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12Meaning of Liquid assets
Liquid assets are those assets that are equivalent to or as good as cash. Their liquidation is secure, meaning that the holder can convert them for cash without any issues. Also, it should happen in a short duration of time with little or no loss of value on conversion. Such assets include cash, bank accounts, marketable equity securities and bonds, mutual fund investments, exchange-traded funds, accounts receivable or sundry debtors. Liquid assets, particularly financial instruments, should have a ready organized market wherein they can be easily converted into cash. Also, the market should have a large number of buyers and sellers for an easy interface and liquidity.
A rare commodity or an asset that does not have ready buyers is not a liquid asset. For example, let us consider the case of a unique piece of a diamond. It can be a costly and highly valuable asset for the owner. But it will take time to sell it. Also, finding a buyer willing to pay the correct price for it can be difficult.
Similarly, a building can be precious and economically significant for the owner, be it a company or an individual. But if a sudden need for money arises, it cannot be used for the purpose. Finding the correct buyer immediately for selling the landed properties will be difficult. Moreover, selling it during the running business will be a distress sale, and hence, there will be a significant loss of money realization as compared to its fair market value. Therefore, such assets will not qualify for being liquid assets.
On the other hand, if a company has invested in mutual funds, and wants to liquidate it for urgent money needs, it can easily do so. There is a ready market for mutual funds redemptions/encashment. Also, they can be exchanged for cash at the present market value itself and that too quickly even at stock exchanges. Therefore, they are a form of liquid assets.
Accounting treatment of liquid assets
Liquid assets are shown in the Assets side of the balance sheet of any firm or company. These assets are recorded in the broad category of “current assets”, which can be converted into cash within one year. Cash itself is topmost on the list. Then come cash equivalents like bank accounts which are as good as cash. Marketable equity securities and bonds, mutual fund investments, exchange-traded funds, etc. come next. They may take a few working days for liquidation.
Accounts receivable and inventory are semi-liquid types of liquid assets as their realization is subjective. And liquidation may take some time, even a few months. Fixed assets like land, building, machinery, etc. come last. Liquidation of such assets is not easy and can take considerable time too. These are more or less, not liquid.
There are many financial ratios to measure the liquidity and ability of a company to pay off its short-term liabilities. Higher liquidity ratios mean the company is in a better position to meet its short-term or immediate financial obligations. These obligations can be repaying creditors or even meeting working capital requirements in times of distress.
The most common liquidity ratios for a company are:
This ratio determines if the company has sufficient liquid assets in hand to meet its short-term obligations. The formula for quick ratio is:
Current assets (including accounts receivable but not inventory) / Current liabilities
Therefore, this ratio is a good indicator of a company’s liquidity as it excludes mostly non-liquid inventory.
This ratio is a further refinement of the quick ratio and includes only cash or assets equivalent to the cash for calculation purposes. It does not include accounts receivables for calculation. It is so because its realization may take some time.
The formula for calculating this ratio is:
Current assets (Only cash and assets similar to cash)/ Current liabilities
Importance of liquid assets
Liquid assets are the backbone of any business unit, be it a small firm, or a big multinational corporation. If a company has limited liquid assets, and more amounts stuck in accounts receivable or inventory, it may face a liquidity crunch to meet its immediate financial obligations and working capital requirements. Furthermore, in adverse business conditions like recession or sudden fall in demand in the market, liquid assets are essential to help the company to survive and sail through.
An adequate amount of liquid assets in the balance sheet boosts a company’s chances to receive finance from banks and financial corporations. A company can use these assets to make quick payments for its purchases, get higher discounts, and best deals from suppliers and hence, improve overall performance and profitability of the company.