Table of Contents

Liquidity Cushion: What It Is, How It Works, and Examples

By 澳洲幸运5官方开奖结果体彩网:Will Kenton

Updated September 30, 2024

Reviewed by

Ebony Howard

Fact checked by

Suzanne Kvilhaug

A close up of a person, holding their glasses and looking at their computer screen. — Gracy Cary / Getty Images

What Is a Liquidity Cushion?

A liquidity cushion refers to the cash or highly liquid assets that an individual or company might hold to meet unexpected demands for cash during a 澳洲幸运5官方开奖结果体彩网:liquidity crisis. It's a rainy day fund, an 澳洲幸运5官方开奖结果体彩网:emergency fund.

Key Takeaways

Liquidity refers to the cash assets a company or individual has on hand. Assets that are not cash and hard to turn into cash quickly are illiquid.
Cash in reserve is a hedge against external shocks to an individual or company's operating expenses.
A company or individual's operating expenses, their obligations (like debt payments) versus their income, may have a thin margin. When this is the case, having a liquidity cushion means they won't have to sell illiquid assets to cover expenses if there is a shortfall in income.

How a Liquidity Cushion Works

A liquidity cushion protects an individual or a business from having to sell illiquid assets like 澳洲幸运5官方开奖结果体彩网:real estate or equipment to pay off debts.

The same principle applies to banks and other financial institutions that buy and sell assets by borrowing money, also known as trading using leverage. If a company or trader is too highly leveraged and they don't have a liquidity cushion or cash reserve, they can be forced to 🃏sell assets at a loss if they can't dip into cash reserves to service debt obligations.

Fast Fact

The opposite of a liquidity cushion is a liquidity crunch, where an individual or a company finds it does not have the cash on hand to pay its o💮bligations by the due date.

In finance, when banks do not have the cash to cover depositors' demands for money, it's called a liquidity crisis.

Examples

Automobile companies are wise to keep a bit of a cash buffer, given that their industry is so cyclical. The Ford Motor Company, for example, mortgaged all of the company’s assets for $23.6 billion in loans in November 2006 to finance an overhaul and give it a cushion to protect itself against a recession.

This was a shrewd move. Unlike General Motors and Chrysler, Ford did not need to be 澳洲幸运5官方开奖结果体彩网:bailed out by the government during the 澳洲幸运5官方开奖结果体彩网:global financial crisis. Nor did Ford have to give any concessions to union workers as a condition for federal aid. Moreove🅺r, its self-sufficiency also 𝔍turned into a valuable marketing tool.

Similarly, The Dodd-Frank Wall 🐼Street Refor🦄m and Consumer Protection Act of 2010 (Dodd-Frank Act) requires banks to have a liquidity cushion in case of another financial crisis similar to the financial crisis of 2008. According to the Federal Housing Finance Agency, "The Dodd-Frank Act requires certain financial companies with total consolidated assets of more than $250 billion, and which are regulated by a primary federal financial regulatory agency, to conduct annual stress tests to determine whether the companies have sufficient capital to absorb losses and support operations during adverse economic conditions."

What Is Liquidity?

Liquidity is how quickly an asset🌠 can be turned into cash. Monkey market accounts are liquid, whereas r꧋eal estate is not.

How Do I Get an Emergency Fund?

Most emergency funds are build slowly, over many months or even years. To start one, open a high-yield savings accoun💎t. You can do this at most banks and credit unions, and some brok💯erages. The key is to have a plan.

You may want to follow the adage of 澳洲幸运5官方开奖结果体彩网:paying yourself first. Make your savings goal—this emergency fund—a line item on your budget. Treat it like a bill, like paying for electricity. And consider automating it. You can set it to withdraw funds from your checking account on the same day per month, and it will do so without you needing to do anything. That way, you'll know that the funds will be going where you need them to—and you won't be tempted to skip a month.

How Much Money Should Be in an Emergency Fund?

Though this will vary based on your particular circumstances, one rule of thumb is to save three to six months' worth of expenses in an emergency fund. This would allow you to survive on your emergency fund if you lost your job—it would give you a three-to-six-month runway to find another job while living off your savings.

The Bottom Line

A liquidity cushion is an emergency fund for companies, organizations, and individuals. It's wise to have one. A liquidity cushion of 澳洲幸运5官方开奖结果体彩网:cash reserves or 澳洲幸运5官方开奖结果体彩网:money market instruments can prevent you from having to sell more illiquid securities or other investments–poℱssibly at a loss–to raise cash to meet short-t𒊎erm obligations like repaying loans, bills or wages.

Article Sources

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U.S. Securities and Exchange Commission. "."
Federal Housing Finance Agency. "."

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