What is a liquid asset?
An asset that can be quickly and readily turned into cash is said to be liquid. Examples of liquid assets are marketable securities, cash, and money market instruments. Following liquid assets as a percentage of net worth can be an issue for both people and companies. For financial accounting reasons, liquid assets are included as current assets on a company’s balance sheet.
Knowing About Liquid Assets
Examples of liquid assets are cash on hand or an asset with a simple conversion to cash. Since cash as legal tender is the ultimate goal, cash has the most liquidity. Because the asset holder may rapidly and easily obtain cash through a transaction exchange, assets can be converted quickly, making them similar to currency.
Because the owner is confident that the assets can be readily converted into cash at any time, liquid assets are frequently thought of as cash and may also be referred to as cash equivalents.
A liquid asset cannot be deemed liquid unless several conditions are met. It must be in a well-established, liquid market with many accessible consumers. Additionally, ownership transfers need to be safe and straightforward. The time it takes to convert to cash may differ in different circumstances.
Cash and securities that may be exchanged for cash instantly are the most liquid assets. Businesses may also consider assets with a cash conversion forecast of a year or less liquid. These resources are referred to as the current assets of a corporation. This expands the definition of liquid assets to encompass inventory and accounts receivable.
Accounting for Balance Sheets
The balance sheet in financial accounting uses a hierarchical approach to divide assets into current and long-term categories based on liquidity. Within a year, a corporation looks to its current assets for cash conversion. Current assets have varying times for converting to liquid assets, depending on the type of asset. Since cash on hand is cash itself, it is the most liquid asset.
An individual or business can pay off debts using cash, a form of legal money. Following cash as investments that may be exchanged for cash quickly—often instantly on the open market—are cash equivalents and marketable securities. Inventory and accounts receivable might also be considered additional current assets.
The hierarchy of assets on the balance sheet makes them less liquid. As a result, non-liquid assets are included in the long-term assets section of the balance sheet. These assets are anticipated to be converted to cash in a year or longer. Some examples of non-liquid assets are land, real estate investments, machinery, and equipment; these assets might be difficult or impossible to convert into cash and take a long time.
Illustrations of Liquid Assets
Liquid assets that businesses and people can own include:
Money and Its Relatives
Because it already exists as money, cash is the most liquid asset. This covers actual cash and the balances in checking and savings accounts. It also includes foreign currency, although some of it could be challenging to exchange for more local money.
Other asset holdings that can be considered similar to cash because of their short duration and low risk (or insurance coverage) are known as cash equivalents. Treasury bills, Treasury notes, commercial paper, certificates of deposit (CD), and money market funds are a few types of cash equivalents. Remember that some things can have less liquidity depending on the vehicle’s parameters. Certain CDs, for instance, are unbreakable or come with hefty early termination penalties.
Tradeable Equities
Some marketable securities have an underlying asset that makes them liquid. Index funds, ETFs, preferred stocks, bonds, and stocks are a few examples. Options and futures are examples of additional instruments.
The length of holding is a crucial factor in determining the liquidity of marketable securities. Quick conversion from liquid assets to cash is necessary, yet this is only sometimes achievable due to the nature of the security. Additionally, remember that some investments are not strictly considered current assets and must be shown as long-term assets on the balance sheet.
Receivables for Accounts
Receivables are a contentious kind of liquid asset. On the one hand, businesses have a legitimate right to money frequently owed to them while conducting business. It is possible that a consumer purchased an item on credit; the business is entitled to payment when the credit period expires.
Conversely, unpaid balances on accounts receivable could remain unpaid. Additionally, getting payment from a past-due client could take an inexplicably lengthy period. Recognize that an organization might need help collecting its entire accounts receivable total when thinking about liquid assets. Because of this, to limit accounts receivable to only what the business believes it will be able to collect, liquid asset analysis may incorporate the counter-asset authorized for doubtful accounts balance.
Countdown
Inventory is another challenging current asset to evaluate. If inventory for a high-demand product has a sizable market with prominent marketplaces, it might occasionally be considered a liquid asset. Think about the most recent iPhone model; any models listed as inventory could rapidly increase market demand.
Conversely, what happens if interest in the iPhone wanes? What happens if Apple is left with outdated inventory when a new model is released? What happens if the majority of the inventory is taken by breaking into the central warehouses? Since inventory is turned into cash during regular business operations, it is considered a liquid asset. But if a recession hits or anything mentioned above happens, inventory could not be as liquid.
Examining Expired Assets
Liquid assets must be managed in a business for internal and external reporting. A business with more liquid assets can better meet its debt payments when they become due.
Businesses manage the amount of cash on their balance sheet that can be used to pay invoices and cover necessary expenses through strategic operations. Businesses in specific sectors, such as banking, are legally required to maintain a certain level of cash and cash equivalents.
Analysts examine liquidity using several essential criteria, sometimes known as solvency ratios. The quick and current ratios are two of the more popular ones. The current ratio assesses a company’s ability to handle unforeseen and exceptional events, such as a pandemic, and meet its current liabilities with all its assets.
A stricter solvency ratio, the fast ratio, assesses whether a business can pay its current liabilities with only its liquid assets. Accounts receivable are included in the quick ratio.
Markets: Liquid and Non-Liquid
Both individuals and enterprises deal with liquid and non-liquid markets. Although there may be other factors to consider, cash is the ultimate goal for liquidity, and ease of cash conversion often distinguishes a liquid market from a non-liquid one.
For an asset to be easily converted into cash, the liquid asset must have an established market with a sufficient number of buyers and sellers. Additionally, there should be no significant changes to the asset’s market price that may reduce or increase the illiquidity for later market players.
Because there are many buyers and sellers on the stock market, which makes it simple to convert purchases into cash, the market is an example of being liquid. Publicly traded equities are liquid investments since stocks can be sold on demand for total market values through electronic marketplaces. However, liquidity can differ per security depending on market capitalization and typical share volume transactions.
Since trillions of dollars are exchanged on the foreign exchange market every day, around the clock, no one can ever control the exchange rate, making it the most liquid market in the world.
Commodities and secondary market debt are examples of other liquid markets.
Intractable Markets
Illiquid marketplaces have unique factors and limitations to take into account. When choosing which assets to allocate toward liquid versus non-liquid and when making investment decisions, these considerations can be crucial for individuals and investors.
For instance, a real estate owner might want to sell their home to settle debt. Unlike equities, the liquidity of the real estate market varies based on the property and market. Therefore, the owner may have to accept a lower price to sell the home quickly. A speedy sale will only sometimes provide the entire market value anticipated and may even have some detrimental consequences for the general liquidity of the market.
Private market fixed income is another contentious illiquid asset that can be traded or liquidated, albeit less frequently. Investors typically apply a liquidity premium when evaluating illiquid assets, requiring a greater yield and return in exchange for the risk of liquidity.
Conditions Regarding the Liquid Asset Value
Requirements regarding the value of liquid assets may apply to specific businesses or entities. The purpose of this restriction is to safeguard the company’s short-term viability and the safety of its customers.
FHA lenders have established the liquid asset requirements for banking institutions to obtain a license from the U.S. Department of Housing and Urban Development. Non-supervised mortgagees, for instance, must maintain a minimum of $200,000 in liquid assets at all times.
The Federal Deposit Insurance Corporation (FDIC) sets the minimum amount of free and clear liquid assets that lending institutions must keep on hand. It also describes the policies that dictate when an institution must have more liquid assets, including the following: (1) recent trends indicate a significant decline in large liability accounts; (2) a significant portion of the loan portfolio consists of non-marketable loans; or (3) the institution’s ability to access capital markets is hampered.
Finally, the Securities and Exchange Commission (SEC) has suggested changes to money market funds. Following the purchase of an asset, a money market fund is required by Rule 2a-7 to retain at least 10% of its total assets in daily liquid assets and 30% of its total assets in weekly liquid assets. Fresh ideas to raise the thresholds for daily and weekly liquid assets are under consideration.
What Qualifies as a Liquid Asset Example?
Money market assets are one type of liquid asset. Generally speaking, hold limitations and lockup periods (i.e., the inability to sell holdings for a predetermined amount of time) are absent from money market accounts. Additionally, a broad spectrum of buyers and sellers are informed about the pricing. Money market securities are generally more active and, therefore, more accessible to purchase and sell on the open market, which makes the asset liquid and easily convertible into cash.
Why are liquid assets called such?
Assets can be defined as liquid to indicate flexibility, fluidity, and ease of adjustment. Fluid assets can be traded swiftly and efficiently, unlike more inflexible assets that are difficult to convert into cash.
A car: is it a liquid asset?
Depending on the vehicle, Well-maintained cars can be in high demand on the open market, accelerating the sale process. However, there are a few things to remember.
First, the price you ask for may affect its liquidity. It can be harder to locate buyers for your top-dollar quote, and you’ll sell your car for less money. Second, the car’s condition is essential. Generally speaking, higher-quality assets will be more liquid.
And last, the overall vehicle market affects an automobile’s liquidity. How are interest rates and the state of the economy? What is the market share of your particular year, make, and model? Is your vehicle pricey, unusual, or customized, in which case sellers might not be interested? Although many variables are at play, most automobiles sell quickly.
What makes liquid assets valuable?
Liquid assets are crucial because a business constantly requires cash to pay its short-term obligations. A business must pay its suppliers’ invoices or employees’ wages in cash. Even though a business might only sometimes have a lot of cash on hand, it still needs to ensure it has enough liquid assets to turn into cash if an urgent financial need arises swiftly.
What distinguishes an illiquid asset from a liquid asset?
A liquid asset is anything that can be quickly converted into cash and will provide a future financial advantage to a business. Illiquid assets, on the other hand, are more challenging to sell. Compare a single share of Amazon stock to an office in downtown New York. It could take months for the office building to find a buyer, start the legal process, create the necessary paperwork, and close the purchase. Conversely, a publicly traded company share may be purchased or sold online relatively quickly.
The Final Word
One way to gauge a company’s ability to pay off short-term debt is by looking at its liquid assets. Products quickly turned into cash are known as liquid assets, and even businesses with large profits could struggle with liquidity if they lack the short-term funds needed to pay their creditors.
Conclusion
- A liquid asset can be quickly turned into cash in a short time.
- In general, liquid assets have liquid marketplaces with high levels of demand and security.
- Liquid assets are recorded in the current assets section of a company’s balance sheet.
- Business assets are typically separated using the quick and current ratio approaches to analyze liquidity types and solvency.
- Examples of liquid assets are cash, cash equivalents, money market accounts, marketable securities, short-term bonds, and accounts receivable.
