Definition of financial asset

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What is a financial asset?

A financial asset is a liquid asset that derives its value from a contractual right or a claim of ownership. Examples of financial assets are cash, stocks, bonds, mutual funds, and bank deposits. Unlike land, property, commodities, or other tangible physical assets, financial assets do not necessarily have inherent physical value or even physical form. Rather, their value reflects supply and demand factors in the market in which they trade, as well as the degree of risk they carry.

Understanding a financial asset

Most assets are classified as real, financial or intangible. Real assets are physical assets that derive their value from substances or properties, such as precious metals, land, real estate, and commodities like soybeans, wheat, petroleum, and iron.

Intangible assets are valuable assets that are not of a physical nature. They include patents, trademarks and intellectual property.

Financial assets lie between the other two assets. Financial assets can appear intangible – not physical – with only the value shown on a piece of paper such as a dollar bill or a list on a computer screen. What this document or list represents, however, is a claim of ownership of an entity, such as a state-owned enterprise, or contractual rights to payments, such as interest income from a bond. Financial assets derive their value from a contractual claim on an underlying asset.

This underlying asset can be real or intangible. Commodities, for example, are the actual underlying assets that are linked to financial assets such as commodity futures, contracts, or certain exchange-traded funds (ETFs). Likewise, real estate is the real asset associated with shares of real estate investment trusts (REITs). REITs are financial assets and are publicly traded entities that own a portfolio of properties.

The Internal Revenue Service (IRS) requires businesses to report their financial and real assets as tangible assets for tax purposes. The grouping of tangible fixed assets is distinct from intangible fixed assets.

Key points to remember

  • A financial asset is a liquid asset that represents (and derives its value from) an entity’s ownership claim or contractual rights to future payments from an entity.
  • The value of a financial asset can be based on an underlying tangible or real asset, but market supply and demand also influence its value.
  • Examples of financial assets are stocks, bonds, cash, CDs, and bank deposits.

Common types of financial assets

According to the commonly cited definition of International Financial Reporting Standards (IFRS), financial assets include:

  • Cash
  • Equity instruments of an entity, for example a share certificate
  • A contractual right to receive a financial asset from another entity, called a receivable
  • The contractual right to exchange financial assets or financial liabilities with another entity on favorable terms
  • A contract that will be settled in the equity instruments of an entity

In addition to stocks and debt, the above definition includes financial derivatives, bonds, money market or other accounts and equity. Many of these financial assets do not have a fixed monetary value until they have been converted to cash, especially in the case of stocks whose value and price fluctuate.

Besides cash, the most common types of financial assets encountered by investors are:

  • Stocks are financial assets with no set end or expiration date. An investor who buys shares becomes part owner of a company and shares its profits and losses. The shares can be held indefinitely or sold to other investors.
  • Bonds are a way for companies or governments to finance short-term projects. The holder of the bond is the lender and the bonds indicate how much money is owed, the interest rate paid and the due date of the bond.
  • A certificate of deposit (CD) allows an investor to deposit a sum of money in a bank for a specified period with a guaranteed interest rate. A CD pays monthly interest and can usually be kept for between three months and five years depending on the contract.

Advantages and disadvantages of highly liquid financial assets

The purest form of financial assets is cash and cash equivalents: checking accounts, savings accounts, and money market accounts. Liquid accounts are easily turned into funds to pay bills and cover financial emergencies or urgent requests.

Other varieties of financial assets might not be as liquid. Liquidity is the ability to quickly turn a financial asset into cash. For stocks, it is the ability of an investor to buy or sell holdings in a ready market. Liquid markets are those where there are a lot of buyers and sellers and no extended time to try to execute a trade.

In the case of stocks like stocks and bonds, an investor must sell and wait for the settlement date to receive their money, usually two business days. Other financial assets have variable settlement terms.

Maintaining funds in liquid financial assets can lead to better preservation of capital. Money in bank accounts, savings accounts and CD accounts are insured against loss up to $ 250,000 by the Federal Deposit Insurance Corporation (FDIC) for credit union accounts. If for some reason the bank goes bankrupt, your account has dollar-for-dollar coverage of up to $ 250,000. However, since the FDIC covers each financial institution individually, an investor with traded CDs totaling over $ 250,000 in a bank faces losses if the bank becomes insolvent.

Liquid assets like checking and savings accounts have limited return on investment (ROI) capacity. Return on investment is the profit you receive from an asset divided by the cost of owning that asset. In checking and savings accounts, the return on investment is minimal. They can provide modest interest income, but unlike stocks, they offer little appreciation. Plus, CDs and money market accounts restrict withdrawals for months or years. When interest rates fall, redeemable CDs are often called and investors end up shifting their money to potentially low income investments.

Advantages
  • Liquid financial assets are easily converted into cash.
  • Certain financial assets have the capacity to increase in value.
  • The FDIC and NCUA insure accounts up to $ 250,000.
The inconvenients
  • Very liquid financial assets have little appreciation
  • Illiquid financial assets can be difficult to convert to cash.
  • The value of a financial asset is as great as the underlying entity.

Advantages and disadvantages of illiquid assets

The opposite of a liquid asset is an illiquid asset. Real estate and fine antiques are examples of illiquid financial assets. These items are valuable but cannot be converted to cash quickly.

Another example of an illiquid financial asset are stocks that do not have a high volume of transactions in the markets. These are often investments such as penny stocks or high yielding speculative investments where there may not be a ready buyer when you are ready to sell.

Keeping too much money tied up in illiquid investments has drawbacks, even in ordinary situations. This could cause a person to use a high interest rate credit card to cover their bills, which would increase debt and negatively affect retirement and other investment goals.

Real example of financial assets

Businesses, as well as individuals, hold financial assets. In the case of an investment or asset management company, financial assets include money in the portfolios that the company manages for clients, called assets under management (AUM). For example, BlackRock Inc. is the largest investment manager in the United States and globally, judging by its $ 6.84 billion in assets under management (as of June 30, 2019).

In the case of banks, financial assets include the value of outstanding loans they have made to their customers. Capital One, the 10th largest bank in the United States, reported total assets of $ 373,191 million in its first quarter 2019 financial statements; of this amount, $ 240,273 million came from real estate, commercial and industrial loans.


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