Liquid assets to net worth ratio

The liquidity ratio asks how many months of bills a household can pay from its short-term assets. This ratio asks a different question.

It asks what share of everything the household has built up is sitting in liquid form. Liquid assets on top, net worth below.

And unlike most ratios, there is no single good answer. It depends on when the money is needed.

If the goals are years away, a low ratio is the right one. Money parked in liquid assets earns little. A large share held that way will hurt the long-term goals.

If the goals fall due soon, the ratio should be higher. Money needed next year has to be in assets that can be turned into cash without a loss.

So the same number can be healthy for one client and wrong for another. The test is the calendar, not a benchmark.

Section 3.9.8 introduces this as another liquidity ratio that is tracked, immediately after the liquidity ratio itself, and gives it an interpretation rule rather than a benchmark:

• If there is a longer period to the goals, then this ratio should be low. A high ratio would indicate that a large portion of the savings are held in liquid assets and would be earning low returns. That affects the ability to meet long-term goals efficiently.
• If goals have to be met in the near term, then adequate assets must be held in easily realisable assets, and the ratio needs to be higher.

What goes in the numerator comes from section 3.9.7, and the exclusions are where the marks are. Liquid assets are those convertible into cash at short notice: savings bank balances, fixed deposits maturing within 6 months, liquid funds and similar short-term assets. Left out: real estate (slow to sell at fair value), closed-end fund units (not as easily realisable as open-end units), shares and open-end equity schemes (quick to sell, but the value can swing widely in the short term), and open-end debt schemes (a significant market element in valuation makes returns volatile).

The denominator is net worth, from section 3.9.5: total assets minus total liabilities — not total assets, and not income.

The workbook gives no benchmark figure and no worked example for this ratio. There is no 4-to-6 band here, and no percentage. The 4-to-6 figure belongs to the liquidity ratio, which is measured in months of expenses. Quoting it against this ratio is a wrong answer.

Liquid assets to net worth ratio = Liquid assets ÷ Net worth

Liquid assets = savings bank + FDs maturing within 6 months + liquid funds
                and similar short-term assets
Net worth     = Total assets − Total liabilities

Illustrative figures. Two clients, the same ratio, opposite verdicts.

Client 1 — Nikhil, 31. Goals: retirement in 29 years, a house in 8 years.

Liquid assets = 3 + 5 + 4 = Rs 12,00,000. Ratio = 12 ÷ 30 = 40%.

For Nikhil that is too high. Two-fifths of his net worth is earning deposit-level returns while his goals are 8 and 29 years out. Shifting Rs 7,00,000 into long-term assets brings the ratio to 5 ÷ 30 = 17%, and still leaves Rs 5,00,000 liquid. His net worth does not change at all — the money only moves from one asset to another.

Client 2 — Mrs Iyer, 58. Same Rs 30,00,000 net worth, same 40% — but her daughter's wedding is 10 months away and needs Rs 10,00,000. For her the 40% is right, and if she had Nikhil's 17% she would be Rs 5,00,000 short of a bill falling due next year, with only equity to sell.

The arithmetic is identical. The advice is opposite, and the only thing that changed is when the money is needed.

Chapter 3 (Cash Flow Management and Budgeting), at the end of section 3.9.8, after the liquidity ratio and before the financial assets ratio at 3.9.9. Expect a conceptual question: should this ratio be high or low for an investor whose goals are far away — the answer is low, because liquid assets earn low returns.

• The denominator is net worth, not total assets. Net worth is assets minus liabilities.
• There is no benchmark band for this ratio. The 4 to 6 figure belongs to the liquidity ratio and is counted in months of expenses.
• High is not good and low is not good. The verdict depends entirely on how far away the goals are.
• Shares are excluded from liquid assets, even though they sell in seconds, because of the uncertainty in their value.
• Only deposits maturing within 6 months count. A 3-year FD is not a liquid asset in this workbook.
• Do not confuse it with the financial assets ratio, which splits total assets into financial and physical, or with the savings to income ratio, which divides accumulated savings by annual income.