Liquidity ratio in personal finance indicates your ability to meet committed expenses by using your cash assets. This ratio tells how comfortably you can meet your financial obligations when you are faced with any emergency such as job loss, accident, prolonged ill-health, etc.
This ratio indicates the number of months for which you can meet the expenses of your current lifestyle, if in case you lose all your income sources.
How to calculate the Liquidity Ratio for individuals?
Liquidity refers to how easily an asset can be converted to cash. Assets such as real estate are not easy to liquidate.
It is calculated as below:
LIQUIDITY RATIO = CASH OR CASH EQUIVALENTS / MONTHLY COMMITTED EXPENSES
Cash and cash equivalent assets such as money in bank savings accounts, fixed deposits, money market funds, liquid mutual funds are easy to liquidate.
Monthly committed expenses are the sum of all mandatory expenses such as your groceries, utility bills, children’s education expenses, insurance premiums, loan EMIs, etc. It does not include any investments you make every month.
Example: If your monthly expense is Rs.1 lakh, and the value of your cash and cash equivalent assets is Rs.10 lakhs, then your Liquidity Ratio is 10 (10lakhs/1 lakh).
It is advisable to maintain 3-6 months of expenses in cash or cash equivalent assets to serve as your emergency fund. This means that the ideal liquidity ratio should be in the range between 3 and 6.
Higher the number, the better it is as it means that you can utilize your cash reserves for a longer time in case of an emergency.