Updated June 20, 2023
Definition of Liquid Assets
An asset is said to be a liquid asset if it can be readily converted, using buying or selling in markets, into cash or cash equivalent to satisfy short-term financial needs without any significant loss in its value.
Explanation
It can be converted into cash quickly without much change in its value. Assets like savings accounts receivable, stocks, sovereign bonds, etc., can be sold in the market and are called liquid assets. Many examples of liquid assets include cash, sovereign bonds, accounts receivable, and marketable debt &equity securities.
The formula for Liquid Assets
To calculate the value of liquid assets, analysts use liquidity metrics. Liquidity ratios determine the worth of liquid assets that form part of any business.
Current ratio: It is a measure of existing assets that can be used to pay current liabilities, i.e., liabilities due within a year.
Current Ratio = Current Assets / Current Liabilities
A higher current ratio, usually greater than 1, suggests that the company can pay off its current liabilities using its existing assets. Conversely, a percentage lower than 1 means a shortfall in paying off current liabilities.
Quick ratio or acid-test ratio: A quick ratio determines a company’s ability to pay current obligations with the most liquid assets available.
Quick Ratio = (Cash + Short-Term Marketable Securities + Accounts Receivable)/Current Liabilities
A higher ratio, usually greater than 1, means the business has assets with the most excellent liquidity feature that can be used to pay off current liabilities quickly.
Cash ratio: The cash ratio determines a business’s short-term obligation-paying capacity using only cash and cash equivalents. This ratio effectively measures the company’s most liquid assets, like cash.
Cash Ratio = (Cash + Marketable Securities)/Current Liabilities
Example of Liquid Assets
Examples of liquid assets are given below:
RR. Tools and Works had a good year in 2019, with sales of $400,000. However, the business owners are concerned with the liquidity aspect of the company. Therefore, analyze the assets and liabilities given in the excerpt and comment.
| Items | Amount |
| Cash | $65,000 |
| Receivables | $25,000 |
| Inventory | $125,000 |
| Other Payables | $55,000 |
| Short-term debt | $90,000 |
| Taxes payable | $30,000 |
The current ratio is calculated as
Current Ratio = (Cash + Receivables + Inventory)/(Other Payables + Short-Term Debt + Taxes Payable)
- Current Ratio = 1.229
The cash ratio is calculated as
Cash Ratio = Cash / (Other Payables + Short-Term Debt + Taxes Payable)
- Cash Ratio = 0.371
A grocery supermarket is struggling with business liquidity. Observe the following financial excerpt and comment on the critical areas of weakness.
| Items | 2019 | 2018 |
| Cash | $ 95,000 | $ 115,000 |
| Stocks | $ 250,000 | $ 242,000 |
| Raw material | $ 650,000 | $ 695,000 |
| Receivables | $ 120,000 | $ 145,000 |
| Current assets | $ 1,115,000 | $ 1,197,000 |
| Payables | $65,000 | $45,000 |
| 1-Year debt | $342,000 | $300,000 |
| Salaries payable | $155,000 | $124,000 |
| Customer deposits | $34,000 | $38,500 |
| Current liabilities | $596,000 | $507,500 |
The business is reeling under low cash, as evident from the cash ratio, which, as a percentage of current liabilities, stood at 8.5% in 2019 as opposed to 9.6% in 2018.
The quick ratio dropped from 0.99 to 0.78, indicating the lack of marketable securities vis-à-vis growth vis- < UNK>- vis current liabilities growth.
The company has a more substantial, although declining, current ratio to fulfill the requirements of current liabilities.
Analyzing Liquid Assets
It is an essential component of any business. When analyzing a company’s financial statements, it is necessary to consider its liquidity. Liquidity consideration is helpful for management reporting as well as stakeholder reporting. Businesses are evaluated on many factors, including liquidity factors. Liquidity determines the business’s liquid assets and provides for the business’s operational requirements. Cash management and working capital management are some such requirements that are dependent on liquidity.
It is analyzed on parameters like current ratio, quick ratio or acid test ratio, operational cash flow ratio, days sales outstanding, etc. The liquidity of businesses can be affected if there is difficulty in meeting the short-term obligations of the company. The ideal current ratio is debatable, and any business operating in the range of 1 to 2 is considered sound health. Similarly, an excellent quick ratio is 1:1 for the firm to be financially stable. It should be noted that such ideal values are only estimated, which can vary widely from one industry to the other.
Importance
The importance of liquid assets lies in the very character that they have high liquidity. Therefore, it can be beneficial for business needs. The amount and readiness of liquid assets determine the operational cash requirements.
Liquid Assets vs Fixed Assets
Fixed assets are the tangible assets of a business that are used for generating the company’s revenues. In contrast, they do not necessarily help create revenues but are used in the business’s day-to-day activities. Fixed assets include property, plant, equipment, office buildings, computers, machinery, etc.
An essential characteristic of fixed assets is that they are primarily associated with depreciation over their useful life. The definition and ambit of fixed assets can vary from company to company. Remarkably, fixed assets are recorded in the non-current assets while in the current assets section of the balance sheet. The depreciation expense incurred on fixed assets is recorded in the income statement.
Benefits
- As the famous saying goes, “cash is king” It is always good for businesses to have certain liquidity and review it occasionally.
- Institutions such as banks, non-banking lenders, and other investment funds must have a fixed amount of liquid assets, either in regulatory terms or management guidelines.
- liquidity serves the need for operational activities in the business. Companies with a good amount of liquidity smoothly tackle issues related to working capital.
Disadvantages
- It does not earn much for the business except for the lowest interest rates in the market.
- Holding too many liquid assets or liquidity can harm the business as reinvestment and inflationary aspects become crucial.
- It is also subject to taxes; hence, holding liquid assets means facing the double whammy of taxes and inflation-beating.
Conclusion
It provides liquidity to businesses, which translates to cash or equivalents for immediate business needs. However, even liquid assets might require two to three days of transaction/settlement time, depending on market accessibility. Different businesses hold different amounts of liquid assets, with the basis being financial strategy, goals, and management perspective.
It provides flexibility and accessibility of funds in day-to-day business while providing security in difficult times. From the perspective of individual investors, the portfolio must become diversified and dynamic when allocated to liquid assets. However, as with businesses, individual investors should not keep chunks of investments in liquid assets because of the risk of low returns.
Recommended Articles
This is a guide to Liquid Assets. Here we also discuss the definition and analyzing liquid assets along with their benefits and disadvantages. You may also have a look at the following articles to learn more –
