What Is a Liquid Asset?
A liquid asset is an asset that can easily be converted into cash in a short amount of time. Liquid assets includethings like cash, money marketinstruments, and marketable securities. Both individuals and businesses can be concerned with tracking liquid assets as a portion of their net worth. For the purposes of financial accounting, a company’s liquid assets are reported on its balance sheet as current assets.
Key Takeaways
- A liquid asset is an asset that can easily be converted into cash within a short amount of time.
- Liquid assets generally tend to have liquid markets with high levels of demand and security.
- Businesses record liquid assets in the current assets portion of their balance sheet.
- Business assets are usually broken out through the quick and current ratio methods to analyze liquidity types and solvency.
- Examples of liquid assets may include cash, cash equivalents, money market accounts, marketable securities, short-term bonds, or accounts receivable.
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Understanding Liquid Assets
Aliquid assetis cash on hand or an asset that can be easily converted to cash. In terms of liquidity, cash is supreme since cash as legal tender is the ultimate goal. Assets can then be converted to cash in a short time are similar to cash itself because the asset holder can quickly and easily get cash in a transaction exchange.
Liquid assets are often viewed as cash, and likewise may be called cash equivalents because the owner is confident the assets can easily be exchanged for cash at any time.
Generally, several factors must exist for a liquid asset to be considered liquid. It must be in an established, liquid market with a large number of readily available buyers. Ownership transfer must also be secure and easily facilitated. In some cases, the amount of time to cash conversion will vary.
The most liquid assets are cash and securities that can immediately be transacted for cash. Companies can also look to assets with a cash conversion expectation of one year or less as liquid. Collectively, these assets are known as a company’s current assets. This broadens the scope of liquid assets to include accounts receivable and inventory.
All liquid assets are current assets. By their nature, the benefits of long-term assets aren't generally recognized within the next 12 months.
Balance Sheet Accounting
In financial accounting, the balance sheet breaks assets down by current and long-term with a hierarchical method in accordance to liquidity. A company’s current assets are assets a company looks to for cash conversion within a one-year period. Current assets have different liquidity conversion timeframes depending on the type of asset. Cash on hand is considered the most liquid type of liquid asset since it is cash itself.
Cash islegal tenderthat an individual or company can use to make payments on liability obligations. Cash equivalents and marketable securities follow cash as investments that can be transacted for cash within a very short period, often immediately in the open market. Other current assets can also include accounts receivable and inventory.
On the balance sheet, assets become less liquid by their hierarchy. As such, the long-term assets portion of the balance sheet includes non-liquid assets. These assets are expected for cash conversion in one year or more. Land, real estateinvestments, equipment, and machinery are considered types of non-liquid assetsbecause they take time to convert to cash, costs can be incurred to convert them to cash, and they may not convert to cash at all.
Examples of Liquid Assets
Examples of liquid assets held by both individuals and businesses include:
Cash and Cash Equivalents
Cash is the most liquid asset possible as it is already in the form of money. This includes physical cash, savings account balances, and checking account balances. It also includes cash from foreign countries, though some foreign currency may be difficult to convert to a more local currency.
Cash equivalents are other asset holding that may be treated similar as cash due to their low risk (or insurance coverage) and short-term duration. Examples of cash equivalents include Treasury bills, Treasury notes, commercial paper, certificates of deposit (CD), or money market funds. Note that some items may have less liquidity based on terms of the vehicle. For example, some CDs can not be broken or require a substantial penalty for early termination.
Marketable Securities
Some marketable securities are considered liquid based on the underlying asset. Examples may include stocks, bonds, preferred shares of stock, index funds, or ETFs. Other instruments may include futures or options.
A critical part in understanding the liquidity of marketable securities is their holding duration. Liquid assets must be convertible to cash quickly; depending on the nature of the security, this isn't always possible. Also, be mindful that certain investments must be reported on the balance sheet as a long-term asset and are not technically considered current assets.
Accounts Receivable
Accounts receivable are a controversial type of liquid asset. On one hand, a company has a legal claim to cash that is due to them often as part of their business operations. A customer may have bought something on credit; after the credit term is up, the company is due to receive cash.
On the other hand, accounts receivable balances may go uncollected. It may also take an unforeseeably long amount of time to collect payment from a delinquent client. When considering liquid assets, be aware that a company may not collect all of its accounts receivable balance. For this reason, liquid asset analysis may include the contra asset allowable for doubtful accounts balance to reduce accounts receivable to only what the company thinks they will collect.
Inventory
Another difficult current asset to assess is inventory. In some situations, inventory may be considered a liquid asset if it has a large market with highly visible marketplaces for a product in high demand. Consider the latest iPhone; any models being recorded as inventory may quickly be demanded by the market.
Alternatively, what if demand for the iPhone sours? What if a new model comes out, and Apple is stuck with obsolescent inventory? What if primary warehouses are broken into and most of the inventory stolen? In theory, inventory is a liquid asset because it gets converted to cash as part of normal business operations. However, should business slow in a recession or any event above occurs, inventory may not be as liquid.
Analyzing Liquid Assets
In business, liquid assets are important to manage for both internal performance and external reporting. A company with more liquid assets has a greater capability of paying debt obligations as they become due.
Companies have strategic processes for managing the amount of cash on their balance sheet available to pay bills and manage required expenditures. Industries like banking have a required amount of cash and cash equivalents that the company must hold to comply with industry regulations.
There are several key ratios analysts use to analyze liquidity, often called solvency ratios. Two of the most common are the quick ratio and the current ratio. In the current ratio, current assets are used to assess a company’s ability to cover its current liabilities with all of its current assets and to survive unplanned and special circ*mstances like a pandemic.
The quick ratio is a more stringent solvency ratio that looks at a company’s ability to cover its current liabilities with just its most liquid assets. The quick ratio does include accounts receivable.
The quick ratio and the current ratio are key financial statement ratios used to break down liquidity levels and analyze solvency.
Liquid and Non-Liquid Markets
Both individuals and businesses deal with liquid and non-liquid markets. Cash as supreme is the ultimate goal for liquidity and ease of conversion to cash generally separates the distinction of a liquid vs. non-liquid market but there can also be some other considerations.
A liquid asset must have an established market in which enough buyers and sellers exist so that an asset can easily be converted to cash. The market priceof the asset should also not be significantly changed, resulting in less liquidity or greater illiquidity for subsequent market participants.
Thestock marketis an example of a liquid market because of itslarge number of buyers and sellers which results in easy conversion to cash.Because stocks can be sold using electronic markets for full market prices on demand, publicly listed equity securities are liquid assets. Liquidity can vary by security, however, based on market capitalization and average share volume transactions.
Theforeign exchange marketis deemed to be the mostliquid marketin the world because it hosts the exchange of trillions of dollarseach day, 24 hours a day, making it impossible for any one individual to influence the exchange rate. Other liquid markets include commodities and secondary market debt.
Illiquid Markets
Illiquid markets have their own considerations and constraints. These factors can be important for individuals and investors when allocating for liquid vs. non-liquid assets and making investment decisions.
For example, a real estate owner may wish to sell a property to pay off debt obligations. Real estate liquidity can vary depending on the property and market but it is not a liquid market like stocks. As such, the property owner may need to accept a lower price in order to sell the property quickly. A quick sale can have some negative effects on the market liquidity overall and will not always generate the full market value expected.
Another type of controversial illiquid asset may include private market fixed income which can be liquidated or traded but less actively. Overall, in considering illiquid assets, investors usually apply some type of liquidity premium which requires a higher yield and return for the risk of liquidity.
Requirements on the Value of Liquid Assets
Some companies or entities may face requirements on the value of liquid assets. This restriction is to ensure the short-term health of the company and protection of its clients.
The U.S. Department of Housing and Urban Development has outlined liquid asset requirements for financial institutions to become FHA-approved lenders. For example, non-supervised mortgagees must possess a minimum of $200,000 of liquid assets at all times.
The Federal Deposit Insurance Corporation (FDIC) stipulates the level of unencumbered liquid assets lending institutions must have on hand. It also outlines policies when institutions are required to have more liquid assets are required, such as (1) recent trends show substantial reductions in large liability accounts, (2) the loan portfolio includes a high volume of non-marketable loans, or (3) the institution's access to capital markets is impaired.
Last, the Securities and Exchange Commission (SEC) has proposed amendments to money market funds. Rule 2a-7 outlines requirements after the acquisition of an asset where a money market fund must hold at least 10% of its total assets in daily liquid assets and 30% of its total assets in weekly liquid assets. New proposals are being considered to increase both daily and weekly liquid asset thresholds.
What Is an Example of a Liquid Asset?
An example of a liquid asset is money market holdings. Money market accounts usually do not have hold restrictions or lockup periods (i.e. you are not permitted to sell holdings for a specific period of time). In addition, the price is broadly communicated across a wide range of buyers and sellers. Due to usually higher volumes of activity for money market securities, it's fairly easy to buy and sell in the open market, making the asset liquid and easily convertible to cash.
Why Are Assets Called Liquid?
Assets may be described as liquid to explain that they have fluidity, have flexibility, and can easily change. As opposed more rigid assets that can't be easily exchanged for cash, fluid assets can easily change form and be quickly traded.
Is a Car a Liquid Asset?
It depends on the car. For the most part, vehicles in good condition may be desired in the open market, prompting a quick sale. There's a few things to keep in mind, though.
First, the price you offer for your may impacts the liquidity of it. You will be more likely to sell your vehicle for less and may find it difficult to find buyers for your top dollar quote. Second, the condition of the car matters. Better quality assets will usually be more liquid.
Last, a car's liquidity depends on the broad car market. How are economic conditions and interest rates? What is the demand for your specific make, model, and year? Is your car rare, expensive, or custom (in which sellers may be disinterested)? There are many factors to contribute, although most cars can generally be sold quickly.
Why Are Liquid Assets Important?
Liquid assets are important because a company consistently needs cash to meet its short-term obligations. Without cash, a company can't pay its bills to vendors or wages to employees. A company may not always have a lot of cash on hand, but it better make sure it has sufficient amounts of liquid assets that can quickly be converted into cash if needed should an immediate need for money arise.
What Is the Difference Between a Liquid Asset and Illiquid Asset?
A liquid asset is an item of future economic benefit to a company that can easily be exchanged for cash. On the other hand, illiquid assets are more difficult to sell. Consider an office building in downtown New York compared to a single share of stock of Amazon. The office building may take months to find a buyer, engage in negotiations, draft legal documentation, and finalize the deal. On the other hand, a single share of stock of publicly traded companies can usually be bought or sold online very quickly.
The Bottom Line
To measure how well a company will meet its short-term debt obligations, a company should be mindful of its liquid assets. Liquid assets are items that can be quickly converted to cash, and companies earning tremendous profit may still face liquidity problems if they don't have the short-term resources to pay bills.
