Based on the ease with which they can be converted to cash, assets are classified as liquid, current assets or illiquid, long-term assets. Assets are economic benefits on which creditors and owners of an entity have claims. Illiquid assets provide the structural basis for business activities in the long term, whereas liquid assets ensure the continuation of the current business cycle. Liquid assets are important because they are readily convertible to cash to pay for any liabilities that are coming due. These assets can be funded by both short- and long-term funds. Short-term funds should not be used to fund illiquid assets that will not be sold quickly for cash for fund repayments.
Liquid assets include mainly cash, outstanding accounts receivable and marketable securities held. Liquid assets are part of the working capital that is needed to maintain ongoing business operations. A company must maintain a certain level of cash reserve to pay for operating expenses on a continuing basis. Alternatively, it should have sufficient noncash liquid assets that can be converted to cash conveniently to cover current expenses. Companies should not keep an excessive amount of liquid assets; an unwarranted excess of liquid assets would be better used for long-term business expansion.
Purpose of Liquidity
A company keeps a certain amount of liquid assets in place for the purpose of meeting short-term obligations. These are current liabilities that come due within a year and can be met timely only with liquid assets, due to their immediate convertibility to cash. A companies often measures its liquidity using the quick ratio, which compares the amount of liquid assets with the amount of current liabilities. A low quick ratio may indicate a shortage of liquid assets and a potential problem with liquidity to cover some of the coming-due liabilities.
Companies fund liquid assets mainly using short-term funding sources -- namely, current liabilities -- and any internally generated cash profits. Using current liabilities to fund liquid assets matches the maturity between assets and liabilities and pairs the lower return of liquid assets with the lower cost of short-term funds. A company may devote some long-term funds to current, liquid assets to generate a level of net working capital -- defined as total current assets minus total current liabilities. The extra working capital further ensures a company’s liquidity.
Misuse of Funds
While long-term funds may be used for short-term, liquid assets at higher financing costs to the company, short-term funds should never be used for long-term, illiquid assets, even though they may be cheaper. A longer period of time is need to liquidate long-term, illiquid assets; they likely cannot be converted to cash in time to pay for current liabilities that are coming due relatively soon. The misuse of short-term funds for long-term assets weakens a company’s liquidity and potentially disrupts ongoing operations.