Liquidity Vs. Solvency

by Christopher Raines

    Liquidity and solvency are dashboard signs of your financial health. The former, also known as cash flow, measures your ability to pay monthly bills and meet emergencies that require cash. Solvency refers to net worth, which is how much you have left to call your own if you pay off your debts. When you can use cash, you are less likely to rely on credit for purchases and meeting the costs of living. If you can remain liquid, you avoid drowning in debt and becoming insolvent.

    Liquid assets consist of cash and items that you can quickly turn into cash. You will commonly find cash in checking, savings and money market accounts. Stocks and bonds usually take little time and effort to blossom to cash, because you often have ready buyers and a convenient place, or exchange, for selling. Your home and car normally do not sell quickly and often involve advertising, listing, price adjustments, negotiations, counter-offers and other efforts to attract buyers. These and other physical assets are not considered liquid assets and are not designed to give you emergency cash.

    A liquidity ratio tells you how many months you can pay monthly expenses should your income stream stop. You simply divide the total cash on hand, what you have in checking, savings and your other liquid assets by your monthly expenses, including bills. With $6,000 in cash and other liquid assets a month and $2,000 in monthly expenses, you could meet expenses and monthly bills for up to three months. Brigham Young University’s Marriott School recommends that you have at least twice your monthly bills in liquid assets so that you have enough for two months worth of expenses and bills.

    You are insolvent if you owe more than your assets are worth. Some math can help warn you that you are reaching this financial cliff. Divide you total debt by your total assets to figure your debt ratio; if you owe $240,000 and you have $360,000 worth of assets, then two-thirds of your holdings are tied up in loans, credit cards, mortgages and other debt. The long-term debt coverage ratio measures how much of your take-home income goes to debt payments. With $4,000 in mortgage and credit card payments and $10,000 in monthly income, you have 40 percent of your income being absorbed in debt payments, rather than building your retirement or saving for your children’s college.

    You can solve a cash-flow problem more easily than insolvency. If cash gets tight and scarce, you can trim expenses by driving less, eating at home and reducing some luxuries. Buying more liquid assets and finding better and more sources of income can increase your liquidity. Unlike many of your monthly expenses like food and utilities, debt obligations are fixed. You must repay your loan or credit card charges; total debt decreases only when you make your debt payments or sell property. If you have a strong liquidity ratio, you can earmark extra cash for extra debt payments to lower your risk of becoming insolvent and losing your home or vehicles.

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    About the Author

    Christopher Raines began freelance writing on the internet in November 2008 after learning about eHow from a local news broadcast. By profession, he is an attorney. Raines earned his undergraduate business degree from UNC-Chapel Hill in 1993 and a law degree from UNC Law School in 1996.

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