Liquidity ratio
Also written Liquid ratio
Liquid assets divided by monthly expenses including loan repayments — the number of months a household could keep paying its bills from short-term assets if income stopped.
In plain language
A household can be wealthy and still be caught short. Real estate cannot pay next month's school fees, and shares may have to be sold at the worst moment.
The liquidity ratio measures how well the household is equipped to meet its expenses from its short-term assets. Its answer comes out in months: a ratio of 6 means six months of expenses are covered by assets that can be turned into cash quickly and at a predictable value.
The near-term liquidity need is normally taken as the expenses the investor will incur over the following 6 months, including loan repayments; in exceptional situations a longer period may be considered.
How it works
What counts as liquid. Liquid assets are those that can be easily converted into cash at short notice: money in a savings bank account, fixed deposits maturing within 6 months, liquid funds and similar short-term assets.
What the workbook keeps out, and why:
- Real estate — it can take a long time to sell at fair value.
- Closed-end fund units — not as easily realisable as open-end units.
- Shares and open-end equity schemes — easily sold, but their value can fluctuate widely in the short term, making them unsuitable for realising cash at short notice.
- Open-end debt schemes — they carry a significant market element in valuation that makes their returns volatile.
The workbook example (NFG). Monthly expenses including loan repayments are Rs 1.5 lakh. Assets: equity shares Rs 3 lakh, savings bank Rs 7 lakh, short-term FDs Rs 2 lakh, long-term FDs Rs 6 lakh, open-end liquid funds Rs 4 lakh, other open-end funds Rs 5 lakh, closed-end funds Rs 12 lakh. Liquid assets = 7 + 2 + 4 = Rs 13 lakh, and the ratio = 13 ÷ 1.5 = 8.67 (the workbook prints 8.66).
Benchmark. A ratio of at least 4 to 6 indicates a comfortable level — expenses covered for 4 to 6 months even if regular income is lost or falls. Liquidity has a cost, though: shorter deposits and liquid funds typically earn less, so the balance beyond requirement belongs in longer-term assets.
A related measure is the liquid assets to net worth ratio, which should be low when goals are far away and higher when goals are near.
The formula
Liquidity ratio = Liquid assets ÷ Monthly expenses (including loan repayments)
A worked example
Illustrative figures.
The Deshmukh family spends Rs 70,000 a month on living expenses and pays a home loan EMI of Rs 30,000 — Rs 1,00,000 a month in all. Their holdings:
| Asset | Value | Liquid? |
|---|---|---|
| Savings bank balance | Rs 1,50,000 | Yes |
| FD maturing in 4 months | Rs 2,00,000 | Yes |
| FD maturing in 3 years | Rs 5,00,000 | No — beyond 6 months |
| Liquid fund | Rs 1,00,000 | Yes |
| Equity mutual fund | Rs 9,00,000 | No — value can swing |
| Listed shares | Rs 4,00,000 | No — value can swing |
| Liquid assets | Rs 4,50,000 |
Liquidity ratio = 4,50,000 ÷ 1,00,000 = 4.5. Inside the 4 to 6 band, at its lower end.
Two common mistakes would flatter the number. Leaving the EMI out of expenses gives 4,50,000 ÷ 70,000 = 6.4. Counting the equity fund and shares as liquid gives 17,50,000 ÷ 1,00,000 = 17.5. Neither is what the workbook measures — an EMI still falls due when income stops, and an equity fund redeemed in a falling market does not deliver its statement value.
If the family wants six months of cover, it needs Rs 6,00,000 in liquid assets — a further Rs 1,50,000, for example by letting part of the next maturing deposit sit in a liquid fund.
Why NISM asks about it
Chapter 3 (Cash Flow Management and Budgeting), section 3.9.7 on liquid assets and 3.9.8 on the liquidity ratio; the emergency fund in 3.8 covers the same ground from the planning side. Expect a list of holdings from which you must pick the liquid ones before dividing — exactly the NFG example — and a question on which assets are excluded and why.
Common exam traps
- Expenses include loan repayments. The workbook says so twice.
- Shares are excluded because of the uncertainty in their value, even though they can be sold quickly.
- Only FDs maturing within 6 months count. Long-term deposits are left out of the NFG total.
- The benchmark wording is not consistent inside the chapter. Section 3.9.8 first says a ratio of at least 4 to 6 is comfortable, and a few lines later that around 6 indicates a comfortable situation; the emergency fund in 3.8 is sized at six months. If an option says 4 to 6, that is the formal benchmark; 6 months is the emergency-fund figure.
- Section 3.9.7 is loose about mutual funds. Its opening list includes "liquid funds or other mutual funds", but the same section then excludes open-end equity and debt schemes, and the NFG example counts only the liquid fund. Follow the worked example.
- More is not always better. Liquidity comes at a cost; a very high ratio means savings are earning low returns.
Check yourself
1.What liquidity ratio does the chapter describe as a comfortable level for a household?
- a)At least 1 to 2
- b)At least 4 to 6
- c)At least 10 to 12
- d)At least 20
Show the answer
Answer: (b) At least 4 to 6
"A ratio of at least 4 to 6 indicates a comfortable level for the household to meet its expenses for 4 to 6 months, even if there was a loss or decline in regular income." The ratio is calculated as Liquid Assets divided by Monthly Expenses, with expenses including loan repayments.
Where this is taught
Free preparation for NISM Series X-ARelated terms
- Liquid assetsThe collateral a clearing member deposits with the clearing corporation, valued daily after haircuts, which must cover MTM losses, VaR margin, extreme loss margin and base minimum capital.
- Debt to income ratioMonthly debt servicing commitment divided by monthly income — the ratio that says whether a household's income can carry the loans it already has, let alone another one.
- Emergency fundA pool of money held in liquid assets, sized at six months of household expenses, kept aside so that an interruption in income does not force the sale of long-term investments.
- Liquid assets to net worth ratioLiquid assets as a share of net worth — read against the timing of the household's goals, so a low figure is right when goals are distant and a higher one when they are near.
- Savings to income ratioTotal accumulated savings divided by annual income — a measure of how prepared a household is for long-term goals such as retirement, expected to rise with age.
- Physical assetsTangible assets such as real estate, gold and other precious metals — held for appreciation, treated as natural inflation hedges, and illiquid, unregulated and large-ticket by nature.
- Personal balance sheetA statement of an individual's or household's assets and liabilities at a particular date, whose difference is net worth — the starting point for the personal finance ratios.
- Financial assets ratioThe share of an investor's total assets held in financial form — shares, deposits, mutual funds — rather than physical form such as gold or real estate, expressed as a percentage.