When a business is involved in a merger or acquisition, it’s common for the original company to carry all of the liquid assets. That means they walk away with all of the liquid assets – including stock. While that’s not really “giving something away” in the same way that paying employees or selling office furniture isn’t really giving something away, some businesses choose to keep most of their liquid assets. The question becomes how to properly value such assets.
A liquid asset is simply an asset that can quickly be converted to cash. Usually liquid assets are typically seen as non-liquid cash equivalents, and in that case the owner is less confident that the assets will be easily exchanged for cash on some future date. For this reason, they may prefer to keep most of their liquid assets, even though doing so reduces their liquidity. The problem with this approach for small businesses is that it can lead to poor cash flow situations if the value of the liquid assets is low enough to correspondingly reduce the value of the remaining available cash. This can result in low operating liquidity, a lower credit rating, or even the inability to obtain credit.
Small businesses often face the dilemma of holding too much of their inventory – in other words, the value of their inventories may actually exceed the cost of their assets. If this occurs, a business may want to consider converting some of their liquid assets to fixed assets – perhaps redeemable for cash. If they convert a significant portion of their inventory (perhaps 80%) to fixed assets, they can reduce their liquidity requirement while simultaneously increasing their ability to secure financing. This article describes how to convert short-term inventory to fixed assets, as well as why such conversions may be needed for some small businesses.
Generally, businesses have two types of liquid assets – long-term and short-term. A business can convert one of its liquid assets (usually its accounts receivable) into either a long-term asset or a short-term one, depending on the situation. When a business holds more inventory than it can sell to pay its invoices, it may want to convert some or all of its inventory into fixed assets to provide it with additional funding. Or, if it has too many short-term debts to pay on a monthly basis, it may choose to convert some or all of its inventory into cash.
Businesses usually face two major problems when they want to convert their inventory to fixed assets – they either can’t easily convert their inventory to cash, or they need to do so but will face problems getting the cash to cover the conversion costs. Usually, business owners face problems getting cash to cover expenses when they convert their inventory to equity (e.g., stock). For example, if a manufacturing company wants to convert 100% of its inventory to fixed assets, it will usually need to obtain additional financing. Businesses that cannot easily convert their inventory into cash also face problems converting their inventory into equity. In this case, the company would often have to give up some of its intangible assets, such as goodwill and research and development expenses.
Businesses face two further problems when they try to convert their inventory to fixed income. First, they have to determine how much of their liquid assets should be converted to liquid assets and how much should be retained as unprofitable dry powder. Second, they have to determine how much of their liquid assets should be converted to equity (fixed income).
To convert inventory to fixed income, businesses usually obtain either a traditional bridge or an explication, which is a form of bridge loan. Bridge loans are typically used to bridge gap problems between current cash flows and future cash needs. An explication, which is sometimes referred to as an equity injection, provides businesses with the cash they need to buy low-worth accounts receivable. Usually, these kinds of loans are obtained from short-term lending institutions that are not financial vehicles of banks.
Because most businesses’ cash flows are based on daily sales transactions, they usually do not have problems converting their liquid assets, including Accounts Receivable, into equity (equity minus capitalized stock or net worth) quickly. However, small businesses may experience more difficulties when they need to convert their Accounts Receivable to fixed income. This occurs when the level of Accounts Receivable is less than the amount of accounts receivable currently in the inventory. To remedy this problem, most small businesses will settle their Accounts Receivable by executing a credit facility.