When you first study or work in the business field, you will constantly hear new terms, and to succeed, you will need to make yourself acquainted with these terms and concepts. In accounting and finance, you will hear the words assets, liabilities, and equity a lot. These terms are the basis of the accounting equation, which states that assets equal liabilities plus equity. But what does this mean? It means that everything the company owns consists of either the money the shareholders put into the company or the money the company borrows from external sources. So, in other words, equity is the contribution of owners in financing the company, while liabilities are the obligations the company has towards creditors. On the other hand, assets are any resources the company has. These concepts may be a little bit confusing. Therefore, in this article, we will focus on only one term, which is assets. We will break it down for you in a very simple way. You will learn what assets are, the types of assets, and most importantly, everything about the liquidity of assets. Let’s know about assets from most to least liquid.
What is an asset?
An asset is anything a business or an individual owns in the present, and they expect to receive an economic benefit from it in the future. The acquisition of an asset happens through past events such as purchasing new equipment or receiving cash from selling a piece of land. An asset is also all the things others owe to an individual or a company. This could occur due to transactions such as selling items on credit and receiving accounts receivable or notes receivable in return. At this moment, the account receivable or notes receivables are considered assets because they will generate future economic benefits to the company, which is the cash the company will get from the buyers. So, in conclusion, to consider something you have as an asset, there are certain conditions. First, you must have rights over this thing, which means that you have the authority to sell it, lease it, or do whatever you want. Second, this thing must have an anticipated economic value and can be sold for the sake of this benefit.
Third, this thing can generate a profit or benefit in the future. For instance, if you own a machine that creates wool, then it is considered one of your assets. This is because it brings economic benefits from the wool it produces. And also, you can sell or lease it and get cash in return.
Types of assets
In accounting, assets are recorded in the balance sheet, also known as the statement of financial position, from most to least liquid into two sections: current assets and long-term assets. But you may be wondering what liquidity is. Liquidity is the ability and how fast you can turn your assets into cash. Assets with the most liquidity are the ones you can turn into cash very quickly. In the balance sheet, current assets are the assets that can be converted to cash within only one fiscal year. Any asset that needs more than one year to turn into cash is recognized as a long-term or noncurrent asset. So, in any company’s balance sheet, we will find assets recorded from most to least liquid as follow:
Current assets:
- Cash: Cash is the mean of exchange in commercial transactions, and it is the base for measuring all other items. For sure, cash is the most liquid asset because it is already converted to cash and can be used with its current market value at once.
- Cash equivalents: They are very liquid because they can be converted into cash in a period that does not exceed three months, which means that there is no risk that their market value will change as well. Examples of cash equivalents are commercial papers, treasury bills, and money market funds.
- Account receivables: These are claims that the company or an individual has against others; they give an oral promise to pay the amount of money they owe in the future.
- Inventory: They consist of the cost of raw materials, work in process, and finished for manufacturing companies. While in merchandising company, it represents the cost of finished goods. Compared to other current assets, inventory is a less liquid asset because selling them may take times more than usual. Moreover, inventory can be obsolete, and then we will not be able to sell them
- Supplies: Supplies are things such as pens, paper, etc.
Long-term assets:
- Long-term investments: They represent items such as bonds, long-term notes, ordinary shares, land held for future use, pension fund, sinking fund, and more.
- Property, plant, and equipment (PPE): These are tangible assets that companies expect they will use for a long period of more than one year. They are subject to depreciation except for lands that undergo impairment.
- Intangible assets: These are the assets that do have an existence in a physical way but have value. Examples of intangible assets are copyrights, trademarks, franchises, trade names, patents, and customer lists, and most importantly, goodwill. They are considered assets because they can be sold and have future economic value for companies or individuals.
Important notes
- Assets are not restricted to the items we have shown above; there are other items of assets such as prepaid expenses, marketable securities, and more. However, we tried to cover the most important ones.
- Liquidity is not a simple concept, and that is why it is hard to find one way to measure the liquidity of a single element.
- Companies use different finance methods to measure their overall liquidity, such as the current ratio and quick ratio. The current ratio is the fastest and simplest way to measure liquidity; its formula is current assets over current liabilities. The quick ratio is very similar except that we exclude inventory from current assets because, as we said before, inventory is a least liquid asset than other current assets.
Why does liquidity matter?
Liquidity is important because it measures the company’s and individual’s ability to meet their obligations. For instance, one of the factors creditors use to decide whether to give a loan or not is liquidity. High liquidity reassures them the debtors will have enough cash to pay their debts.
