Alternate name: Current assets
Liquid Assets Example
You have a small business where you sell handcrafted jewelry. You own the building and land that it sits on. On your balance sheet under assets, you have four accounts: cash, accounts receivable, inventory, and building and land. You use a checking account dedicated to your business to pay your bills. Which accounts are liquid assets? The answer is cash, accounts receivable, inventory, and the checking account.
Cash is the only perfectly liquid asset. Accounts receivable, the money your customers owe you, are expected to be paid in full in one year or less, making them a liquid asset. Even though you have to find a buyer for it, inventory is considered obsolete when it reaches the end of its life cycle (which, for example, can be just one year). Your checking account is liquid because it is a cash equivalent, or “near cash,” and can meet your short-term needs.
Cash, accounts receivable, and inventory are liquid assets, but another type of current asset often seen on a business’s balance sheet is marketable securities. Marketable securities are short-term investments with a maturity of one year or less, so they are also considered liquid.
How Liquid Assets Work
There is no direct measurement for how liquid a particular current asset is, but some criteria that can be used to know if an asset qualifies as liquid is the speed and the cost by which it converts into cash. The higher speed and the lower cost, the more liquid the asset is. We can approximate a firm’s liquidity by using formulas and financial ratios to measure it such as the current ratio. Here is the calculation: Current Ratio = Current Assets ÷ Current Liabilities For a more precise measurement, calculate what is called the quick ratio, another measure of short-term liquidity: Quick Ratio = Current Assets - Inventory ÷ Current Liabilities
Examples of Liquidity Analysis
Here are examples of both current ratio and quick ratio formulas based on Microsoft’s balance sheet and income statement from its 2005 annual report (in millions): Current Ratio: $70,566 ÷ $14,696 = 4.8 Quick Ratio: ($70,566 - $421) ÷ $14,696 = 4.8
Financial Analysis
Microsoft had 4.8 times as much invested in current assets as it owed in current liabilities, according to both the current and quick ratios. This left the company in a very liquid position, which can be a positive. It allows Microsoft to pay its debts, but if the company has too much in liquid assets, it may be missing out on investment opportunities. If you consider the quick ratio and subtract the small amount of inventory Microsoft was holding, you see that the amount of liquid assets on hand starts to drop. In this case, the quick ratio didn’t make much difference, since the amount of inventory was low. However, if the quick ratio is below 1.0, this means the business can’t pay its bills without selling inventory and is not as liquid as Microsoft is in the above example.
Illiquid Assets
In order to fully understand liquid assets, you have to also know what assets are considered illiquid, meaning they can’t be converted to cash quickly and easily. Many mutual funds are also considered to be illiquid because the investors can’t always get to their money instantly. From a business perspective, the portion of the balance sheet that is fixed assets contains the more illiquid assets. Generally, for small businesses, the fixed assets on the balance sheet are property, plant, and equipment. These assets are considered illiquid because they can’t be converted to cash quickly or easily and may take a hit to their market value because of use and depreciation.
