For business owners, assets are a crucial part of their business. Assets are the culmination of what they and others put into the business, the combination of resources from the liabilities and equity. However, most business owners are unaware of the different rates of liquidity between the different kinds of assets and why it is important to properly determine what they are. So we at From Red To Black LLC are going to explain how to categorize assets based on liquidity.
To begin with, you need to understand the concept of liquidity. In the simplest terms, liquidity is how easily your assets can be converted into cold, hard cash. It happens to be rather important since, even if the business is doing an amazing job and earning a ton of profit on paper, without enough liquid assets they might not be able to pay their bills and remain open.
Based on liquidity, assets can be broken into two different categories: Current Assets and Fixed Assets.
Current Assets are the assets that are the most liquid, with the expectation that they can be converted into cash or used up within a year or so. Some typical assets in this category are:
Cash
Cash Equivalents
Accounts Receivables
Supplies
Inventory
Prepaid Expenses
Usually, you would arrange your current assets by how quickly they can be converted into cash, with that account being the first one. Checking and savings accounts usually follow, as they can be readily converted, while accounts receivables must be collected or sold off to a factor and take slightly longer to be converted. The most difficult to convert among the current assets tends to be inventory and prepaid expenses, which vary depending on factors like industry and time, and often aren’t taken into consideration.
As for Fixed Assets, these are assets that will last anywhere from more than a year to the life of the business. In general, these assets include:
Equipment
Buildings
Land
The assets that fall into this category are often the more complex of all available ones due to their longevity. Some of the assets within this category will have an unchanging value, such as land, while others must be depreciated or amortized in order to have an accurate gauge of their value, such as equipment.
You can determine how liquid your asset ratio is by calculating something called a Quick Ratio, which basically takes the most liquid current assets you have available (typically Cash, Cash Equivalents, and Accounts Receivables) and then divide them by your current liabilities, which are liabilities that are due within a year.
For example, let’s say the total value of all of your current assets comes up to $80,000 and the total value of your current liabilities is roughly $140,000. The formula would be as follows:
$80,000 (Current Assets) / $140,000 (Current Liabilities) = 0.57 (Current Ratio)
The closer the ratio happens to be to 1.0 or higher, the easier the business can meet its obligations and pay its bills, which is essential for keeping the business running. As per usual, this is a simplification of the entire process and it will vary depending on the business and industry. But it should serve in helping a small business get a grasp of their assets and liquidity. For more helpful advice, feel free to subscribe and stay updated with new posts to our blog.
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