What is a financial asset?
A financial asset is a liquid asset that derives its value from a contractual right or a claim to ownership. Cash, stocks, bonds, mutual funds and bank deposits are all examples of financial assets. Unlike land, property, goods or other tangible physical assets, financial assets do not necessarily have an inherent physical value or even physical form. On the contrary, their value reflects the factors of supply and demand in the market in which they trade, as well as the degree of risk they entail.
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 assets of value that are not physical in nature. They include patents, trademarks and intellectual property.
Financial assets are between the other two assets. Financial assets can seem intangible – not physical – with only the value indicated on a piece of paper such as a dollar bill or an inscription on a computer screen. What this paper or quote represents, however, is a claim to ownership of an entity, such as a public company, or contractual payment rights – for example, 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 underlying real assets that are attached to financial assets such as commodity futures, contracts, or certain exchange-traded funds (ETFs). Likewise, real estate is the actual asset associated with the actions of real estate investment trusts (REITs). REITs are financial assets and are publicly traded entities that have a portfolio of properties.
The Internal Revenue Service (IRS) requires companies to report financial and real assets together as tangible assets for tax purposes. The combination of tangible assets is distinct from intangible assets.
Key points to remember
- A financial asset is a liquid asset that represents – and derives its value – a claim to ownership of an entity 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.
- Stocks, bonds, cash, CDs and bank deposits are examples of financial assets.
Common types of financial assets
According to the commonly cited definition of International Financial Reporting Standards (IFRS), financial assets include:
- Equity instruments of an entity, such as 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 liabilities with another entity under favorable conditions
- A contract that will settle in the equity instruments of an entity
In addition to stocks and receivables, the above definition includes financial derivatives, bonds, money market or other account assets and equity investments. Many of these financial assets have no fixed monetary value until they are converted into cash, particularly in the case of stocks where their value and price fluctuate.
Aside from cash, the most common types of financial assets encountered by investors are:
Shares are financial assets with no defined end or expiration date. An investor buying shares becomes a co-owner of a business and shares its profits and losses. The shares can be held indefinitely or sold to other investors.
- Bonds are a way for businesses or governments to finance short-term projects. The bond holder is the lender, and the bonds indicate how much money is owed, the interest rate paid, and the maturity 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 generally be kept 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 may not be as liquid. Liquidity is the ability to quickly transform a financial asset into cash. For stocks, it is an investor’s ability to buy or sell assets in a ready market. Liquid markets are those where there are many buyers and sellers and there is no extended delay in trying to execute a transaction.
In the case of stocks such as stocks and bonds, an investor must sell and wait until the settlement date to receive their money, usually two business days. Other financial assets have variable settlement periods.
Maintaining funds in liquid financial assets can lead to better capital preservation. Money in bank accounts, savings and CDs is insured against a loss of up to $ 250,000 by the Federal Deposit Insurance Corporation (FDIC) – the National Credit Union Administration (NCUA) for credit union accounts. If for any reason the bank goes bankrupt, your account has dollar for dollar coverage up to $ 250,000. However, since the FDIC covers each financial institution individually, an investor with negotiated CDs totaling more than $ 250,000 in a bank incurs losses if the bank becomes insolvent.
Liquid assets such as chequing and savings accounts have a limited return on investment (ROI). The return on investment is the profit you receive from an asset that is lower than the cost of owning that asset. ROI in chequing and savings accounts is minimal. They can provide modest interest income but, unlike stocks, they offer little appreciation. In addition, CDs and money market accounts limit withdrawals for months or years. When interest rates fall, repayable CDs are often called and investors end up shifting their money to potentially low-income investments.
Liquid financial assets are easily converted into cash.
Certain financial assets have the capacity to appreciate their value.
The FDIC and the NCUA maintain accounts up to $ 250,000.
Very liquid financial assets have little appreciation
Illiquid financial assets can be difficult to convert to cash.
The value of a financial asset is only as strong as the underlying entity.
Advantages and disadvantages of illiquid assets
The opposite of a liquid asset is a non-liquid asset. Real estate and fine antiques are examples of illiquid financial assets. These items are valuable but cannot be quickly converted to cash.
Another example of an illiquid financial asset is stocks that do not have a high volume of trading in the markets. These are often investments such as penny stocks or high yield 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 lead a person to use a high interest credit card to cover their bills, increase their debt and negatively affect their 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 U.S. and worldwide, judging by its $ 6.5 trillion in assets under management (as of March 31, 2019).
In the case of banks, financial assets include the value of outstanding loans they have made to customers. Capital One, the 10th largest bank in the United States, declared total assets of $ 372,537,597 billion in its first quarter 2019 financial statements; of this amount, $ 247,090,748 billion came from home, business and industrial loans.