What’s your favorite liquid?
I like chocolate milk. It is sweet and smooth.
I asked my daughter. She said water, but she isn’t well acquainted yet (she’s 2).
Wait this is a personal finance blog, right?
Right. So when I say “What’s your liquidity?” I am referring to liquid in the financial sense of the word.
It is a term that is often thrown around in the financial services industry but is overlooked when it comes to personal finance. With that being said, I believe that grasping the concept liquidity will be helpful as you move along your financial journey.
What is liquidity?
When we say liquidity, we are not referring to a fluid of some sort. Rather, liquidity can be explained as the “ease with which something can be traded for something else”. Cash is known to be liquid while an antique car is not liquid (or illiquid). Liquidity is also commonly defined as the ability to convert your assets into cash.
Liquidity in action
Time is important
When it comes to determining liquidity, time is important. Cash is very liquid because you can convert it into another asset of the same value very quickly. Referring back to the example, a shoe collection will take a long time to find a buyer at the price consistent with the actual value. If one wanted to convert an illiquid asset quickly, one will have to take a discounted price.
Why should you care?
Liquidity is of particular importance in emergency situations. If you find yourself in a bad spot financially, you need to know what you could sell to get cash fast. This is plan B if plan A (an emergency fund) doesn’t cover the bill. Usually, in these type of situations, you don’t have the luxury to wait months to get cash.
Assess your liquidity
- Is there a market for this item?
- Are there enough buyers within the market to purchase the item at face value (or close to it)?
- Or is the demand low because the market over saturated with sellers?
Asset Rich and Cash Poor
If the answer is no to any of these questions, you may be in an “asset rich and cash poor“ situation. Meaning you have one or many valuable assets that you can’t convert to cash. The catch is that certain assets (investments, house, etc.) appreciate in value and cash does not. Increasing liquidity in this situation could mean that you are leaving money on the table.