Welcome to Day 6 of the 30-Day Financial Wellness Challenge.
Each day will comprise of financial exercises, some short and others a bit longer, to help you become financially fit. The goal is to tackle different aspects of personal finances one day at a time.
After the 30 days, you’ll have a stronger understanding of your financial health and an action plan to improve your financial wellbeing. Review Day 5: Your Savings Rate
On Day 6, we’re discussing liquidity and your ability to cover your expenses by calculating your cash ratio.
It’s probably the first time you’ve read the term liquidity applied to personal finance. But it is just a fancy way of saying the amount of cash you have to cover expenses.
We all need a cash reserve, but the amount of that reserve depends on our monthly expenses and other liabilities. By understanding liquidity and calculating your cash ratio, you’ll gain a better understanding of how well you can cover periods of income disruption.
Your cash situation
A 2018 Federal Reserve study indicated that 40% of people don’t have $400 in cash or cash equivalents to cover an emergency. Can you cover a $400 emergency with cash? And do you have enough cash to cover one month of living expenses? How about 6 months? In many situations, the availability of cash will determine if you can meet your financial obligations.
On Day 1, I challenged you to calculate your net worth. When doing so, you listed all your assets that included the amounts in your checking, savings, and investment accounts. Today, we’re going to use those numbers to help you determine your liquidity and calculate your cash ratio.
Note: On Day 5, I had you calculate your Savings Rate by inputting the amounts saved last year and last month. What you saved, however, can be different from the cash savings you have available. Your savings rate shows how much your saving but the cash ratio shows how much savings you actually have.
Liquidity and Liquid Assets
Liquidity simply means cash assets or other assets that can easily be converted into cash. The following are assets from the most to the least liquid:
Cash is the most liquid because there’s no need to convert it into cash. The most liquid asset is cash in your wallet. The next would be money deposited into accounts that can be withdrawn easily. These are ranked as follows:
- Checking accounts
- Savings accounts
- Money market accounts
- Club accounts
- Certificate of deposits
Securities are assets like stocks, bonds and treasury notes that can easily be converted into cash. These securities are often held by online brokerages or investment firms. Securities are less liquid because it takes time to sell them at a higher market rate. Otherwise, it’s not advantageous to sell securities if you’ll take a big loss.
Fixed assets are tangible investments like real estate, cars, artwork, and equipment. These assets are less liquid because it may take more time to convert them into cash.
What does liquidity reveal?
It’s important to understand your assets and their levels of liquidity. Life can be a financial rollercoaster. Liquidity offers two answers:
- how much cash and assets easily converted into cash to cover an immediate financial emergency.
- the number of months you have to meet monthly expenses with cash assets while unemployed or underemployed.
Day 6 Assignment
If you’ve done the other day’s challenge, then you’ll have this information easily available.
- List all your cash and assets easily converted into cash. (Day 1 Challenge)
- List your monthly expenses and obligations. (Day 3 Challenge)
- Calculate your cash ratio.
|Savings account(s)||$||Includes emergency savings funds|
|Money market account||$|
|Certificate of deposits||$|
|Total Liquid Assets||$|
Now, take the numbers from Day 3: Expense Statement or complete the form below. Remember, add in all your expenses.
Monthly Expense Statement
|Mortgage or Rent||$|
- Get very detailed with your cash amounts.
- During an emergency or period of unemployment, all savings regardless of purpose can be used to cover basic living expenses.
How to Calculate Cash Ratio
The cash ratio is one of the liquidity ratios. It strictly uses cash or cash equivalents to determine your ability to cover emergencies or periods of unemployment. The formula is as follows:
Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities
- Cash Equivalents are money in your various banking accounts.
- Short-term Investments are securities that are not specifically tied to your retirement.
- Liabilities are monthly obligations both fixed and variable (or bills, debt, and discretionary from Day 3).
Here’s an example:
$1000 cash + $6500 cash equivalents + $7000 investments / $3200 (expenses) = 4.5
With a 4.5 ratio, this means I have four and a half months of cash available to cover any periods of income disruption.
Calculating Your Cash Ratio
|Total Liquid Assets||$||$14,500|
|+ Total Monthly Expenses||$||$3,200|
|= Cash Ratio||4.5|
|What does it mean?||4.5 months of cash to cover expenses|
Congrats, you’ve calculated your cash ratio.
Why are liquidity and calculating cash ratio important?
- An important step to determine how you can manage through a financial crisis.
- Knowing your cash ratio will help you set a target goal to increase your liquidity
- Personal Capital is a free personal finance app with a 360-degree view of your money. With Personal Capital, you can see all your accounts in one place with planning and analysis tools.
- Cleo and Charlie are the perfect personal financial assistant you can text and chat. They give you insights on how you’re spending, how much you’re saving, and other useful financial tips.
Next Daily Challenge: Day 7 – Debt-to-Income Ratio – Are you over-leveraged?
Frequently Asked Questions
Is liquidity the same things as saving into an emergency fund?
It’s similar but not quite the same. Liquidity takes into account all your cash and assets easily converted into cash to determine if you can meet your monthly expenses. An emergency fund, as generally defined, is a savings account meant to cover emergencies but often doesn’t cover periods of unemployment. I recommend an emergency fund strategy that includes a rainy day fund and an opportunity fund to cover unexpected expenses and periods of income disruption.
Why is liquidity important?
Access to cash or having a cash reserve is essential to your financial wellbeing. It will give you peace of mind knowing you can cover your monthly obligations. It’s recommended
What if my liquidity isn’t enough to cover my expenses?
You’ll need to make adjustments with your income to allocate more towards savings. Or it may indicate the need to eliminate debt and reduce bills to lower your monthly expenses. Thus, allowing your liquid assets to cover more months.