current assets are equal to current liabilities and that the business is just able to cover all of its short-term obligations.

 

For Finance Liquidity of a Person there are different comparisons based on mathematical ratios.

If he is planning to apply for a loan, he should evaluate his liquidity to examine if he is over borrowing based on his cash in-flows and net worth.

Below listed are few ratios in all which help individuals to evaluate their financial position.

  1. Basic Liquidity Ratio:

This ratio indicates an individual’s ability to meet his or her monthly expenses in case of an emergency or a catastrophe.

Basic Liquidity Ratio = Cash (near cash)/Monthly Expenses

Cash (near cash) includes all liquid assets like savings a/c, Fixed Deposit, cash in hand and Liquid Funds.Monthly Expenses include mandatory fixed and variable expenses. An average of 12 months is taken into consideration while calculating mandatory variable expense and the expenditure tends to vary every month. It does not include voluntary expenses like those on entertainment, vacation or those that can be avoided, if needed.

  1. Liquidity Ratio:

This ratio helps a person to know his liquidity, essential to be prepared for any unforeseen financial hardships.

Liquidity Ratio = Liquid Assets/ Net Worth

 

Liquid Assets include all cash (near cash assets), equities, Equity Mutual Funds, Debt Funds (which include Short Term, Gilt Funds, Monthly Income Plans and other such funds except Closed-Ended Funds) and other assets which can be redeemed within three to four working days.
Net Worth is the amount left after deducting total liabilities from total assets.

The ideal liquidity ratio is 15%. At least 15% of one’s portfolio should have assets, which can be redeemed almost immediately in case of an emergency. Anything less is not healthy.

  1. Savings Ratio:

This ratio indicates the amount an individual sets aside as savings for his future goals.

Savings Ratio = Savings/ Gross Income

Savings include any form of savings like Fixed Deposits, Liquid Funds, Mutual Funds, Equities, Debt, Bonds, PPF, Post Office Small Saving Schemes and others where the individual saves on a regular basis. Gross Income includes income earned through business, profession or in the form of salary, bonus, EPF contribution, interest, dividend, rent/royalty and any other form of income.

The ideal savings ratio is at least 10%. At least 10% of a person’s gross income should go towards savings. Anything less might not be quite what one might want it to be.

  1. Debt to Asset Ratio:

This ratio helps a person to understand whether he is over borrowed or is in a comfortable position, i.e., if he faces any solvency problems. This ratio should always be used when one is planning to take a new loan. If an individual is over borrowed, it is best to avoid getting into something new. Instead the person should wait until he has finished paying off his previous loan amount.

Debt to Asset Ratio = Total Liabilities/ Total Assets

Total Liabilities are all liabilities like personal loan, home loan, and car loan, any credit card outstanding, amount taken from private money lenders and any other form of loan.

Total Assets include all assets that a person has like investments, cash (near cash), home, car, jewelry and other assets.
The ideal debt to asset ratio is maximum 50%. The maximum debt any individual can take should not exceed 50% of his total assets. Total Assets include all assets that a person has like investments, cash (near cash), home, car, jewelry and other assets. The ideal debt to asset ratio is maximum 50%. The maximum debt any individual can take should not exceed 50% of his total assets.

 

 

AUTHOR: Finwizz Financial Services
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