A.M. Best's Insurance Resources defines liquidity as "the ability of an individual or business to quickly convert assets into cash without incurring a considerable loss." In a challenging economy many struggle with too little liquidity. For many their primary asset, a home, is financed for more than it is worth. However, significant disadvantages come with being too liquid as well -- whether you own a business or just want to balance your checkbook.
Interest rates for cash investment options are always lower than others. Compare a passbook savings account or a business money market account with a certificate of deposit that is locked at a two-year rate to realize that you pay for liquidity. Compare even less liquid options, such as tax-deferred investments that penalize you in taxes for withdrawing early, to find even higher interest rates. If investors at a bank or other financial institution know they have your money at their disposal for a longer period, it can earn more from it and pay you more in return.
When a nation borrows substantial amounts of money to meet its obligations, a higher potential for inflation exists. Its money will then have lower purchasing power, which applies to personal and business finances as well. If you "own" money, or you are liquid, at a low price and the cost of goods jumps dramatically, your cash is worth less than it was when you acquired it. If you invest in a product that appreciates, it can act as a hedge to inflation since its value is not trapped at the lower value.
Unless you gather your liquidity in a jar and hide it under your bed, you will have to pay taxes on the minimal amount of interest you receive for your investment. Paying taxes in addition to increasing inflation means you lose money on these low-interest liquid investments. In addition, if you put your liquidity into an IRA, you can often claim a tax deduction on the money and reduce your federal tax bill, which works the same way in a small business. You may also miss potential grants and tax credits for investing in machinery and employment initiatives that promise tax savings.
Many cite peace of mind as a reason to be liquid. If 401(k) balances suddenly decline due to a stock market correction and the potential for inflation increases, having excess unnecessary liquidity in the previous years compounds the problem. In a business, too much liquidity may indicate you are spending too little on research and development. If you do not create new revenue streams and your existing revenue declines due to normal demand curves and product life cycles, you will likely lose market share. This "opportunity cost" of being too conservative with liquid cash can be high.
- A.M. Best: Glossary of Insurance Terms
- Money Management: Take Into Consideration the Liquidity Advantages
- Q Finance: Liquidity Ratio Analysis
- Salisbury University: Cash and Liquidity Management
- Ellis County (KS): Business Machinery & Equipment Tax Credit
- U.S. Department of Energy: Consumer Energy Tax Incentives