A:

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, whether on-hand or deposited in a bank, and marketable securities such as stocks and bonds.

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.

The things a business owns that contribute to its profitability but that 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 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, it is a sign that it 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.

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 ratios 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.

RELATED FAQS
  1. What investments are considered liquid assets?

    In this article, you'll learn what liquid assets are, what assets are considered liquid, and what investments are considered ... Read Answer >>
  2. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ... Read Answer >>
  3. Is it important for a company always to have a high liquidity ratio?

    Understand the significance of the liquidity ratio and how it is used in conjunction with other measures to arrive at an ... Read Answer >>
  4. How does securitization increase liquidity?

    Learn how securitization increases affects working capital and liquidity, and why it matters for a company seeking to increase ... Read Answer >>
Related Articles
  1. Investing

    Understanding Liquidity Risk

    Make sure that your trades are safe by learning how to measure the liquidity risk.
  2. Investing

    Financial Analysis: Solvency vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health.
  3. Investing

    ETF Liquidity: Why It Matters

    Lower levels of liquidity in exchange-traded funds make it harder to trade them profitably.
  4. Investing

    What is Reduced Bond Liquidity and Why Does it Matter Now?

    Reduced bond liquidity caused investor concern earlier in the year, but some signs point to a resurgence going forward.
  5. Investing

    Liquid & Illiquid Assets

    The easier it is to convert the asset, the more liquid the asset is considered.
  6. Investing

    Working Capital Position

    Learn how to determine a company's working capital position to correctly analyze liquidity.
  7. Investing

    Liquidity Measurement Ratios

    Learn about the current ratio, quick ratio, cash ratio and cash conversion cycle.
  8. Investing

    Advantages of Maintaining Low Working Capital

    Understand the benefits and advantages of maintaining low working capital as related to liquidity needs, capital allocation and operational efficiency.
RELATED TERMS
  1. Liquidity Risk

    Liquidity risk refers to the marketability of an investment and ...
  2. Overall Liquidity Ratio

    Overall liquidity ratio is the measurement of a company’s capacity ...
  3. Liquid Market

    A liquid market is one where there are many bids and offers and ...
  4. Broad Liquidity

    Broad liquidity is a category of the money supply which includes: ...
  5. Liquidator

    A liquidator is a person or entity that liquidates something, ...
  6. Core Liquidity

    Cash and other financial assets that banks possess that can easily ...
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center