What is the Order of Liquidity?

Order of Liquidity

The order of liquidity refers to the sequence or arrangement of assets and liabilities on a company’s balance sheet based on their liquidity. Liquidity refers to how quickly an asset can be converted into cash without affecting its market price, or how soon a liability needs to be paid.

Assets are typically listed on a balance sheet in the order of liquidity, starting with the most liquid assets. Here’s a common order:

1. Cash and Cash Equivalents: This includes physical cash, checking accounts, and highly liquid investments such as treasury bills and money market funds.
2. Marketable Securities: These are investments that can be easily sold, such as stocks and bonds.
3. Accounts Receivable: Money owed to the company by its customers.
4. Inventory: Goods that the company plans to sell.
5. Prepaid Expenses: Payments for goods or services that the company will receive in the future.
6. Long-term Investments: Investments that the company plans to hold for more than one year.
7. Property, Plant, and Equipment (PP&E): These are long-term assets that are used in the company’s operations and are not expected to be sold in the normal course of business.
8. Intangible Assets: Non-physical assets such as patents, copyrights, and brand recognition.

Liabilities are usually listed in the order in which they’re due to be paid. Here’s a common order:

1. Accounts Payable: Money the company owes to suppliers.
2. Accrued Expenses: Expenses that have been incurred but not yet paid.
3. Short-term Debt: Debt that is due within one year.
4. Long-term Debt: Debt that is due in more than one year.
5. Deferred Revenue: Money received by the company for goods or services that it has not yet delivered.

Arranging assets and liabilities in the order of liquidity provides useful information about a company’s short-term financial health and its ability to meet its short-term obligations.

Example of the Order of Liquidity

Let’s take a look at an example of a balance sheet for a fictional company “ABC Enterprises” to illustrate the order of liquidity.

Assets

1. Cash and Cash Equivalents: $50,000
2. Marketable Securities: $30,000
3. Accounts Receivable: $40,000
4. Inventory: $70,000
5. Prepaid Expenses: $10,000
6. Long-term Investments: $100,000
7. Property, Plant, and Equipment: $500,000
8. Intangible Assets: $20,000

Total Assets: $820,000

Liabilities

1. Accounts Payable: $20,000
2. Accrued Expenses: $15,000
3. Short-term Debt: $50,000
4. Long-term Debt: $200,000
5. Deferred Revenue: $5,000

Total Liabilities: $290,000

In this example, you can see that the assets and liabilities are listed in the order of their liquidity. The most liquid assets (cash) are listed first, and the least liquid (intangible assets) are listed last. Similarly, for liabilities, those that are due soonest (accounts payable) are listed first, and those that are due in the longer term (deferred revenue) are listed last. This order of liquidity provides a clearer picture of the company’s financial situation, showing how well it can meet its short-term obligations and how effectively it can convert its assets into cash.