Calculating net worth and liquid net worth can provide two valuable snapshots of someone’s financial health. Both look at what someone owns and what they owe. Both can help measure how someone’s progressing towards their goals.
But while net worth offers a more panoramic view — taking in all assets and all liabilities — liquid net worth narrows the focus to the portion of someone’s net worth that can more easily be turned into cash.
Why limit the view?
Some people never bother looking at their finances from either angle, or they only look at the big picture that net worth represents. Tracking both net worth and liquid net worth on a regular basis can be useful, however.
Here are a few reasons why:
They can provide a more accurate measure of wealth. When the numbers grow, it’s typically a positive sign that an individual is moving forward financially. And if the numbers decline over time, it could mean that person needs to make some changes.
It may be part of how a lender determines a borrower’s ability to take on more debt. Those with a higher net worth, but especially a higher liquid net worth, may get better terms or lower interest rates on loans.
On the flip side, knowing both their net worth and liquid net worth can help consumers decide if they’re really ready to buy a car or a house.
If the numbers aren’t great, one may choose to wait until they have more money in savings or make a plan to pay down more credit card debt.
It can offer a more realistic perspective of assets vs. debts. Some people may think carrying a pile of debt is okay, as long as they have some large assets (like a house or a retirement account) to offset those nagging liabilities (like student loan debt or credit card bills).
Knowing their net worth could reveal that their cushion isn’t quite as comfortable as they thought.
And understanding their liquid net worth could push that point even further, by showing how much money is actually available on a current basis for bills or unexpected expenses.
Why liquid net worth matters
Imagine a person needs money for something important — a major home or car repair, a trip to the ER, or starting a new business. They need it now… or, at least, within the next few weeks or months. Where are they going to get the money?
They might not want to look at selling things like their home, their car, their retirement savings, their baseball card collection, or Grandma’s wedding ring unless it’s absolutely necessary.
Those kinds of assets can be difficult to convert to cash in a hurry—and there could be consequences if they did decide to go that route.
Instead, it may be easier to tap their more “liquid assets,” such as cash from a checking, savings, or money market account, or cash equivalents, like stocks and bonds, mutual funds, exchange-traded funds, or money market funds.
What’s a good amount to keep available in liquid assets? That’s subjective. The financial industry sometimes refers to a person with at least $1 million in cash or assets that can promptly be converted to cash as a high-net-worth individual — and that person usually can expect to receive special services, like access to exclusive investments, from banks and other financial institutions.
But just having enough to cover three to six months’ worth of expenses is a great place to start. It could keep an individual from getting behind on their bills, running up credit card debt and making a mess of their credit score when an unexpected expense comes up or a loss of income occurs. It’s why financial professionals often urge clients to prioritize having an emergency fund.
And those who monitor their liquid net worth may have the opportunity to make adjustments on their own terms, instead of in a rush. They can still sell their baseball card collection if they’re ready someday, for example. But without the pressure, they can wait until they get the right price from the right buyer.
Calculating liquid net worth
When business owners want an indication of their company’s ability to pay current liabilities without having to sell any inventory or get additional financing, they might look at a “liquidity ratio.”
A “quick ratio” (sometimes called an “acid test ratio”) measures a company’s capacity to meet its short-term obligations using only its most liquid assets. It is determined by dividing all of the company’s current assets (cash equivalents, marketable securities and accounts receivable) by its current liabilities.
A high ratio result is generally a sign that the company is in good financial health. A low ratio might indicate that the company may struggle to pay its debts.
An individual can run a similar analysis. On one side of a sheet of paper, they can list all of their liquid assets — the cash and cash equivalents they could easily and quickly get their hands on if they needed money.
On the other side of the paper, they would list current liabilities — credit card bills, student loan payments, unsecured loans, medical debt, etc.
The next step is to add up each list and subtract the liabilities from the assets. Their liquid net worth is the amount they would have left if they used their liquid assets to pay off their current liabilities.
To determine a personal liquidity ratio, they can divide their liquid assets by their monthly expenses. This number can help indicate a person’s ability to meet regular expenses when an unexpected expense or job loss occurs.
For example, if an individual has $12,000 in liquid assets and monthly expenses of $3,000, their liquidity ratio is 4. This indicates that they could be able to use their liquid assets to manage their expenses for about four months.
Improving liquid net worth
When an individual or family’s liquid net worth isn’t where they want it, there are a few steps they might consider taking:
• If they haven’t already, they might want to start an emergency fund. They may have to start small — with just enough to cover an unexpected bill or two. But with time and attention, the fund could grow large enough to cover their costs for a while if there’s a job loss, their work hours are cut, or they choose to take a sabbatical.
• If possible, they may want to ratchet up their efforts toward paying down credit card balances. A debt reduction plan, such as the Debt Snowball method, can help target “bad debt” (or high-interest debt) to get it paid down faster.
• If they like the idea of keeping more money in the market, they might want to include more accessible investments in their overall plan. Stocks and bonds, mutual funds and exchange-traded funds (ETFs) can be liquidated fairly quickly when held outside a tax-advantaged retirement account. But there are both pros (the potential to grow money faster than with a safer investment, such as a savings account) and cons (volatility, fees and taxes) to consider with this choice.
An individual’s net worth and liquid net worth typically don’t remain static. Life happens, and finances tend to go up and down through the years.
That can make monitoring and managing both the big picture and a more narrowly-focused view of one’s wealth a valuable part of maintaining overall financial health.
Original source: Mediafeed.org