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Cash is piling up. Your bank balances are getting pretty solid. Do you have more than you need? How much is too much to keep in your practice checking account? What about the size of your personal emergency fund? Should you invest it, or pay off the remainder of your debts? In this episode of Dentist Money™, Reese and Ryan discuss why having a lot of assets doesn’t always mean financial security and the amount of cash you should keep in your bank account.
Reese Harper: Welcome to the Dentist Money Show where we help dentists make smart financial decisions. I’m your host, Reese Harper, here with my co-host, Sir Ryan Isaac.
Ryan Isaac: Hello Reese. Today we are going to talk about liquidity. It’s very complicated, and to kick things off I’m going to start by talking about the most famous liquid of all—
Reese Harper: Carbon dioxide.
Ryan Isaac: Carbon water. The most famous liquid of all is water.
Reese Harper: I never thought of water as being famous. I knew you were going to say that, so I just threw you off. I guess if you really think about, I mean who hasn’t heard of that famous substance water?
Ryan Isaac: I was actually curious, if you took all the consumed beverages from around the world, water would have to be the most famous wouldn’t it? It wouldn’t be vodka?
Reese Harper: Most popular? Well as you know it makes up about two-thirds of the human body.
Ryan Isaac: Yes, do you know how many days a person can survive without water?
Reese Harper: At least 3-4 days probably.
Ryan Isaac: I looked at a website called livescience.com and they said 3-5 days, no sarcasm. Some people have made it as long as 8-10 days.
Reese Harper: Who?
Ryan Isaac: Some people. Yes, some people say that some people have made it.
Reese Harper: Live Science said that some people have done that. I’d like to meet that guy. I’ve seen that on some outdoor movies where people are stuck in the wild for months, and they eat dirt or snow. Sometimes they can get some liquid out of there, but they seem to last for months.
Ryan Isaac: Yes they do. A few websites say the minimum amount of water a human needs per day is about a liter per day. Some of that water does come from the consumption of food though.
Reese Harper: Fruit right?
Ryan Isaac: Fruit.
Reese Harper: What about pizza? I mean is there water in pizza?
Ryan Isaac: You’ve got some tomato sauce.
Reese Harper: We’re getting way off topic here. My wife is really good about encouraging me to drink water by the way. Just along those lines of staying on subject. But I heard eight glasses of water a day was a recommendation—it’s a good idea. But I’m wondering, if I ate eight pizzas a day, would I get enough water to replace the eight glasses of recommended water?
Ryan Isaac: Now I’m not a scientist or a dietician, but I don’t think you can sub pizza for recommended water intake. Could you eat 7-8 pizzas a day?
Reese Harper: No, but that’s not the point!
Ryan Isaac: Well that sounded like the point. You should know better is the point.
Reese Harper: This is a curious mind at work, Ryan.
Ryan Isaac: That’s fine, you’re always questioning. It’s probably a myth anyway. It’s just easy to remember that. All right—the other side of this is that it’s actually possible to drink too much water.
Reese Harper: Yeah, there’s a name for that, and I did actually know this. I think it’s called water intoxication.
Ryan Isaac: Yes, now this isn’t a funny story even though the name of the competition is funny. There’s this woman in California who did a water drinking competition for a radio show in California. It’s not a funny story like I said—but they were doing a competition called “Hold Your Wee For a Wee.” As in a Nintendo Wii. We’re not laughing at this story—this is tragedy. The name is funny. They had a contest to see who could drink the most amount of water without going to the bathroom, and she ended up drinking two gallons in three hours which was too much water for her body, and she ended up dying later that day.
Reese Harper: Why did you share that story? I don’t understand this.
Ryan Isaac: It was too much. It was too much liquidity.
Reese Harper: On the air? Like that’s super sad. I think I remember doing a challenge like that though in my teenage years, and there probably was some sort of lawsuit against the radio station for that day though.
Ryan Isaac: Like I said, they probably came up with the name for it and thought it would be hilarious. The lawsuit was 16.5 million to the husband, but here’s where we are going with this—we’re going to talk about liquidity. So in the world of finance, liquidity is represented by cash or the level of access to assets that can be quickly turned into cash. Some things are more liquid than others—like your green paper money. You only carry bills. Or the cash you have in your bank account—that’s the most liquid form of money.
Reese Harper: Yeah then you have your bank accounts; you’ve got money market funds, bonds, bond mutual funds, stocks or even stock mutual funds. As long as all these things aren’t tied up inside of a retirement plan, they can be turned into cash pretty quickly without a lot of consequences or penalties. Now some of those examples I just shared are most volatile—they move up and down more than others, but they can all be converted rather quickly into the ol’ greenback that Ryan carries in his wallet.
Ryan Isaac: My billfold is what they call it. Then you have all of your investments that are tied up in other things like qualified retirement plans, which those are the 401Ks and IRAs. There’s real estate, practice equity, things like that; these kind of things aren’t nearly as liquid. Reese you start by telling us—why is it important for dentists to maintain a certain level of liquidity in their practice and personal finances?
Reese Harper: Why don’t we start by having you tell me—I always have to be the person that tells us, and there’s only two of us here.
Ryan Isaac: I’m Sir Ryan Isaac the co-host.
Reese Harper: All right, so liquidity is like the financial equivalent to water—the beverage we just talked about. You can go a little without it, but eventually you need it to survive and thrive. How did you like that? So if you own a bunch of real estate or have hundreds of thousands or even millions of dollars in practice equity, your financial security can still be put at risk if you don’t have adequate liquidity to take care of the ups and downs that come with business ownership. A lot of people get carried away thinking that they are a multi millionaire, and that they are in a really great financial position when the lack of liquidity on their balance sheet will be their down fall. It’s a huge risk and people don’t acknowledge it often enough. They just get excited about the stuff they own.
Ryan Isaac: You’re saying there’s a big difference in the financial strength of somebody who is highly liquid and someone who is just really asset heavy on paper?
Reese Harper: Yeah, all investors need to measure their individual balance sheets and make sure that they are liquid enough. There’s a bunch of time, red tape and transaction costs that go into turning assets like real estate into cash, so my point is that on paper you can add up everything you own and say, “I’m really wealthy.” But unless there’s a large percentage of your wealth that’s accessible and liquid, your hands are going to be tied.
Ryan Isaac: Yeah, we were just talking about a local company here that went through that a few years ago—it’s called Love Sac. Did you go into Lovesac by the way?
Reese Harper: Yeah, I’m a big fan.
Ryan Isaac: Do you still have yours?
Reese Harper: I sold it, but my kids still want one. It’s a phase—every 3-4 years, “Dad where did the Lovesac go?” I’m like, it was taking up 1,000 square feet of our house, and it was dirty and collecting dust.
Ryan Isaac: The store is still open, and they are still selling things.
Reese Harper: A lot. Now they’re selling couches—the Love Sacs have kind of fizzled.
Ryan Isaac: So Lovesac, again the company that made those huge over-sized bean bags that were really popular. I can’t believe that was about fifteen years ago. Time flies. Their founder and CEO—he won a million bucks. Do you remember the TV show he was on with Richard Branson called the Rebel Billionaire? He was jumping out of hot air balloons. He won a million bucks for the company; they got to about thirty million in sales by 2005, and then in 2006 they filed bankruptcy because they owed their suppliers over three million dollars and couldn’t pay the bills.
Reese Harper: Yeah, I was talking to our producer about this. He actually sent out an email to get a little bit of insight on this from different people. It was kind of a big story back in the day. But there was a lot of revenue coming in, and you would think that with three million in sales, that three million would pay the bills. But the issue is, they had tied up all their money in assets and they started defaulting on a lot of their debts. So you have millions of dollars in Love Sacs sitting in stores. They have a ton of value, but as you know you cannot pay your suppliers with Love Sacs.
Ryan Isaac: That’s a good example though of a hugely successful company—they grew really quick and fast, and miss managed its cash flow.
Reese Harper: And maybe an example that’s a little closer to home—some of you are like, I don’t sell Lovesacs I clean teeth and fix teeth and hit teeth and drill teeth. We see a lot of dentists run into this problem with liquidity. It’s common to see a dentist spend his entire career accumulating equity in some land, a few rental properties and a building, and then he pays off all this debt with the extra cash he’s earned over the years, but not all the debt is paid off, right? A big chunk of it is paid off, but it’s still leveraged, and then for whatever reason practice collections decline, which we’ve seen a lot happen over the last few years. Lenders aren’t willing to lend a refinance on you because your income is down and collections are dipping, but you’ve got these mortgage payments and a lifestyle you’re still used to maintaining—this isn’t a hypothetical by the way Ryan. This happens a lot. You’re not in a bind quite yet, but you start to get in a bind because you have a little bit of cash in the practice checking, then you have these assets that need to have payments made, collections dip, income declines, lifestyle expenses are high, and you’ve got to liquidate property in order to not lose other properties. You don’t want to sell any of your properties because the market is soft, but you don’t have much of a choice because of the payments that you’re obligated to make. And so the result is, you have to sell one property at a loss and your net worth goes up in smoke on that balance sheet item that would have been fine if you just could have had the right amount of liquidity to weather that storm during the couple of years where either rents are declining on the rentals that you have, or you don’t have a tenant in there, or your income is down so you can’t make the normal payments that you used to on the properties. That’s an example that we see that’s pretty common and it ends up putting a lot of your net worth at risk and equity and property that you worked hard to pay down in the first place.
Ryan Isaac: Yeah, you’re forced to sell. We’ve seen those situations like you said; it’s not just hypothetical. It’s common, and dentists definitely need to get set up with adequate levels of liquidity.
Reese Harper: And that applies to the smallest level, right? Even if you just have one house, one mortgage payment, and you’ve paid it down a lot. We’ve seen situations where that one mortgage payment that you have to make, you don’t have the liquidity. You’ve done great; you have a 401K; you’ve paid down debt, your student loans are gone, and your house is halfway paid off, but then your collections decline, you are struggling to make lifestyle expenses. You have to choose between keeping the practice doors open, food, or keeping the mortgage payment going, and what do you pick? I mean at some point a lot of people end up losing their homes. Lenders would rather foreclose on a house that has a lot of equity on it than one that doesn’t. So you just need to keep adequate liquidity to make sure that the debt that you do have never ends up taking your assets away from you like a practice or a house.
Ryan Isaac: And when we talk about liquidity, the money doesn’t have to just sit in a practice checking account right? You can create conservative investment portfolios that protect your money from inflation but also protect you from getting put in a situation like we’ve seen. So for the person who has built adequate liquidity, what kind of things does it help them to do?
Reese Harper: Well the first thing—I think they can make the best decisions for their retirement plan. If you go back to the water example, if you’re trying to live and survive on a liter of water a day, then it’s probably going to keep you from doing things that are better for you in the long run. You might be worried if you go on a walk out in the sun that you’re going to start sweating and you lose all your fluids. So instead of getting some fresh air and some exercise, you end up sitting in your house in a dark room all day and hiding out in the basement—obviously not going to be good for your overall financial health. You don’t have a lot of options when you don’t have liquidity. You can’t make decisions that are good for your overall health.
Ryan Isaac: Sitting in the dark room—I think there’s a high likelihood of consuming Hot Pockets and playing video games in that situation.
Reese Harper: Wouldn’t know anything about that. I don’t know how you came up with that example.
Ryan Isaac: It just came to mind.
Reese Harper: It’s not a good situation. So if you don’t maintain a certain level access to cash, you might look at your practice and say, “it looks like my competitor around the block is getting a ton of new practice, and the best thing for my practice is probably to invest in a better social media campaign or some sort of marketing. But my practice checking account is really low, and I need that money to pay some suppliers, so I guess we are going to stick with the old word of mouth strategy. We’re going to forego the marketing plan. The same thing might happen if you’re choosing between two locations and you have to go with a less desirable location because you don’t have enough access to pay the rent at the better location. Having cash just gives you more confidence to pursue the right strategy for your business—marketing, location, hiring the right people and the right team.
Ryan Isaac: Well let’s go into that a little bit more. Why is it important to hold onto a certain amount of cash and other liquid assets in your person portfolio?
Reese Harper: It’s like a cushion that helps you absorb unexpected costs. There’s always that emergency you didn’t see coming—the unexpected medical bill, the roof starts leaking, and when you have cash available it really softens the blow, and you can move forward without feeling like you’ve got to take on more debt or you have to sell off assets. So in the context of investing—having liquidity gives you the ability to endure market fluctuations like we have talked about in prior podcasts. You’re not living and dying by the daily ups and downs in the market because you’ve created a buffer that allows you to ride things out, and I think it’s really important.
Ryan Isaac: That example—it allows you to have confidence even though your portfolio is passing through some volatility. You’ve got enough liquidity to last through a bear market and let your investments pass through their natural up and down cycle.
Reese Harper: You can have more control too over your tax rate. That’s one thing people don’t think about, is your taxes change year to year. The money that’s liquid is something you have already paid taxes on, so spending and living on that money doesn’t create an income tax consequence like money you pull out from your 401K. So you don’t want to be the dentist that has to pull all of your retirement income from their 401K accounts during retirement, or you will run the risk of having a taxable income that’s higher or at least as high as it was during your peak earning years. That’s just not the way you want to do planning.
Ryan Isaac: Yeah, and we see how that gives people a lot of peace of mind. Especially like you’re saying, as they head into retirement they have so many more options. And it’s hard to put a price on that, but essentially what you’re saying is having the right amount of liquidity is kind of like having another form of insurance on your own finances. We have insurance policies on our houses and our businesses, and cars are protected against unexpected events. So what are some of the reasons that dentists end up not having enough liquidity?
Reese Harper: I think a lot of them contribute a lot more than they should to their debts in really early years, and they never end up piling any baseline level of liquidity. A baseline level meaning a few years worth of personal spending, or they end up putting all of their savings into a 401K which in and of itself isn’t a bad thing, but it isn’t super liquid. You can’t have access to that during a tough time without taxes and penalties and everything. I spent a lot of time talking about this one in our presentations to dental study clubs and chapters, and there are certain years when your taxes are really low, and you want to take advantage of those times to build up your emergency fund and your after-tax liquid investments instead of stuffing them inside your 401K during those years. There’s going to be plenty of time for you to do that in future years, but just make sure you have a solid emergency fund and solid cash balances, and a decent start on an investment portfolio that’s not in your 401K as early as you can.
Ryan Isaac: So the radio station story—is it possible to have too much liquidity?
Reese Harper: Yes and no. As long as your liquid assets are distributed properly and well balanced, more liquidity is usually a good thing. The most financially secure person is the person that has thirty times their living expenses just in money in the bank that’s not tied up in a 401K. We call that an LT—a 30 LT is who Ryan is; I’m still working on mine. If that liquidity isn’t invested in getting a solid return or a consistent return and above inflation return, but if you ask me if it’s possible to have too much cash like bank accounts, it totally is. It’s kind of like the gal who drank too much water on the radio contest that you told. It was kind of a scary story, but there’s a point where you just have too much cash on hand. You might not die, but the money is not going to grow like it should. And when all of your money is sitting in cash, it’s not making a return and so the extra money would be better served as part of a debt repayment plan or as in investment plan. So it needs to be invested or used to reduce debt, but not just sitting in the bank.
Ryan Isaac: So, we need enough to stay flexible, but like you said you don’t want it to be sitting around in checking accounts. So what’s the recommendation then for the amount of cash reserve that someone should have? What’s the sweet spot?
Reese Harper: For your practice, a good rule of thumb is to focus on a multiple of your overhead. I recommend probably 1-3 months of overhead depending on your debt ratio at the time. If you carry more than three months worth of overhead in cash, you probably have a little bit on the excessive side, and you need to consider investing some of that excess cash towards really concrete investments goals or taking it out and investing it personally so that it is away from the liability of the practice. For your personal life, I would probably go six months worth of living expenses at a minimum in an account that you use for personal emergencies. And then you should also have more money invested outside of your 401K. Once you’re done with that basic emergency reserve, keep going with after-tax savings that’s not tied up in a 401K. You’re going to balance those two things out, and this is a discussion that you need to talk to your advisor about or your CPA and make sure that you know what the right mix is for your own tax situation.
Ryan Isaac: Yeah, it’s very personal. That’s good advice, and like you said, liquidity is definitely something we talk to our clients about on a regular basis. It’s one of the key financial elements that we track in our planning process. You mentioned this—we just did an analysis for all of our clients a couple months ago. It’s called the Liquid Term. You called it LT because it’s cool to say it like that. But what we do is we take the dentists liquid assets—business and personal, and we divide it by their annual personal spending. So keep in mind, we’re not just talking about bank accounts, we’re talking about bonds or money markets or non-401K investments. When we calculate this LT it gives us an estimate on the number of years someone could live just on their liquid assets which helps a lot for their retirement planning.
Reese Harper: If you wonder if you’ve got enough liquid assets and you want to see how you compare to our peers, give us a ring and we can give you some feedback on where you sit on our client benchmark.
Ryan Isaac: Let’s wrap it up there; I think let’s go drink some water? Pace ourselves a little bit?
Reese Harper: Remember to stay thirsty my friends. Can I actually say that without getting in trouble?
Ryan Isaac: Well we’re just promoting good health. That’s all we’re saying. Thanks to all our listeners for joining us. Remember to leave us a review on this podcast. If you would like more information, follow us on Facebook, visit our website dentistadvisors.com. You can sign up for our free newsletter or schedule an appointment on our calendar, and we have a phone number right on our website.
Reese Harper: Carry on.Cash Management