Why liquidity matters and how to calculate it, with examples

8 minutes
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So far, we've talked about two of the items that I call the big three when it comes to getting a business loan. The first one was debt service coverage ratio, and the most recent one was collateral. In this lesson, we're going to talk about the final the third piece of the Big Three, when it comes to getting an approval for a business loan, and that is your liquidity. And we're going to go through one example of how of how to calculate your liquidity using a personal financial statement. So liquidity comes from essentially cash that you have on hand in a variety of places. And the way a banker understands the amount of liquidity that you have available, is when you fill out what is called a personal financial statement.

And just as a reminder, that is just a listing of all the assets that you have that have value and all the liabilities that you have where you have to pay someone else that subtracting with your liabilities from your assets is how they come up with your total net worth. And that is found on your personal financial statement. It's a document that you have to fill out. And sometimes you'll have to provide supporting documentation. If you say that you have $50,000 in the bank, the lender may ask you to provide a copy of your bank statements to prove that is true. So, each lender tends to have their own personal financial statement.

However, it's important to note that they are very common across the board and the way that they are structured. And also, if you're going for a small business administration loan, an SBA loan, the SBA has their own format for a personal financial statement. So you may be asked to fill a personal financial statement out for every single lender that you talk to. Most of the time, if they're asking you to do that and to sign up by the way, it's because they have specific legal language on that personal financial statement. That might be where they're including the right for them to pull credit on you and things like that. And as I mentioned earlier, anything on your personal financial statement can be verified via statements like if you say you have $40,000 in an IRA, the lender may ask for a copy of your statement from Whomever is managing the IRA on your behalf, but liquidity comes from two main places, and that is cash or marketable securities, marketable securities are just investments that can be sold quickly.

And I'm going to show you where that both of these fall on a personal financial statement. What liquidity does is two things, it shows that you have some savings to fall back on. If you run out, let's say your business is not doing well. And it's not producing money, it shows that you have some cash to live on in case things get tight, but also liquidity is where your equity injection comes from. For more on that, go back to the previous lesson about collateral I talked about where if you're buying $100,000 piece of real estate, the typical LTV is 80% on that a lender would give you 80,000 that remaining 20,000 would come out of your liquidity and that would be your equity injection. So liquidity proves to things that you have an emergency fund to fall back on and that you have the required equity injection to put into whatever the purchase says that you're making and using the loan for.

So this is just a snapshot of a personal financial statement. And just plugged in some numbers here just to give you something to think about. So starting at the top on your assets, the one thing you want to remember about this is the way this typically flows is that the top level item is the most liquid the most able to be turned into cash quickly. And then things at the bottom are less liquid. Same thing is true with your liabilities. The items at the top are the most current liabilities, the things you're going to have to pay the most soon in your timeframe.

And then further down, the less the less time, the more time you'll have to pay that liability off. So starting at the top right under assets, you can see cash and checking accounts and cash and savings accounts. I've done two numbers for you $5,000 in your checking accounts and $15,000 in your savings accounts, and then you don't have any certificates of deposit. And you have $2,000 in securities, whether that's stocks, bonds, or mutual funds. Notice that life insurance that's to two blocks down does not fall under securities. And that is not considered liquid.

Remember, the quiddity is your cash in your marketable securities, things that can be sold in the marketplace relatively quickly, roughly 30 to 60 days to turn them into true hard cash to calculate your liquidity. I've got some other things in here for you or retirement funds. That is not part of your liquidity again, because those are things that you can't necessarily sell. You can't sell a 401k Yes, you can liquidate a 401k. But you can't sell it and it takes time. They're often restrictions on how long or how quickly you can turn a 401k into cash.

So lenders will typically not include those and then real estate so your total assets are $202,000. And then you've got some debts, a note payable to someone you've got a real estate mortgage and your total liabilities are 153,000 That leaves you with a net worth of 49,000 of that 49,000. I'm gonna ask you to pause for just a second and tell me what counts as the quiddity what is the total amount of liquidity that you have on hand? Okay, I hope you took a second to pause and do that. And so the total liquidity that you have at this point will be the 5000 in the checking account, the 15,000 in the savings account and the $2,000 in marketable securities in your securities for a total of $22,000. Now, let's go back to the real estate example, you're buying $100,000 piece of real estate, the LTV, the lenders willing to give you on that as 80% so they'll give you a loan for 80,000 of the hundred thousand dollar purchase.

Where does that remaining $20,000 come from? It has to come from your liquidity. So they're assuming out of $22,000 you'll you'll use 20 $22,000. You'll use $20,000 of your liquidity to buy that that will go into the go to the purchase of that Real Estate leaving you only with $2,000. So you may have enough liquidity to pass this benchmark. But one thing that could pop up in this example is the lender can be really concerned that after you've used 20,000 of your 22,000, you'll only have $2,000 left in your emergency fund.

And that in and of itself could cause you a problem when you go to seek approval for the loan. The good news is you do have the equity injection. It's just in this instance, what a lot of people forget when they're applying for a loan is that if you're completely liquidating yourself, the lender can get really antsy about your future financial position. So the total liquidity in this example was $22,000. Again, just to reiterate, so make sure you're getting it 5000 from the checking account 15,000 from the savings account, and $2,000 from the marketable securities at 20,000. And personal property in your automobiles or jewelry doesn't count at 10,000 in your 401k doesn't count $150,000 In your real estate, none of those are considered highly liquid things.

You could sell all of them or liquidate all of them at some point, but they take time to do in this instance, for liquidity, they're looking for things that can be so quickly. You've got $22,000 in liquidity. So what happens if more is needed? Well, a lot of people ask if they can go out and borrow money in order to add to the liquidity, let's say in that example, you're using 20 of the 22,000. The lenders tells you they're concerned, you're only going to have 2000 left and you ask if you can borrow $20,000 instead of using your own cash, I would tell you that there are some lenders who would allow you to do that the vast majority are going to be concerned with that idea. But they will then do is if they're even going to consider letting you do that.

Then the $20,000 is now a new debt. They add that monthly payment into your debt service coverage ratio and it could throw you out of whack. Also, the lender may ask you to bring in someone else who's got more liquidity as a cosigner or a co guarantor. In order to strengthen your position

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