Liquidity & liquid assets: Definitions, measurement & importance

Building a sustainable financial future requires a combination of accessible funds to spend and growth-oriented investments. Your portfolio must balance your immediate needs with compounding gains toward future goals.

A key part of deciding how you'll save and invest is understanding both the benefits and challenges of liquid cash and the liquidity of all your assets. Understanding when and why you need liquidity will help you make decisions on how to grow your investments as well as empower you to handle unexpected expenses confidently.

Liquidity is how easily an asset can be converted into cash and be spent. Every asset and investment requires finding a market if you decide to sell it—whether it's the stock market, where selling a stock or mutual fund is usually fast and simple, or the more complicated world of finding a buyer for real estate.

Keeping some of your assets liquid allows you to spend money when the need arises, but many assets that grow in value over time aren't fully liquid. That's why people opt to widen their asset allocations instead of keeping all their money in a checking account.

An asset's liquidity includes how quickly you could sell it as well as how much of the value is retained when you do. For instance, you might be able to sell your house quickly if homes are in high demand in your area, but the faster you need to sell, the more likely you are to entertain lower offers than you'd consider if you had time to wait.

Knowing your asset liquidity helps you understand what you can immediately spend, what might be available to you within a couple of years and what needs to be saved for future goals like retirement.

Within financial circles, liquidity is characterized in two main ways: market liquidity and accounting liquidity. It's valuable to understand both in the context of your personal purchasing power and household wealth.

Market liquidity focuses on selling assets like investments or property and how many interested buyers there are at a given time. Liquidity doesn't stay the same for certain assets. While the demand for cash and cash equivalents is relatively stable, demand for other assets varies widely.

Concert tickets to an upcoming sold-out show, for instance, may be a highly liquid market if there are lots of people ready to pay full price. On the other hand, those same unused tickets lose all liquidity the day after the concert—there's no longer anyone willing to pay for them.

Accounting liquidity refers to cash flow, or how easily you can meet your recurring obligations based on your available cash. Having strong accounting liquidity means being able to pay your bills, including debt payments, using your most liquid assets without resorting to selling nonliquid assets at a loss.

Perhaps your family has plenty of assets, like home equity and two cars, but because of high daycare bills or college tuition in the short-term, each month you are spending your entire paycheck and even dipping into savings. Long-term, you have a strong positive net worth, but because you don't want to sell your home or cars, right now, you're in a tight place for accounting liquidity. Reducing expenses, increasing income or tapping other liquid assets like a savings account can help you boost accounting liquidity.

Different asset classes have different liquidity. The most liquid assets are cash and accounts known as "cash equivalents," like savings, checking and money market accounts. Even certificates of deposit (CDs) and I bonds could be considered liquid, slightly less liquid than a checking or savings account, but fairly easily accessible.

Assets like mutual funds, stocks and bonds are considered quite liquid because of how quickly they can be sold for their current value. However, selling equities quickly can result in a loss of value if the market happens to be in a downturn. If your equities are part of retirement accounts, but you aren't yet retirement age, selling these assets early could incur penalties, making them a less desirable source of liquidity than a cash equivalent.

Illiquid assets include anything with a small or niche market; they may be able to be sold, but not necessarily for the current value or purchase price. For example, if you buy a necklace for $1,000 today, you might not be able to sell it for $1,000 tomorrow if you can't find someone who wants to buy it for that price. Other examples include cars, which tend to sell for far less than their purchase price, and real estate.

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How can liquid assets earn interest?

Not sure how to have your cash earning gains while also maintaining it as a liquid asset?  Learn more about the most effective places to keep your cash.

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Companies have very specific metrics for measuring liquidity using ratios that help them easily identify whether they have the cash flow they need or if they need to free up more money for ongoing operations.

In a family, you might want to use a modified version of the "quick ratio" that companies use to measure liquidity. To use this ratio, add up all your cash and cash equivalents, all market securities like brokerage accounts and any money owed to you, then divide that total by how much debt you have. The higher the resulting ratio, the better your liquidity.

Another practical way to evaluate your liquidity is to look at your "cash ratio." In a given month, look at how much cash you have coming in and divide it by your liabilities, or payments that have to go out. If the cash is consistently higher than the liabilities, you have enough liquidity to make all your payments.

Most people keep emergency funds in cash and cash equivalents to ensure the liquidity they need. Having enough to cover three to six months' worth of household expenses in these accounts is prudent to absorb the shock of a job loss or an unexpected expense. Also, it's recommended to have other funds you anticipate using in less than three to five years as longer term investments that have greater earning potential invested elsewhere.

Many assets with high growth potential, like retirement accounts, aren't highly liquid. Ideally, your portfolio includes just enough liquid assets to cover both your day-to-day expenses and a reasonable cushion. The rest of your portfolio should be growing. Those earnings reduce the amount you need in earned income as you save toward your goals.

A Thrivent financial advisor can help you assess your financial portfolio and figure out if you currently have too much or too little liquidity and offer advice on how to course-correct. These experts can help you achieve the competing goals of keeping your money growing in the market while also having cash on hand to pay for an emergency expense. Understanding liquidity helps you balance the needs of the now with your financial plan for growing your wealth into the future.