An asset's liquidity is a function of how easily it can be converted into cash.
In corporate finance, liquid assets are those that can be used to pay off debts in a hurry. The most common examples of liquid assets are cash – on-hand or deposited in a bank – and marketable securities such as stocks and bonds.
Liquid Assets
If a debt suddenly becomes due, the simplest way to meet that obligation is with cash. Physical currency is the only truly liquid asset, since it represents capital in its most accessible form. Because funds deposited in checking or savings accounts can generally be accessed almost immediately, they are also considered a liquid asset.
Stocks and bonds require a slightly more complicated transaction to convert the investment into cash but are still considered highly liquid. The open market provides ready access to both buyers and sellers for these types of securities, so they can be easily sold on short notice without impacting their value. (For related reading, see"Common Examples of Marketable Securities.")
Fixed Assets
The things a business owns that contribute to its profitability but are not easily converted into currency are called fixed assets. Common examples of fixed assets include real estate, vehicles and equipment. If a shipping business needs to pay off a creditor on a short deadline, selling its fleet of delivery vans or pieces of large packaging equipment would not be the most efficient way to generate funds. Fixed assets represent a long-term investment of capital with the goal of adding ongoing value to the business.
There are some assets that are neither fixed nor totally liquid. These types of assets are included in the current asset total on a company's balance sheet. In addition to cash and other liquid assets, this category includes inventory and accounts receivable. While these assets cannot be liquidated on a moment's notice, they generally are turned into cash within a year or less.
A business's liquidity is important for many reasons. It directly affects the company's appeal to investors. If a company has $1.5 million in assets, of which $1 million are liquid, thatis a signit is financially healthy. The company's capital is not tied up in burdensome fixed assets that depreciate over time, and it is better positioned to weather any potential financial storms.
Liquidity in an Economic Downturn
In the event of a decrease in revenue or an economic downturn, a company that is highly illiquid would have to deal with selling off, or liquidating, fixed assets to meet its financial obligations. This could mean selling property or equipment that is essential to the day-to-day operations of the business, limiting its ability to generate revenue down the road. A company with large stores of cash would be able to pay off creditors easily without having to liquidate fixed assets that are necessary to keep the business running.
A company's liquid asset total also impacts a number of key financial ratios. Companies use metrics such as the cash, current and quick ratio to assess how well the business manages its money. Financial institutions look at these ratios when evaluating a business as a candidate for a loan. Investors look at these liquidity ratios as indicators of a company's financial health and stability.
(For related reading, see"Understanding Financial Liquidity.")
FAQs
An asset's liquidity is a function of how easily it can be converted into cash. In corporate finance, liquid assets are those that can be used to pay off debts in a hurry. The most common examples of liquid assets are cash – on-hand or deposited in a bank – and marketable securities such as stocks and bonds.
Why are liquid assets important in business? ›
Liquidity is one of the key factors that determine success in the world of business. Liquid assets ensure a company's ability to meet its immediate financial obligations and operating expenses.
What are the advantages of liquid assets? ›
One major pro of liquidity is that you have the flexibility to make investment changes, and you can easily use some of your liquid assets to fund another type of purchase. For example, you can sell one type of stock to buy another in order to diversify your portfolio.
What are the benefits of liquidity to a business? ›
A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
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 include things like cash, money market instruments, and marketable securities.
Why is it important to maintain liquid assets? ›
Liquid assets are a particularly important safeguard to have if you experience financial hardship and need cash fast. Your liquid assets also help contribute to your overall net worth.
Why is a company's liquidity so important and how do you best measure it? ›
It focuses on the company's ability to meet its current obligations, which are usually short-term in nature. Liquidity Ratios help measure this capability by analyzing the ratio of liquid assets (cash and accounts receivable) to current liabilities (debt due within a year), as reported on the balance sheet.
Why do investors prefer liquid assets? ›
Liquidity, or your business's ability to quickly convert assets into cash, is vital on multiple fronts. These resources help you weather financial challenges, secure credit, and settle liabilities with short notice.
What are disadvantages of liquid assets? ›
Cons of liquid funds compared to regular savings accounts
Their returns are not guaranteed, unlike the fixed interest from a savings account. Costs and charges: Liquid funds may have associated costs such as fund management fees, which can slightly reduce the net returns.
Why do banks need liquid assets? ›
To remain viable, a financial institution must have enough liquid assets to meet withdrawals by depositors and other near-term obligations. Capital is the difference between all of a firm's assets and its liabilities. Capital acts as a financial cushion to absorb losses.
Liquidity refers to the efficiency or ease with which an asset or security can be converted into ready cash without affecting its market price. The most liquid asset of all is cash itself.
Is liquidity an advantage or disadvantage? ›
Liquidity is a double-edged sword, as it provides investors with flexibility and the ability to manage their investments actively. Still, it also exposes them to potential risks and disadvantages that need to be carefully considered.
What is the purpose of liquidity? ›
Liquidity is a company's ability to convert assets to cash or acquire cash—through a loan or money in the bank—to pay its short-term obligations or liabilities.
What are liquid assets worth? ›
Liquid net worth is the amount of money you have in cash or cash equivalents after you deduct your liabilities from your liquid assets. It's quite similar to net worth, but the only difference is that it doesn't account for non-liquid assets such as real estate or retirement accounts.
What is the liquid asset requirement? ›
A liquid asset requirement, or ratio, is defined as the obligation of commercial banks to maintain a predetermined percentage of total deposits and certain other liabilities in the form of liquid assets. In a number of countries this requirement is calculated as a percentage of short-term liabilities.
What are high quality liquid assets? ›
The high-quality liquid assets (HQLA) include only those with a high potential to be converted easily and quickly into cash (in times of distress). HQLA are cash or assets that can be converted into cash quickly through sales (or by being pledged as collateral) with no significant loss of value.
What is the importance of assets to a business? ›
Assets are important as they can help you to: generate revenue. increase your business' value. facilitate the running of your business.
Why is liquidity management important in business? ›
As liquidity management requires total visibility into financial data, it helps companies create more accurate scenario analysis and cash forecasting. Thus, it guides important financial decisions, such as whether to invest in expansion or new projects or whether a lender will approve a loan for your organization.
Why do users need a good understanding of a company's liquid assets? ›
The more “liquid” an asset is, the easier it is to convert into cash in hand when necessary. Liquid assets can help small business owners calculate their net worth and do financial planning. Liquid assets are also recorded on a company's balance sheet.
Which statement explains why liquid assets are needed in a business? ›
Expert-Verified Answer
The statement below that explains why liquid assets are needed in a business is that liquid assets must be available to pay current liabilities.
