Guide to Order of Liquidity (With Definitions and Examples)
Companies create balance sheets and income statements to communicate the information they have gathered over a specific period. These financial reports can be essential to list the assets in order of liquidity. Understanding this order allows you to help a company determine how to use their resources most efficiently. In this article, we discuss what this order is and the meaning of liquidity, review the liquidity order on a balance sheet, explain why you may list assets in this order, explore factors to consider, and highlight the benefits of this approach.
What is the order of liquidity?
Order of liquidity is how a company presents their assets in the order of how long it can take to convert them into cash. Companies often list these assets on their balance sheet financial reports to help their employees and investors understand a business's immediate spending power. The assets listed first are often cash and other items that contribute to the company's overall revenue. The assets at the bottom of the list often help the business's production of goods and services, and companies can often only sell them if needed.
What is liquidity?
Liquidity refers to a company's ability to pay its debts. When generating financial reports, businesses include information to help investors and company officials determine if they have the assets available to pay current liabilities and show financial strength. If businesses don't have enough cash or current assets to pay their debts to other companies and organizations, they can liquidate other assets to help, including buildings and furniture.
Liquidity order for assets on a balance sheet
Here's how companies and organizations most often list their order of liquidity for assets on a balance sheet:
Companies consider cash to be the most liquid asset because it can quickly pay company liabilities or help them gain new assets that can improve the business's functionality. Cash can include the amount of money a company has and any money currently stored in bank accounts. Because a company can spend cash right away, it doesn't require any conversion. It can benefit a company or organization to have cash available when generating its financial reports.
Marketable securities are items such as stocks, bonds, and commercial papers that companies can convert into cash within a few business days. Depending on how much the company has invested, these aren't a major source of income, but because companies can convert them quickly, they list them second. Companies can also use them as collateral to get additional sources of revenue.
Accounts receivable are payments that clients and consumers owe a company or organization for their goods and services. Most often, businesses give accounts receivable to clients as an invoice and allow them to pay the invoice through the company's credit terms. This means it might take clients some time to pay the account in full, so the company can't always rely on accounts receivable for quick cash conversion. Companies typically try to recover their accounts receivable within one fiscal year.
Inventory includes any goods or services that the company can sell to consumers. Companies often need a few months to convert their inventory to cash, depending on the market and the skills of their sales team. If a company wants to sell its stock and liquidate its assets more quickly, it can consider using discounts and promotions. This may cause a smaller generation of cash.
Fixed assets are items that a company or organization uses to create its goods and services, including furniture, vehicles, land, and buildings. These assets can require a few days to a few months to sell, depending on their current market potential. They're also very important to a business's overall production and companies often wait to sell these items unless there's an emergency need for cash. Companies can put their original price minus any depreciation when listing fixed assets. This helps to show how much each item can sell realistically.
Goodwill refers to intangible assets exchanged during the sale of a company. These assets can include the company's loyal customer base, brand reputation, and intellectual property. Because a company can't convert these assets into cash until it sells its business, it lists them last in the order. They're still important assets to note because they can help investors and shareholders determine the value of the business.
Why are assets listed in order of liquidity?
There are several reasons companies use this method on their balance sheet, including:
Check cash generation capability
By looking at how quickly a company can convert each asset to cash, investors and creditors can understand how well the business is performing. This information can help them decide whether to invest in the company or extend existing credit. It can also help them determine the best order to liquidate assets in an emergency.
See potential changes in value
Companies can lose value in their assets over time, particularly if they don't maintain or use them well. By carefully tracking the liquidity of various assets, investors and creditors can understand and analyze the company's performance. It also helps them assess the potential risks and rewards of investing in or lending to a particular company.
Besides showing the cash generation potential of various assets, companies also list their liabilities on the balance sheet. This can help you understand if a company can pay off its liabilities, including legal fees, loan payments, and warranty policies, on time. The liquidity of liabilities can also be an essential factor for creditors when deciding whether to extend new loans to a company.
Make decisions about the company's resources
By understanding the liquidity of various assets, companies can make better decisions about using their resources. For example, if a company has inventory that isn't selling quickly, it might use discounts or promotions to move it quicker. If a company has cash but not much inventory, it might want to invest in new assets to increase its production capacity.
Factors to consider when ordering assets
When ordering assets, there are several factors to consider, including:
One of the most important factors to consider is the company's liquidity ratios, which measure its ability to generate cash. This can include looking at current and quick asset turnover ratios and the cash conversion cycle. Companies may also use other metrics like the debt-to-equity ratio or return on assets to assess asset liquidity.
The market conditions in which a company operates, including the overall economic climate and industry trends, can significantly impact asset liquidity. For example, if sales are slow because of an economic downturn or increased competition, companies may liquidate assets more quickly. If a company is heavily reliant on one customer or supplier, a change in its business can significantly impact its liquidity.
Some assets, like inventory and accounts receivable, are more liquid than others, like land or buildings. This means the company can easily convert them into cash, giving it more flexibility when managing its finances. Other factors, like location, age, condition, or legal issues, can also affect asset liquidity.
Financial report understanding
When trying to understand the liquidity of an asset, it's helpful to look at a company's financial reports. These reports provide detailed information on each asset, its liquidity ratios, and other relevant metrics like return on investment or debt-to-equity ratio. This allows investors to make informed decisions about the amount of money they want to invest in a company.
Types of assets
Current assets have a shorter maturity period, meaning they're more liquid, and companies can sell them more quickly in case of an emergency. Non-current assets may require more time to sell, but may also generate higher returns over the long term. By understanding the difference between these types of assets, companies can make better decisions about managing their resources and prioritizing investments.
Benefits of the liquidity order
There are many benefits to understanding the liquidity order for assets and liabilities, including:
Helps businesses make better decisions about their resources by understanding a company's cash generation potential and its ability to pay off liabilities promptly.
Helps businesses assess their financial health and make informed decisions about credit and loans.
Provides insights into a company's overall liquidity through financial insights, which can help in an emergency or when making investment decisions.
Bifurcates liquid and non-liquid assets, allowing businesses to prioritize investments.
Gives investors an idea of how strong a company is from a financial perspective, which can help guide investment decisions.
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