Definition of Liquid Assets
Liquid assets are those that can be quickly and easily converted into cash at their current market value or close to it. They are recorded in the current asset section of a company’s financial balance sheet.
Definition and Examples of Liquid Assets
Liquid assets are typically current assets that can be converted into cash quickly while maintaining their market value. These assets include the current portion of the financial balance sheet and are expected to be converted or used within one year.
Alternative name: Current assets
Note: The term liquidity refers to the level of liquid assets that a business has to meet its financial obligations.
Example of Liquid Assets
You have a small business where you sell handmade jewelry. You own the building and the land on which the business resides. In your asset list, you have four accounts: cash, accounts receivable, inventory, and the building and land. You use the business’s checking account to pay your bills. Which of these accounts are liquid assets?
The answer is cash, accounts receivable, inventory, and the checking account.
Cash is the only liquid asset. Accounts receivable, which is money owed to you by your customers, is expected to be paid in full within one year or less, making it a liquid asset. Although you need to find a buyer for the inventory, it is considered stale once it reaches the end of its life cycle (which can be, for example, just one year). Your checking account is liquid because it is equivalent to cash or “near cash” and can meet your short-term needs.
Cash, accounts receivable, and inventory are liquid assets, but there is another type of current asset often found on a company’s current asset list, which is marketable securities. Marketable securities are short-term investments with a term not exceeding one year, so they are also considered liquid.
How Liquid Assets Work
There is no direct measurement of how liquid a particular current asset is, but some criteria can be used to determine whether the asset meets liquidity requirements. The faster and cheaper it is to convert an asset into cash, the more liquid it is.
We can approximate the liquidity of the company using formulas and financial ratios to measure it, such as the current ratio.
Note: The current ratio shows how many times a company’s current or liquid assets can cover its short-term debts.
Here is the calculation:
Current Ratio = Current Assets ÷ Current Liabilities
For a more accurate measurement, calculate what is called the quick ratio, which is the last measure of short-term liquidity:
Quick Ratio = Current Assets – Inventory ÷ Current Liabilities
Examples of Liquidity Analysis
Here are examples of the current ratio and quick ratio formulas based on Microsoft’s financial balance sheet and income statement from its 2005 annual report (in millions):
Current Ratio: 70,566 ÷ 14,696 = 4.8
Quick Ratio: (70,566 – 421) ÷ 14,696 = 4.8
Financial Analysis
Microsoft had 4.8 times more current assets invested than it owed in current liabilities, according to both the current ratio and the quick ratio. This leaves the company in a very liquid position, which can be positive. It allows Microsoft to pay off its debts, but if the company has too many liquid assets, it might miss investment opportunities.
If you review the quick ratio and factor in the small amount of inventory that Microsoft was holding, you will see that the amount of liquid assets available starts to decline. In this case, the quick ratio didn’t make much difference, as the amount of inventory was low. However, if the quick ratio were less than 1.0, it would mean that the business could not pay its bills without selling inventory and is not as liquid as Microsoft in the example above.
Assets
Illiquid Assets
To fully understand liquid assets, one must also know about assets that are considered illiquid, which are those that cannot be quickly and easily converted into cash. A common example of this is real estate, including buildings and land.
Many investment mutual funds are also considered illiquid because investors cannot access their money immediately.
From a business perspective, fixed assets contain a larger share of illiquid assets. Generally, for small businesses, fixed assets on the balance sheet are properties, plants, and equipment. These assets are considered illiquid because they cannot be converted to cash quickly or easily, and their market value may be affected by use and depreciation.
Takeaway
Liquid assets, which are current assets for operations, can be converted into cash easily and quickly without losing any portion of their market value. Common liquid assets on the financial statement include cash, accounts receivable, marketable securities, and inventory. Checking accounts and savings accounts are also liquid assets. The liquidity of a business can be measured using the current ratio and quick ratio.
Source: https://www.thebalancemoney.com/what-are-liquid-assets-5202064
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