Liquidity: The Apples and Oranges of Your Financial Health

It's important to periodically assess your personal financial health. I enjoy using a free tool, NetWorthIQ, to determine my overall net worth. Essentially, the tool works by applying generally accepted accounting principles to your accounts, summing all of your assets and subtracting all of your debts to produce your net worth. It's just like high school accounting where Assets minus Liabilities equals Owner's Equity. Though this tool is useful for numerically and graphically tracking progress from month to month, it can't be interpreted as a realistic assessment of your financial health. Here's why:

All of your assets and liabilities aren't quite as simple as apples and oranges. Some liabilities have tax advantages and disadvantages, and some assets have costs associated with turning them into cash. For example, a student loan and an auto loan may look similar on paper if they have a similar balance and interest rate, but the interest paid on a student loan is tax deductible. $10,000 in a 401(k) and $10,000 in a RothIRA may seem equal, but the Roth money will never be taxed while the 401(k) will be once it's withdrawn.

So when you're determining your financial health, it's important to figure out not just your net worth, but also your liquidity. Liquidity is essentially your ability to turn your assets into cash. I'm sorry to say that these dorky financial terms don't just apply to corporations and accountants -- they apply to you. Think I'm full of it? Consider this:

Some friends of mine bought a house a few years ago for $190,000 and got a zero-down loan. Today, they owe about $187,500 on the place. After a recent life change, they need to move to a different state. Though their house is listed for several thousand dollars more than they paid and now owe, they're still worried about being able to afford to move. According to Zillow, their home's value exceeds what they owe by about $20,000. But when calculating their liquidity, they need to take into account the likely sale amount and their real estate agent's commission, which happens to be an exceptionally low four and a half percent.

Yesterday, a potential buyer offered $195,000 -- $6,500 more than what they owe. But in order to not lose any money, they'll need to sell the house for at least $196,355. The current offer leaves them bringing $1,300 cash to the table at the time of sale. Sure, they could counter offer, but who's to say that they'd ever get a higher offer?

I'm a big proponent of bean counting. It's an important step in the road to wealth. But when you decide to count your money, be sure to do a second analysis that considers only the liquid value of your assets. Obviously, cash is completely liquid. But when considering at your home's value, use a pessimistic market value (depending on how quickly you need to sell) and subtract whatever you would expect to pay a real estate agent. When considering the value of your retirement savings, subtract any taxes and penalties you would need to pay as well as any non-vested employer contributions. When calculating the value of your vehicles and personal property, think about how much cash you would realistically receive for them from a sale.

You'll probably find that your liquid assets are much smaller than your total assets. Though it might not be fun to look at, it's an important truth factor that speaks wonders about your genuine financial wellbeing.