General accounting
X. 38. The notion of liquidity
Video
It is customary, when presenting the assets in a balance sheet, to list them by degree of liquidity, either from bottom up, or from top down.
In this course, we use the presentation from bottom up.
On the asset side, the cash & bank is the most liquid, then ST financial assets are a bit less liquid, client paper still less... up to land and intangibles fixed assets which are the least liquid assets.
But what do we mean by "liquidity"?
Definition: an asset is said to be liquid if it is easy to sell it quickly without a loss on its value.
Of course this definition is fraught with vagueness and raises plenty of questions. The objective of this lesson precisely is to progress in our understanding of value, money, and investments (financial or physical).
Let's consider, for the time being, that the definition is clear: an asset has a market value; when we need to sell it quickly, either we can without difficulty obtain its market value, or we can't.
Official money (banknotes, coins, and checking accounts) is by definition the most liquid asset.
It is the asset with which, in modern economic systems, we pay suppliers and other creditors.
Illiquid assets. Here is an example: when you own an apartment in a city, it is a fine asset. You may live in it, or rent it. But it is not very liquid. If for some reason you suddenly need urgently cash, and you decide to realize its value quickly, you won't get its normal market price.
You want to have cash, to pay the bills as they come, but not too much. Idle cash you want to "put to work" into assets which generate revenue.
Here 70 of cash was invested into short term financial securities.
To "put cash to work" is to make a financial transaction: exchange cash for a promise from a borrower. (Of course you can also invest it into a physical project, but it won't be liquid anymore, and it will usually be rather risky.)
The above timeline represents the flows of cash from the pocket of the investor (down: investment; up revenues). A typical financial investment is: pay an initial amount, say 1000€, to a borrower, and receive a contract from the borrower promising to pay you back according to a schedule (for instance, 40 euros every year for 6 years, and also on the sixth year the borrower pays you back your initial 1000€).
Under normal economic conditions (from which the present world is getting farther away every day), the safest way to invest cash, while keeping the asset liquid, is to buy short term government bonds (also called "Treasury bonds") from the currency area where your firm operates.
You give out your cash and receive government bonds, which will produce some revenues in the future, and which you can easily transform back into cash whenever you like (by selling them on the so-called "secondary market"), and which have little risk to lose value.
Large creditworthy borrowers also issue promises which are liquid (i.e. easy to sell to somebody else).
Rate risk. Bonds from creditworthy borrowers (governments or big firms) are safe in the sense that there is little risk that they default on the payments of interest and principal as specified in the contract, but if the bonds are longer that "short term" (short term = a few days up to one year) there is still the rate risk.
Here is what's it's about:
Suppose today I lend 1000€ to someone, for 5 years, with a coupon rate of 4% (that's another name for the yearly interest rate paid by the bond).
And, a few days later (that is very soon!) it becomes possible to lend 1000€, under the same conditions of risk and length (called "maturity"), at 6%.
Then, obviously my initial IOU immediately loses value.
Let's see more precisely why. The usual calculation of the value today of the cash flows generated by a bond are as follows:
(here is the spreadsheet if you want to play with the numbers dcf.xls)
The face value of the bond (= initial payment you make to acquire it) is 1000€. Then, line 8, it pays yearly interest of 40€, for 5 years. And on the 5th year you also get back your 1000€ initial payment.
In elementary finance, we compute the value today (also called present value) of each of the future cash flows. If the interest rate of all similar bonds is 4%, the stream of present values, line 12, is
| 38,46 | 36,98 | 35,56 | 34,19 | 854,80 |
The sum of these five present values is 1000€, which is normal: it just says that you exchanged 1000€ for something worth 1000€. There ain't no free lunch in life, nor in finance... If we could buy today for 1000€ something worth today 1001€, there would be a money making machine to build.
But if soon after we invested 1000€ in our 5-year 4% bond, the coupon rate of similar bonds goes up to 6%, then the new values today of our future revenues become this
Suddenly the value of our IOU has become 916€ !
In a finance course we explain why the 40€ of next year are no longer worth today 38,46€ but only 37,74€. In short, if this sum had another value today than 37,74€, there would exist a possibility of "arbitrage", that is we could again build a money making machine.
The anecdote of Nathan Mayer Rothschild and the battle of Waterloo.
When England and its allies, opposed to Napoleon, fought and won the battle of Waterloo, on June 18, 1815, it is said that in London Nathan Mayer Rothschild, who knew the result of the battle before anybody else in the stockmarket (because the Rothschilds had build for their own private use the Internet of the time: homing pigeons), let the stockmarket believe that England had lost. The British government bonds (called "consols", for "consolidated") went down, because England would have to raise the interest rate it paid in order to borrow more money. Rothschild and strawmen bought discreetly as many consols as they could, and this is the origin of the wealth of the Rothschilds.
The veracity of the anecdote is disputed, but, whether true or not, it illustrates very well the rate risk.
It illustrates as well that – despite the saying "time is money" – it is rather information which is money.
Remember that what we want is that our assets do not lose value (on the contrary, that they gain as much value as possible).
We also want that our firm have its "tools" (i.e. all its assets) well tuned to produce profit.
At least that is the view in the modern Western world.
There are other ways to think about firms. After all, that the firm produce goods and services, and pay salaries, could be viewed as a fine objective.
The deep financial reasoning underlying economic activity in the modern Western world leads to paradoxes. For instance General Electric, for years, earned much more money from its financial activities than from manufacturing light bulbs, home appliances or electric motors.
The rationale of modern capitalism sometimes seems to lead to the disappearance of goods and service creation to be replaced by financial activities. Of course this ultimately leads to the destruction of society.
So the name of the game for firms is to make profits.
Measured how?
Answer: with monetary units, that is with the yardstick of liquidity.
(Notice that to equate ultimate liquidity, in a monetary zone, to cash in circulation and sight bank accounts is a limited view. The notion of money supply, controlled by the central-bank-money and the regulations imposed on secondary banks, is a useless concept. And to ponder with gravity whether ST saving accounts, Treasury bonds, or other stuff should be included is even more pointless: money is whatever is accepted as a means of payment and keeps more or less safely its purchasing power.)
Remember: accounting is not an activity limited to some menial office work, its mastery is at the heart of understanding economics (i.e. production and exchange), value, finance and money.
But the true yardstick for value is the preservation of the purchasing power of what we own.
Currencies may be a poor yardstick, and an even poorer reserve of purchasing power.
On November 23, 2010, at a meeting in Saint-Petersburg, Vladimir Putin and Wen Jiabao announced that the dollar would no longer be the currency used in trade exchanges between Russia and China.
In this lesson on liquidity, we went apparently far astray from accounting, balance sheets, cash and the likes. It was an occasion for us to begin to take a larger view of accounting and think about investments, money and currencies.
Mastering accounting is a prerequisite to understanding finance and money. Most of the secrets of finance and money lie in accounting.
