Structural liquidity

The term liquidity comes from Latin, where the verb "liquidus" means "fluid". Whoever has a certain degree of liquidity can therefore meet their ongoing payment obligations on time. The financial planning of a company can therefore also be called liquidity planning. Liquidity planning includes all inflows and outflows within a specific period.

In general, however, the term liquidity can have different meanings in finance and is used for various circumstances. The term is divided into two broad areas: "structural liquidity" and "dispositive liquidity."

Structural liquidity indicates the extent to which economic goods and other assets can be considered financial means or means of payment. Accordingly, cash in hand is characterized by a high structural liquidity, since it already constitutes a means of payment.

The more valuable a tangible asset or item of property is, the higher its structural liquidity usually is. However, the convertibility of an asset — the conversion into a financial medium — is not always straightforward and is not possible for all assets. Convertibility generally provides every borrower with the opportunity to turn an asset into cash.

Furthermore, liquidity also has different liquidity levels. The liquidity levels are divided into liquidity level 1, 2 and 3.

Dispositive liquidity

Dispositive liquidity describes what is generally perceived as the "typical" liquidity, namely the ability of individuals and companies (in finance also referred to as "economic agents") to meet their financial obligations, i.e. payment obligations.

If dispositive liquidity is present, a private person or a company can pay their bills without problems — they are solvent. If the financial resources of the economic agent are exactly equal to the payment obligations, this is referred to as financial equilibrium. It is even better for a private person or a company if they additionally have a cash reserve. Dispositive liquidity is then not only present but even exceeded. Inability to pay (also illiquidity) occurs, however, when financial resources are less than liabilities or claims.

How is liquidity related to lending?

For private individuals, liquidity has a significant impact on their creditworthiness. Of course, credit institutions generally conclude loan agreements only with people who can repay the respective amount on time. To determine whether this is the case, companies use a so-called creditworthiness check.

Creditworthiness (from the Latin noun "bonitas" = "excellence") indicates how creditworthy a person is, i.e. how high their ability and willingness are to repay borrowed amounts. To determine a private person's liquidity, lenders or credit institutions therefore rely on the aforementioned creditworthiness check.

Some credit institutions conduct this themselves or have it carried out by external companies. Naturally, the standards for such a creditworthiness check vary: If it is only a very small loan amount, a person with low liquidity can still expect their loan to be approved and to receive the desired sum. If it is a large amount, the risk for the credit institution is, of course, correspondingly higher.

If, for example, someone applies for a mortgage loan or a loan to purchase an expensive vehicle, they must also have sufficient liquidity to be granted the desired loan amount.

The upper limit available to a borrower for a loan is called the credit line. If the borrower's liquidity situation is poor, their credit line will be relatively low.

Process of the credit check

But how exactly does a creditworthiness check proceed in order to determine a person's liquidity? As already indicated, the creditworthiness check is divided into two parts. On the one hand, the personal creditworthiness is examined, and on the other hand the economic ability to repay. The former is usually in the background.

Determining personal creditworthiness deals primarily with secondary aspects: How reliable and willing to pay is the person? In essence, the person's "financial character" is assessed here rather than their actual liquidity. Liquidity, however, is even more at the center of the assessment of the economic ability to repay. The lending company clearly focuses on the financial history of the person and to what extent they will be able to meet their financial obligations in the future.

To determine liquidity as accurately as possible, many investigative and data-technical steps are necessary. The institutions proceed differently when determining liquidity, since the criteria of each company vary.

The Schufa report for assessing liquidity

In Germany, the liquidity of private individuals is generally checked by obtaining a report from Schufa (Schutzanstalt für allgemeine Kreditsicherung). Schufa collects and consolidates data about people's financial affairs. A credit institution can use Schufa when determining a person's liquidity to find out, for example, whether the person in question has taken out loans in the past that they ultimately could not repay.

Payment arrears, enforcement measures, dunning notices or bounced checks are also signs that a person's liquidity is not in good shape.

In addition, Schufa also provides information on other characteristics related to a person's liquidity: the level of income and the stability of the respective job are typical points that Schufa examines. Of course, checking liquidity also reveals whether the person currently has ongoing loans or liabilities and how high other regular financial items are (rent and other installment positions). Furthermore, Schufa can also provide information about an insolvency.

The other financial side is, of course, also examined: Does the person have certain assets — for example real estate or other investment objects — that positively influence their liquidity? The more financial securities a person can present, the better their liquidity will generally be assessed.

Hard and soft negative entries

When assessing solvency, credit institutions and rating agencies distinguish between hard and soft negative entries in Schufa records.

• Soft negative entries represent relatively minor aspects, such as the failure to pay small invoice amounts.
• Hard negative entries are points such as ongoing insolvencies or entries due to an affidavit of means. Whoever has such a hard negative entry recorded in their Schufa file generally has poor solvency and will hardly be granted a loan.

Nevertheless, a good balance sheet and a high income do not necessarily mean that the desired loan will be approved. If a person's expenses are as high as their income, there is only little financial leeway to repay additional loans. In general, credit institutions grant the desired loan if regular income exceeds expenses by at least the amount of the desired loan installment.

If this is not the case, the loan term can also be extended so that the private person pays lower installments and, despite rather low liquidity, receives the hoped-for sum.