FINANCIAL MANAGEMENT
Liquid Assets
In business, economics or investment, market liquidity
is an asset's ability to be sold without causing a significant movement in
the price and with minimum loss of
value. Money, or cash, is the most liquid asset, and can be used immediately to perform
economic actions like buying, selling, or paying debt, meeting immediate wants
and needs. However, currencies, even major currencies, can suffer loss of
market liquidity in large liquidation events. For instance, scenarios
considering a major dump of US dollar bonds by China, Saudi Arabia, or Japan
(each of which holds trillions of dollars in such bonds) would certainly affect
the market liquidity of the US dollar and US dollar denominated assets. There
is no asset whatsoever that can be sold with no effect on the market.
An act of exchange of a
less liquid asset with a more liquid asset is called liquidation. Liquidity
also refers both to a business's ability to meet its payment obligations, in
terms of possessing sufficient liquid assets, and to such assets themselves.
Liquidity is defined
formally in many accounting regimes and has in recent years been more strictly
defined. For instance, the US Federal Reserve intends to apply quantitative
liquidity requirements based on Basel III liquidity rules as of
fiscal 2012. Bank directors will also be required to know of, and approve,
major liquidity risks personally. Other rules require diversifying counterparty
risk and
portfolio stress testing against extreme scenarios, which tend to identify
unusual market liquidity conditions and avoid investments that are particularly
vulnerable to sudden liquidity shifts.
Overview
A liquid asset has some or all of the following
features. It can be sold rapidly, with minimal loss of value, any time within
market hours. The essential characteristic of a liquid market is that there are
always ready and willing buyers and sellers. Another elegant definition of liquidity
is the probability that the next trade is executed at a price equal to the last
one. A market may be considered deeply liquid if there are ready and willing
buyers and sellers in large quantities. This is related to market depth that can be measured as the units that can be
sold or bought for a given price impact. The opposite is that of market breadth measured as the price impact per unit of
liquidity.
An illiquid asset is an asset which is not
readily salable due to uncertainty about its value or the lack of a market in
which it is regularly traded. The mortgage-related assets which resulted in the
subprime mortgage crisis are examples of
illiquid assets, as their value is not readily determinable despite being
secured by real property. Another example is an asset such as a large block of
stock, the sale of which affects the market value.
The liquidity of a product can be measured as
how often it is bought and sold; this is known as volume. Often investments in liquid markets such as the stock market or futures markets are considered to be
more liquid than investments such as real estate, based on their ability to be converted
quickly. Some assets with liquid secondary markets may be more
advantageous to own, so buyers are willing to pay a higher price for the asset
than for comparable assets without a liquid secondary market. The liquidity
discount is the reduced promised yield or expected return for such assets, like
the difference between newly issued U.S. Treasury bonds compared to off the run treasuries with the same term remaining until
maturity. Buyers know that other investors are not willing to buy off-the-run
so the newly issued bonds have a lower yield and higher price.
Speculators and market makers are key contributors to the liquidity of a
market, or asset. Speculators and market makers are individuals or institutions
that seek to profit from anticipated increases or decreases in a particular
market price. By doing this, they provide the capital needed to facilitate the
liquidity. The risk of illiquidity need not apply only to individual
investments: whole portfolios are subject to market risk. Financial institutions
and asset managers that oversee portfolios are subject to what is called
"structural" and "contingent" liquidity risk. Structural liquidity risk, sometimes called
funding liquidity risk, is the risk associated with funding asset portfolios in
the normal course of
business.
Contingent liquidity risk is the risk associated with finding additional funds
or replacing maturing liabilities under potential, future stressed market
conditions. When a central bank tries to influence the
liquidity (supply) of money, this process
is known as open market operations.
The effect of market liquidity on asset values
The market liquidity of assets affects their
prices and expected returns. Theory and empirical evidence suggests that
investors require higher return on assets with lower market liquidity to
compensate them for the higher cost of trading these assets. That is, for an
asset with given cash flow, the higher its market liquidity, the higher its price
and the lower is its expected return. In addition, risk-averse investors
require higher expected return if the asset’s market-liquidity risk is greater.
This risk involves the exposure of the asset return to shocks in overall market
liquidity, the exposure of the asset own liquidity to shocks in market
liquidity and the effect of market return on the asset’s own liquidity. Here
too, the higher the liquidity risk, the higher the expected return on the asset
or the lower is its price.
Futures
In the futures markets, there is no assurance
that a liquid market may exist for offsetting a commodity contract at all
times. Some future contracts and specific delivery months tend to have
increasingly more trading activity and have higher liquidity than others. The
most useful indicators of liquidity for these contracts are the trading volume
and open interest.
There is also dark liquidity, referring to transactions that occur
off-exchange and are therefore not visible to investors until after the
transaction is complete. It does not contribute to public price discovery.
Banking
In banking, liquidity is the ability to meet
obligations when they come due without incurring unacceptable losses. Managing
liquidity is a daily process requiring bankers to monitor and project cash flows to ensure
adequate liquidity is maintained. Maintaining a balance between short-term
assets and short-term liabilities is critical. For an individual bank, clients'
deposits are its primary liabilities (in the sense that the bank is meant to give
back all client deposits on demand), whereas reserves and loans are its primary
assets (in the sense that these loans are owed to the
bank, not by the bank). The investment portfolio represents a smaller portion
of assets, and serves as the primary source of liquidity. Investment securities
can be liquidated to satisfy deposit withdrawals and increased loan demand.
Banks have several additional options for generating liquidity, such as selling
loans, borrowing from other
banks,
borrowing from a central bank, such as the US Federal Reserve bank, and raising additional
capital. In a worst case scenario, depositors may demand their funds when the
bank is unable to generate adequate cash without incurring substantial
financial losses. In severe cases, this may result in a bank run. Most banks are subject to legally-mandated
requirements intended to help banks avoid a liquidity crisis.
Banks can generally maintain as much liquidity
as desired because bank deposits are insured by governments in most developed
countries. A lack of liquidity can be remedied by raising deposit rates and
effectively marketing deposit products. However, an important measure of a
bank's value and success is the cost of liquidity. A bank can attract
significant liquid funds. Lower costs generate stronger profits, more
stability, and more confidence among depositors, investors, and regulators.
In financial accounting, assets are economic resources. Anything
tangible or intangible that is capable of being owned or controlled to produce
value and that is held to have positive economic value is considered an asset.
Simply stated, assets represent value of ownership that can be converted
into cash (although cash itself is
also considered an asset).
The balance sheet of a firm records the
monetary value of the assets owned by the firm. It is money and other valuables
belonging to an individual or business. Two major asset classes are tangible
assets and intangible assets. Tangible assets contain various subclasses,
including current assets and fixed assets. Current assets include inventory,
while fixed assets include such items as buildings and equipment.
Intangible assets are
nonphysical resources and rights that have a value to the firm because they
give the firm some kind of advantage in the market place. Examples of
intangible assets are goodwill, copyrights, trademarks, patents and computer programs, and financial assets, including such items as accounts
receivable,
bonds and stocks.
Formal
definition
·
An asset is a resource
controlled by the entity as a result of past events or transactions and
from which future economic benefits are expected to flow to the entity (Framework Par 49a).
Asset
characteristics
Probably the most accepted
accounting definition of asset is the one used by the International Accounting Standards Board. The following is a quotation from the IFRS
Framework: "An asset is a resource controlled by the enterprise as a
result of past events and from which future economic benefits are expected to
flow to the enterprise."
This means that:
·
The probable present benefit
involves a capacity, singly or in combination with other assets, in the case of
profit oriented enterprises, to contribute directly or indirectly to future net
cash flows, and, in the case of not-for-profit organizations, to
provide services;
·
The entity can control
access to the benefit;
·
The transaction or event
giving rise to the entity's right to, or control of, the benefit has already
occurred.
Employees are not
considered to be assets, like machinery is, even though they are capable of
generating future economic benefits. This is because an entity does not have
sufficient control over its employees to satisfy the Framework's definition of
an asset.
Assets in accounting
In the financial accounting sense of the term, it is not necessary to be
able to legally enforce the asset's benefit for qualifying a resource as being
an asset, provided the entity can control its use by other means.
The accounting
equation
is the mathematical structure of the balance sheet. It relates assets,
liabilities, and owner's equity:
Assets
= Liabilities + Capital (where Capital for a corporation equals Owner's Equity)
Liabilities
= Assets - Capital
Capital
= Assets - Liabilities
That is, the total value
of a firms Assets are always equal to the combined value of its
"equity" and "liabilities."
Assets are listed on the balance sheet. In a company's balance sheet certain divisions are
required by generally accepted accounting principles (GAAP), which vary from
country to country.[8] Assets can be divided
into e.g. current assets and fixed assets, often with further subdivisions such
as cash, receivables and inventory.
Assets are formally
controlled and managed within larger organizations via the use of asset
tracking tools. These monitor the purchasing, upgrading, servicing, licensing,
disposal etc., of both physical and non-physical assets.
Current assets
Main
article: Current asset
Current assets are cash
and other assets expected to be converted to cash or consumed either in a year
or in the operating cycle (whichever is longer), without disturbing the normal
operations of a business. These assets are continually turned over in the
course of a business during normal business activity. There are 5 major items
included into current assets:
- Cash and cash equivalents — it is the most liquid asset, which includes currency, deposit accounts, and negotiable instruments (e.g., money orders, cheque, bank drafts).
- Short-term investments — include securities bought and held for sale in the near future to generate income on short-term price differences (trading securities).
- Receivables — usually reported as net of allowance for noncollectable accounts.
- Inventory — trading these assets is a normal business of a company. The inventory value reported on the balance sheet is usually the historical cost or fair market value, whichever is lower. This is known as the "lower of cost or market" rule.
- Prepaid expenses — these are expenses paid in cash and recorded as assets before they are used or consumed (common examples are insurance or office supplies). See also adjusting entries.
Marketable securities Securities that can be converted into cash
quickly at a reasonable price
The phrase net current assets (also called working capital) is often used and refers to the total of current assets
less the total of current liabilities.
Long-term investments
Often referred to simply
as "investments". Long-term investments are to be held for many years
and are not intended to be disposed of in the near future. This group usually
consists of three types of investments:
1. Investments in securities such as bonds, common stock, or
long-term notes.
2. Investments in fixed assets not used in operations (e.g., land
held for sale).
3. Investments in special funds (e.g. sinking funds or pension
funds).
Different forms of insurance may also be treated as
long term investments.
Fixed assets
Main
article: Fixed asset
Also referred to as PPE
(property, plant, and equipment), these are purchased for continued and
long-term use in earning profit in a business. This group includes as an asset land, buildings, machinery, furniture, tools, IT equipment, e.g., laptops, and certain wasting resources e.g.,
timberland and minerals. They are written off against profits over their anticipated life by charging depreciation expenses (with exception
of land assets). Accumulated depreciation is shown in the face of the balance
sheet or in the notes. Asset is important factor in balance sheet
These are also called capital assets in management accounting.
Intangible assets
Main
article: Intangible asset
Intangible assets lack of
physical substance and usually are very hard to evaluate. They include patents, copyrights, franchises, goodwill, trademarks, trade names, etc. These assets are (according to US GAAP) amortized to
expense over 5 to 40 years with the exception of goodwill.
Websites are treated differently
in different countries and may fall under either tangible or intangible assets.
Tangible assets
Tangible assets are those
that have a physical substance, such as currencies, buildings, real estate, vehicles, inventories, equipment, and precious
metals
Comparison : current assets , liquid assets and absolute
liquid assets
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Current assets
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Liquid assets
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Absolute liquid assets
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Stocks
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Prepaid expenses
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Debtors
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Debtors
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Bills receivable
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Bills receivable
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Cash in hand
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Cash in hand
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Cash in hand
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Cash at bank
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Cash at bank
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Cash at bank
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Accrued incomes
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Accrued incomes
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Accrued incomes
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Loans and advances (short term)
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Loans and advances (short term)
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Loans and advances (short term)
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Trade investments (short term)
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Trade investments (short term)
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Trade investments (short term)
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