We are sure by now your fear of ratios must have dissipated and you must have realised the simplicity of it.
In fact, ratios are such useful tools that doing a self-check of your finances and your financial situation becomes easy. Everyone who must have read the first part of this series on personal finance ratios must be having their contingency funds in place by now.
So let's move on to the second part of this series that talks about the liquidity ratio.
By now, you ought to be convinced about the importance of liquidity, that is, ready cash availability. It forms an integral part of your asset allocation. You might argue that you already have an emergency fund to meet any liquidity needs that might arise but the million-dollar question is whether it just ends with maintaining an emergency fund?
Every individual is different, so is her/his requirement. Just as Jayant Punjabi (as we read in the first part) faced the problem of immediate cash, a similar problem was faced by Nilesh Pujaria, a 32-year-old businessman, but on a much larger magnitude.
He incurred heavy losses in one of his business ventures and had to borrow a huge amount (Rs 20 lakh to be precise) from moneylenders. Business or no business loan has to be paid back. He had huge amounts of assets but all his investments were in the form of real estate.
Although property is regarded as one of the best form of investments the problem arises when one tries to sell this property. When you need to convert the property to cash, it sure is a very difficult proposition. The proverb 'do not put all your eggs in one basket' is apt here.
To repay the moneylenders Nilesh had to borrow additional amounts of money and then borrow more to repay this newly acquired loan. This led Nilesh to get sucked into a vicious loop of debt.
At this point you won't be wrong if you are wondering what's new about the liquidity ratio when I have already talked about emergency fund or contingency planning in the first part.
Agreed, emergency fund is a very handy tool, especially since it is built taking into consideration all the mandatory expenses. But what if the magnitude of the calamity is much larger such as the one faced by Nilesh? We have to be prepared for all sorts of calamities big or small.
Here is where the importance of liquidity in the portfolio comes into picture.
But the question here is how are you going to do this? Don't worry. You won't need to set up one more fund. All you need to do is check the liquidity of your portfolio, that is, how quickly can you convert your assets into cash form.
How liquid are you?
Liquidity ratio = Liquid assets / Net worth
Where liquid assets comprises of:
- Savings account
- Bank fixed deposit
- Liquid funds
- Cash in hand
- Equities (shares)
- All open-ended mutual funds
And any other type of assets, which can be liquidated within three to four working days!
The top four assets are also termed as cash or near-cash assets as you must have used them to form the emergency or contingency fund. You might argue that equities and all open-ended funds can also be termed in cash or near-cash assets but these investments are your assets, which you will only use in case of extreme emergency.
They are investments you have kept aside to achieve your future goals (like for your child's education or marriage) and not to liquidate before you achieve these goals or unless there is absolutely no other source of arranging the money when emergencies arise.
Net worth would include your total assets less total liabilities. It shows what you are worth after paying off all your liabilities.
Total assets would include:
- Cash or near cash assets
- All your invested assets, that is, all your mutual funds, provident funds, properties, chit funds, shares, bonds, and any other invested assets
- Your house
- Car/ scooter
- Any other assets which an individual will have
Total liabilities would include:
- Short term liabilities like your credit cards payments
- Long term liabilities like home loan, car loan, and any other loan taken from a bank or a private money lender
Assuming your liquid assets total up to Rs 5 lakh and your net worth is Rs One crore then your liquidity ratio would be equal to 500,000 / 100,00,000 = 5 per cent. That is 5 per cent of your portfolio comprises of assets which could be sold off and converted into cash at short notice.
But is it good?
No. The ideal ratio is 15 per cent. In Nilesh's case it would be Rs 15 lakh (that is 15 per cent of Rs One crore). However, this amount would still fall short of meeting his requirement of Rs 20 lakh.
What this tells you is higher liquidity ratio comes in handy when you expect to incur huge outgoes like in Nilesh's case. But then the drawback of having a higher liquidity ratio is that a big part of your assets lie idle (cash, car) or remain unproductive (house) earning you no return or only a nominal return.
What does it signify?
At least 15 percent of your portfolio should comprise of liquid assets, that is, you should be able to sell them off at a short notice and convert it into cash! That much liquidity in a portfolio is a must. This is the least you should have in case of an emergency.
By now you must been convinced not only to have an emergency fund but also to have an adequate amount of liquidity in your overall portfolio as determined by the example above.
Hence, liquidity should be an important feature while building your portfolio. Once you have checked the liquidity in the portfolio as shown above we could move ahead with the third part of our series that would explain savings ratio next week.
The writer is a certified financial planner and can be reached at firstname.lastname@example.org.