The balance sheet is an important report of the financial statements. Within the balance sheet, we can find information on the assets, liabilities and shareholders’ equity of a company.
There are different ways of presenting information on the balance sheet. Some present in order of magnitude, meaning information is presented from highest amount to smallest amount which is quite straightforward. Others use the order of liquidity.
This method can be a little less understood. In this article, we are going to explain the concept of order of liquidity, why companies use this method, dig into various current asset accounts and evaluate their order of liquidity and conclude with an example.
Order of Liquidity [What Is It]
In order to understand the order of liquidity, being familiar with the meaning of liquidity is key. When talking about liquidity of a company, it makes reference to the capacity of a company to settle their liabilities.
On the balance sheet, assets and liabilities of a company are presented. A company that is financially healthy should have enough current assets such as cash or account receivables to settle their current liabilities.
If current assets are low, a company should be able to liquidate non-current assets to settle their liabilities. By defining an account as being liquid, it means that a company can turn the balance of the account into cash relatively quickly.
The order of liquidity is a way of presenting asset accounts on the balance sheet. This method of presentation lists the accounts based on how long it takes for the account to convert into cash.
The accounts that take the least amount of time to convert into cash (meaning the most liquid accounts) are presented first.
When the current assets are presented using the order of liquidity, it helps the reader of the financial statements understand if a company is stable and is able to cover their short term liabilities quickly without the need to liquidate any long term assets.
Why Companies Use Order of Liquidity
Using the order of liquidity to present the current assets has many benefits, not only for the readers of financial statements but for management of the company as well.
Other than helping readers understand how quickly a company can settle their short-term liabilities, it can also help them understand whether a company is financially strong and has enough liquidity to declare dividends. This information can be key for many investors.
For both the management of a company and the readers, a balance sheet presented using the order of liquidity will allow them to grasp what generates cash in the company.
If the need of selling assets to settle liabilities ever arose, it’s easy to see what can be sold first to cover debts.
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Current Asset Accounts and their Order of Liquidity
How quickly a current asset account can convert into cash can change depending on the company and the industry. However, there are accounts that have pretty standard turnaround times for cash conversion.
Let’s look at these current asset accounts below, presented in order of liquidity:
- Cash and cash equivalents: Cash is cash and will always be the most liquid account in current assets. This is because the cash sitting in a bank account can be accessed whenever needed. A company might even have cash on hand.
Therefore, there is no conversion needed for cash as it can be used to buy items or settle liabilities right away. Cash equivalents are short-term investments that are considered highly liquid and can be converted to cash right away or in a matter of a couple days.
This category includes US government treasury bills or certificates of deposit, just to name a couple.
- Marketable securities: Marketable securities are investments such as stocks, bonds, exchange traded funds, etc. that are traded on stock exchanges and can be converted into cash in a few days.
- Account receivables: Account receivables is what’s owed to the company from their customers.
It can usually be converted into cash quickly, depending on the credit policy (generally, companies want to get paid for their goods and services quickly so the credit policy will have a quick deadline – due on receipt, due within 10 days or 30 days are pretty standard).
Even if a customer is taking time to pay, a company could always sell their account receivables to a collecting agency and get cash in exchange.
- Inventories: Inventories are the goods produced by a company to sell to their customers. It’s the core revenue generating items of a company.
Inventories always come after cash and cash equivalents, marketable securities and account receivables because a company could sit on inventories for a while before it’s sold to a customer.
Depending on the industry, it could take a few days to months before inventories are sold. Companies could try to get rid of their inventories quicker by giving discounts.
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Example of Order of Liquidity in Current Assets
Let’s look at an example balance sheet presented in descending order. For the purpose of the example, we are only showing the current assets section.
| Balance sheet as at 31 March 2023 | |
| Assets | |
| Current assets | |
| Marketable securities | $245,000 |
| Inventories | $199,000 |
| Cash and cash equivalents | $155,000 |
| Account receivables | $25,000 |
| Total current assets | $624,000 |
Now, we will present the above balance sheet (current assets section only) using the order of liquidity method of presentation:
| Balance sheet as at 31 March 2023 | |
| Assets | |
| Current assets | |
| Cash | $155,000 |
| Marketable securities | $245,000 |
| Account receivables | $25,000 |
| Inventories | $199,000 |
| Total current assets | $624,000 |
Recap and Final Thoughts [Order of Liquidity of Current Assets]
Order of liquidity is a presentation method showing accounts in the order of time needed to be converted into cash starting with the most liquid accounts. It’s a helpful method for investors to understand the financial situation of a company and their ability to settle their liabilities.
It’s also great for cash management, as companies can know what generates cash and how quick accounts can be converted into cash should the need arise.
For current asset accounts, cash and cash equivalents is the most liquid with inventories being the least liquid due to the amount of time it can take to sell stocks to customers. Marketable securities and account receivables are somewhere in between.
Ultimately, the order of liquidity of accounts will depend on the company and the industry.
