Imagine you had to pay $1,000 to someone tomorrow. To pay this debt, you might pursue a number of options: Withdrawing cash from your bank account, writing a check or selling your possessions to come up with the cash are a few examples.
Some of these options have greater liquidity, or convertibility, than others. With some of the options you can pay the person immediately, while the others require time and another party. The most liquid account options require little to no conversion (and, therefore, minimal loss of value) to pay debts.
The most liquid asset is cash in your domestic currency. When you hand debtors cash, the payment is received and processed almost immediately. Likewise, having cash on hand means the firm has limited barriers regarding buying and selling items.
Foreign currency is another liquid asset, but you cannot pay for items with the same ease as domestic currency. Foreign currency requires the buyer and seller to determine an exchange rate and convert the currency into the mutually agreed upon denomination.
Firms must hold onto enough cash to pay for their financial obligations on time. However, they should not sit on too much cash. Instead, the firm should invest cash into interest-bearing, yet less liquid, assets.
Cash equivalents are another example of liquid assets. These assets can be converted into cash quickly and tend not to lose value in the process. Examples of cash equivalents include commercial paper (a short-term debt instrument), money market funds, your savings and checking account money and Treasury bills.
On financial statements, cash equivalents are totaled in value with cash. Cash equivalents must, by definition, have a maturity date of less than three months.
Receivables are the amounts of money owed to you from others. Though determining when your clients will pay you back can be difficult, the general assumption is that you will receive the money in the near future. The collection time of sales made on credit varies, but the typical length of 30 to 60 days categorizes receivables as a “current” asset.
Long-term investments are less liquid than cash and cash equivalents. Because some of these assets lose value if they are converted before their maturity dates, the owner cannot convert them to cash with ease. Examples of long-term investments are certificates of deposit (CDs), Roth IRAs, bonds and other assets you plan to hold for at least a year.
Inventory and physical items such as plants, property and equipment are other assets, but they are not very liquid. If companies needed to sell such items quickly, they would likely have to be sold at less than market value.