What is Order of Liquidity?
Order of liquidity is the presentation of various assets in the balance sheet in the order of time taken by each to get converted into cash whereby cash is considered as a most liquid asset, followed by cash and cash equivalents, marketable securities, account receivables, inventories, non-current investments, loans and advances, fixed assets (both tangible and intangible).
Order of Liquidity of Assets
- Cash – It is the most liquid asset and doesn’t need any conversion.
- Bank – The balance available is also the liquidated assets without further conversion.
- Marketable Securities – Marketable Securities are the assets such as commercial paper, bonds, the stock traded on an exchange, preferred shares, exchange-traded funds, etc. these assets can be converted into cash in a few days.
- Accounts Receivable – Amount due from the customers of the firm or organization for which goods/services have been provided, and the bill has been raised, but the amount is due to be collected. These get converted into cash according to the company’s credit policy.
- Inventory – It is the stock lying with the company in either raw material, work in progress, or finished goods form. The conversion of inventory into cash could take months, depending on the sales level.
- Fixed Assets – Assets like the land, plant, building, machinery, furniture, vehicles, etc. all are part of fixed assets selling of these, and converting them into cash is a long-term process and requires few days to a month’s time.
- Goodwill – This is the least, but a liquid asset its realization into cash occurs only at the time of sale of the business.
Order of Liquidity for Balance Sheet
The balance sheet is a part of a financial statement that presents the company’s assets, liabilities, and owners’ equity as on a particular point of time, thereby providing insights about an entity’s financial position. Assets are listed in the balance sheet in order of their liquidity where cash is listed at the top as its already liquid no conversion is required. The next in the list are marketable securities like stocks and bonds, which can be sold in the market in a few days generally the next day can be liquidated.
Next, the money which is owned by the business in the normal course of sales, which is accepted by the general credit terms of the company, is generally known as accounts receivables. These receivables generally have 30 – 60 days credit period in order to liquidate themselves. Next, inventory which is the stock lying with the company and can be converted into cash from one month to the time of sales. Sometimes inventory can be sold quickly, so its position may vary from organization to organization. Then comes the non-current assets like plant and machinery, land and building, furniture, vehicles, etc. they need a longer selling period and thus need time in liquidation.
Last in the balance sheet is the goodwill, which cloud be realized only at the time of sale or any other restructuring of the business. Liquidity is the given adequate consideration or priority given at the time of preparing the balance sheet as it is the first document seen by the lenders/investors and other stakeholders so as to understand the company’s position. Liquidity is the ability of an asset to get converted into cash in terms of time. Assets that have the capability of converting into cash within a period of 12 months are considered to be current assets, while others are treated as non-current assets.
Listing of assets as per liquidity is as follows: –
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#1 – Current Assets –
- Cash and cash equivalents
- Marketable Securities
- Accounts Receivable
- Prepaid Expenses
#2 – Non-Current Assets –
Importance of Order of Liquidity
Liquidity measures the capability of the cash generation capability of any asset. It gives an idea about the dividends that are going to be received by the shareholders. With a uniform listing criterion established by an accounting GAAP, it becomes easier for various stakeholders to understand, analyze the company’s balance sheet and make decisions accordingly. This increases both intra-company and inter-company balance sheet comparability. Liquidity order listing gives impressions about various liabilities repayment capacity of a company like loan installments, debentures redemption, or any other short term liability like payment to vendors, etc.
- This displays the company’s ability to turn assets into cash.
- It bifurcates more liquid assets from less liquid assets with their true values.
- It gives lenders and buyers a clear view of the organization. The liquidity ratio of the business will portray to the creditors and investors about how much financially strong the company is.
- It helps in decision making as when your company’s liquidity ratio is monitored timely; management will be in a better position to make quality decisions that will help you to gain more profits and growth.
- Liquidity order helps in times of emergencies by providing quick funds to overcome the scenario that is being faced by the organization.
- Different accounting GAAPs may provide different listing criteria, and thus, the company’s financial position comparability gets affected.
- Liquidity listing of assets may not always be useful for each and every stakeholder like investors who wish to invest for the long-term period will be least bothered about the current liquidity position of the company.
- Certain assets like prepaid and deferred expenses may not find an adequate position as per listing criteria as these will never be realized in cash, but these are current assets because services against payment processed are yet to be utilized.
Order of Liquidity can be described as a listing criterion as specified by applicable accounting GAAP, which decides the order of assets presentation in the company’s balance sheet according to their cash generation capability. This is helpful for varied stakeholders in comparing, analyzing, and decision making as they can easily compare two or more balance sheets of either the same company or with any other company. As per this, cash is considered to be the topmost liquid asset, whereas goodwill is considered as the most illiquid asset as it cannot generate cash until the business gets sold.
This has been a guide to What is Order of Liquidity & its Definition. Here we discuss the order of liquidity for balance sheet and examples along with importance, advantages, and disadvantages. You can learn more about from the following articles –