Finance question?

Question

Can anyone explain why do current assets provide liquidity to the firm while they are not necessarily very liquid?

Answer 1

Current assets are SUPPOSED to be able to be converted into cash within the next operating cycle, usually taken to be 12 mths. However, not everything within Current Assets is so liquid. That's why analysts remove inventory from Current Assets when they calculate the quick ratio. Here's an extract from a very useful site which I've quoted below.

Liquidity is the ability of a firm to meet its near-term obligations as they come due. Inadequate liquidity can spell doom, even for a company with bright long-term prospects and significant noncash assets.
The current ratio is used to express the relative amount of working capital. It is calculated by dividing current assets by current liabilities:
Current Ratio = Current Assets/Current Liabilities

QUICK RATIO: A company could possess a large amount of inventory that is not easily sold. Thus, the current ratio (which includes inventory) could signal no problem, all the while the company is struggling to pay its bills. A tougher ratio is the quick ratio. This ratio provides a more stringent test of debt-paying ability by dividing only a firm's quick assets (cash, short-term investments, and accounts receivable) by current liabilities:

Quick Ratio = (Cash + Short-term Investments + Accounts Receivable)/Current Liabilities

Answer 2

In this case, you are trying to bridge reality with accounting standards. Current assets are assets that could (and management possibly wants to) dispose of in the next 12 months.

This means that there are things in there that fit the accounting standard, but are not truly liquid. For example, you can have assets that are classified as "for sale", which would make them current assets, but have them be highly illiquid (e.g. art, collectors items, unique securities).

So "liquidity" and its associated ratios are not necessarily reflective of reality.