What Are Liquid Assets and How Do They Work?
Liquid assets are any assets that can be easily and quickly converted into cash. In fact, people often refer to liquid assets as cash or cash equivalents, because they know that the asset can be exchanged for actual cash without losing value.
Here’s a closer look at the topic and how liquid assets can contribute to your financial wellbeing.
Key Points
• Liquid assets are easily convertible to cash, allowing quick access to funds without significant loss in value, essential for financial flexibility during emergencies.
• Common examples of liquid assets include cash in bank accounts, stocks, bonds, mutual funds, and money market funds, which can be readily sold for cash.
• Non-liquid assets, such as real estate and collectibles, require more time and effort to convert into cash, often leading to potential value loss during the process.
• Maintaining liquid assets is important for calculating net worth, applying for loans, and ensuring a business can handle emergencies or market fluctuations effectively.
• Building liquid assets involves creating an emergency fund with three to six months’ worth of expenses, allowing for better financial security and investment opportunities.
What Makes an Asset Liquid?
Liquidity means that you can readily access an asset as cash. While you might own any number of valuable assets (e.g., your home, retirement accounts, collectibles) and these can be considered part of your overall net worth, only liquid assets can generate cash quickly, when circumstances demand it. If you needed cash quickly, you likely would not be able to sell your home overnight to get money.
For an asset to be considered liquid, it must be traded on a well-established market with a large number of buyers and sellers. It also must be relatively easy to transfer ownership. Think: stocks, bonds, mutual funds and other marketable securities.
Generally, you can sell stocks and obtain cash readily. By contrast, you probably couldn’t sell your vintage watch collection that fast, and even if you could, there are a number of factors that might influence how much cash value you might obtain from the sale.
Worth noting: Although liquid assets (aka cash and cash equivalents) pose very little risk of loss, they also have little or no capacity for growth.
What Investments Are Considered Liquid Assets?
As you can see, the primary advantage of liquid assets is that they can be converted to cash in a short period of time. For example, stock trades must be settled within two days, according to Securities and Exchange Commission rules. Here, you’ll learn more about what are considered liquid assets.
Examples of Liquid Assets
Here are some specifics about what a liquid asset is.
• Money in the bank. Cash in a checking and savings account is a liquid asset.
• Stocks. Stocks are often considered liquid assets because they can be converted into cash when you sell them. Keep in mind, though, that the most liquid stocks might be the ones that many people want to buy and sell. You may have a more difficult time liquidating stocks that are in lower demand.
• U.S. Treasuries and bonds. These instruments are relatively easy to buy and sell, and these processes are usually done in high volume. They have a wide range of maturity dates, which helps you to figure out when you want to liquidate them. Because U.S. Treasuries are often considered relatively safe and dependable, the interest rates are somewhat lower and could be a good fit for investors who are looking to mitigate risk.
• Mutual funds. Mutual funds are pooled investment vehicles that hold a diversified basket of stocks, bonds, or other investments.
◦ Open-end mutual funds are considered more liquid than closed-end funds because they have no limit on the number of shares they can generate. Also, investors can sell their shares back to the fund at any time.
◦ Closed-end mutual funds, on the other hand, are less common. These funds raise capital from investors via an IPO; after that, the number of shares are fixed, and no new shares are created. Instead, closed-end funds shares can only be bought and sold on an exchange, and thus are considered less liquid than open-end fund shares because they’re more subject to market demand.
• Exchange-traded funds and index funds. Like mutual funds, exchange-traded funds (ETFs) and index funds allow individuals to invest in a diversified basket of investments. ETFs are traded like stocks, throughout the day on the open market, which makes them somewhat more liquid than index funds, which only trade at the end of the day.
• Money market assets. There are two main types of money market assets:
◦ A money market fund is a type of mutual fund that invests in high-quality short-term debt, cash, and cash equivalents. It’s considered low-risk and offers low yields. It is therefore thought of as a relatively safe vs. risky investment. You can cash in your chips at any time, making money-market funds a liquid investment.
◦ Money market funds are different from money market accounts, which are a type of savings account that’s insured by the Federal Deposit Insurance Corporation (FDIC).
• Certificates of deposit. If you have money in a certificate of deposit or CD, this might be considered semi-liquid because your money isn’t available until the official withdrawal date. You can withdraw money if you need it, but if you’re doing so before the maturity date, you’ll likely pay a penalty.
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What Assets Are Considered Non-Liquid?
There are, of course, many assets that are not easy to liquidate quickly. These assets typically take a relatively long time to sell or for the deal to close. You’ll get your money, but most likely not right away, and there may be time or costs associated with the conversion to cash that could impact the final amount. That’s why assets like these are considered illiquid or non-liquid assets.
Examples of Non-Liquid Assets
• Collectibles. Items like jewelry and artwork, as well as hobby collections like stamps and baseball cards, may be hard to value and difficult to sell.
• Employee stock options. While employee stock options can be a valuable form of compensation, they may also be highly non-liquid. That’s because employees must typically remain with a company for years before their options vest, they exercise them, and they finally own the stock.
• Land and real estate. These investments often require negotiation and contracts that can tie up real estate transactions for weeks, if not months.
• Private equity. There are often strict restrictions about when you can sell shares if you’ve invested in private equity assets such as venture capital funds.
Liquid Assets in Business
If you’re running a business, accounts receivable — the money you’re owed from clients — are often considered to be a liquid asset, because you can typically expect to be paid within one or two months of billing.
Any inventory you have on hand, such as office furniture or a product you’re selling, can also be considered liquid, because you could sell them for cash if need be. The liquid assets on your company balance sheet usually list cash first, followed by other assets that are considered liquid, in order of liquidity.
Having more liquid assets is desirable because it indicates that a company can pay off debt more easily. When businesses need to determine how cash liquid they are, they often look at the amount of their net liquid assets. When all current debts and liabilities are paid off, whatever remains is considered their liquid assets.
Are Retirement Accounts like IRAs and 401(k)s Liquid Assets?
Retirement accounts, such as individual retirement accounts (IRAs) and 401(k)s are not really liquid until you’ve reached age 59 ½. Withdraw funds from your account before then, and you may face taxes and a 10% early withdrawal penalty.
What’s more, you can hold a variety of assets inside retirement accounts. For example, if you hold a money market fund inside your IRA, that is a liquid asset. But you could also hold real estate, which very much isn’t.
Reasons Why Liquid Assets Matter
Other than the most obvious reason, which is that cash gives you a great deal of flexibility and can be essential in a crisis, liquid assets serve a number of purposes.
• Calculating net worth: To calculate your net worth, subtract your liabilities (your debt) from your assets (what you own, which can include your liquid assets).
• Applying for loans: Lenders might look at your liquid assets when you apply for a mortgage, car loan, or home equity loan. If your liquid assets are high, you may get better terms or lower interest rates on your loans. Lenders want to know that if you were to lose your job and/or your income, you would be able to continue to pay back the loan using your liquid assets.
• Business interests: Having liquid assets on your balance sheet is a signal that your business is prepared for an emergency or a market shift that could require a cash infusion.
Are All Liquid Assets Taxable?
While income is money you earn or receive, an asset is something of value you possess that can be converted to cash at some point in the future. While owning an asset doesn’t make it taxable, converting it to actual cash would, in most cases.
The IRS, or Internal Revenue Service, has many rules around how the proceeds from the sale of assets can be taxed.
The IRS considers taxable income to include gains from stocks, interest from bonds, dividends, alimony, and more. Gains on the sale of a home might be taxed, depending on the amount of the gain and marital status. If you aren’t sure whether income from the sale of an asset is taxable, it might be wise to consult a tax professional.
Is It Smart to Keep Cashing In Liquid Assets?
The point of maintaining a portion of your assets in liquid investments is partly for flexibility and also for diversification. The more access to cash you have, the more prepared you are to navigate a sudden change in circumstances, whether an emergency expense or an investment opportunity.
Having a portion of your portfolio in cash or cash equivalents can also be a hedge against volatility.
Thus, it may be worth keeping a mix of both liquid and non-liquid assets to help you reach your short-term financial goals as well as longer-term ones. And while cashing in liquid assets might be necessary, it’s also prudent to keep some cash on hand in case you need it. You may want to focus on gathering at least three to six months’ worth of expenses in the form of liquid assets as an emergency fund.
How Liquid Are You?
To figure out how liquid you are, make a list of all your monthly expenses, from rent/mortgage on down, including even your streaming service subscription. Then, make a list of all your liquid assets and investments (being careful to pay attention to the definition of liquid assets vs. illiquid assets, as it can be confusing).
Then, total all your monthly expenses, and compare that sum to the liquid assets in your possession.
Does your total savings cover six months’ worth of monthly expenses? If so, congrats! If not, you’re not very liquid. Don’t despair, though. There are ways to build up more liquidity by growing your emergency fund.
Where to Start Building Liquid Assets
As you start to build your liquid assets, first consider saving a cash cushion in the form of an emergency fund, which should be enough to cover any unexpected expenses that might come along.
Envision what you might need in the event of a crisis (e.g., a job loss, divorce, health event, and so on). In terms of how much to save in an emergency fund, aim to accumulate three to six months’ worth of expenses to cover basic bills, repairs, insurance premiums and copays, as well as any other personal or medical expenses.
One good way to build liquidity is to set money aside every week or month. Or you might have a set savings amount auto-deducted from each paycheck. You could keep the funds in a high-yield savings account to help them grow.
From there, you may consider opening a retirement account or a taxable brokerage account where you can invest in potentially more lucrative (but risky) liquid investments, such as stocks, bonds, mutual funds, and ETFs.
The Takeaway
Liquid assets are assets that can be converted into cash relatively easily — typically with little or no loss in value. Liquid assets can include cash in a checking or savings account, money market accounts, or marketable securities like stocks, bonds, mutual funds, and ETFs.
Liquid investments can play a surprisingly important role in your financial wellbeing. Having ready access to cash can help you pay off debt, cover a crisis, or be able to invest in new opportunities.
Having the right banking partner can help you keep your cash secure and earning interest.
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FAQ
What’s the definition of a liquid asset?
A liquid asset is an asset that is readily converted into cash, such as money in the bank, stocks, or a certificate of deposit (although you might owe a penalty when you liquidate it).
What does non-liquid asset mean?
Non-liquid assets are resources that can’t be quickly converted to cash, such as real estate, employee stock options, or collectibles (such as artwork or jewelry) that would have to be sold, which can take time and the price may fluctuate.
Is a 401(k) considered a liquid asset?
Retirement accounts, such as a 401(k) are not really considered liquid until you are over the age of 59 ½. Before that age, you would face a 10% early withdrawal penalty, as well as taxes, meaning you would take a loss on the value.
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