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Financial Assets: Definition & Types

Financial assets derive value from contractual claims and represent ownership or debt relationships.

  • 10,488 Views | Updated on: Jul 04, 2024

Financial assets are intangible financial instruments that are more liquid than the company’s other assets. They typically take the form of receipts, legal documents, certificates, etc., and their worth is derived from contractual claims.

Liquid financial assets can be quickly converted into actual money. Two parties enter into a contract with financial assets that grants the party who invested the money (the investor) the right to obtain the financial benefit from the party in which the money was invested. Bonds, derivatives, fixed deposits, equity shares, and insurance contracts are a few types of financial assets.

What are Financial Assets?

Financial assets derive value from a contractual claim rather than a physical form. They represent ownership or debt relationships and are typically more liquid than physical assets.

Types of Financial Assets

There are different types of financial assets available in the market. You can choose from any of the following:

Cash (as well as its Equivalents)

These are the company’s financial assets, which include its cash balance, the balance in its bank accounts, checks from customers that the bank has not yet cashed, commercial paper, etc., and are highly liquid current assets.

Equity Stock

When a firm buys equity shares issued by another company, the equity shares become part of the company’s financial assets. This will be the owner’s equity for the company that issued the equity shares and a financial asset for the company that bought the equity shares. This financial asset establishes the right to receive dividends from the issuing company, which are paid to the investor.

Preference Shares

As with equity shares, holders of preference shares have the right to receive dividends, but at a set rate based on the number of shares they have purchased from the company issuing the shares (the issuing company). If the issuing company is wound up, preference shareholders have the right to receive the assets before equity shareholders can purchase the assets.

Debentures

Debentures are financial instruments that grant holders the right to collect interest on the money they have invested at a specific rate and on specified due dates. The sum invested is also returned to the debenture holders at maturity. Debenture holders have the right to claim the assets of the issuing firm before preference shareholders and equity shareholders do when the issuing company is wound up.

Accounts Receivable

The selling party has the right to collect payment from the party who purchases their product when sales are made on a credit basis (known as Debtor). Therefore, that debtor falls under the category of accounts receivable for the selling party.

In other words, these are assets that establish a right to money in exchange for credit sales made by the company within the credit period granted by it and also demonstrate the right to interest if the payment is delayed. This means that the buyer (Debtor) must repay the purchase price plus the interest amount, calculated at the rate determined at the time of sale.

Mutual Funds

A mutual fund is an investment vehicle administered by an asset management firm that requests contributions from small investors in exchange for mutual fund units. As a result, after receiving funds from these investors, the mutual fund invests them in the stock market, building a diverse portfolio. Mutual funds later provide investor returns in the form of capital growth and dividends/interest.

Derivatives

Derivatives are financial instruments, or we may say that they are contracts between two parties, where the value of the contract is derived from the value of the underlying asset, which could be an index, a commodity, a stock, an interest rate, a currency, etc. Options, futures, swaps, and other derivative instruments are most frequently employed.

Insurance Contracts

Insurance contracts are a different category of financial assets where one party (known as a policyholder) pays a premium to the insurance company in exchange for the right to compensation if a business-threatening catastrophe occurs in the future. For instance, if a policyholder has a policy that entitles them to compensation in the event of a fire, the insurance company will reimburse the policyholder’s business for any losses sustained due to the fire.

What are Liquid Assets?

Liquid assets can be quickly and easily converted into cash with minimal impact on their value. These assets are highly marketable and are usually traded in active markets, allowing for rapid transactions. There is a large and active market for these assets, ensuring that buyers and sellers can quickly execute transactions.

What are Illiquid Assets?

Illiquid assets are types of assets that cannot be quickly or easily converted into cash without a significant loss in value. Unlike liquid assets, which can be readily sold at their market value, illiquid assets often require more time to sell and may be subject to discounts if a quick sale is necessary. A limited market for these assets makes it harder to find buyers quickly.

Pros and Cons of Liquid Financial Assets

Liquid financial assets are considered beneficial for many reasons, but at the same time, they also have some disadvantages to them. Let us give a quick look at its pros and cons:

Pros

Cons

Ease of Access: Can be quickly converted to cash.

Lower Returns: Typically offer lower returns compared to illiquid assets.

Financial Flexibility: Provides flexibility to meet short-term needs or take advantage of opportunities.

Inflation Risk: May not keep pace with inflation, reducing purchasing power over time.

Emergency Fund: Ideal for maintaining an emergency fund to cover unexpected expenses.

Opportunity Cost: Holding too much in liquid assets can result in missed opportunities for higher returns.

Risk Management: Reduces financial risk by providing a cushion in times of need.

Tax Implications: Gains from liquid assets may be subject to taxes, potentially reducing overall returns.

Portfolio Diversification: Helps diversify an investment portfolio, balancing more illiquid and higher-risk assets.

Limited Growth Potential: Offers less potential for significant capital appreciation compared to long-term investments.

Pros and Cons of Illiquid Financial Assets

If you are thinking of trying your luck with illiquid financial assets, it would be smart if you go through the advantages and disadvantages of these assets. Let us take a look at the pros and cons of illiquid assets:

Pros

Cons

Higher Potential Returns: Often offer higher returns due to the risk premium.

Difficulty in Selling: Takes longer to find buyers and complete transactions.

Inflation Protection: Some illiquid assets, like real estate, may offer better protection against inflation.

Higher Transaction Costs: Can involve significant costs related to selling, such as legal fees and commissions.

Control and Influence: Investors may have more control over the management and improvement of the asset.

Valuation Challenges: Determining the exact value of the asset can be complex and less transparent.

Stability: Less subject to short-term market volatility compared to liquid assets.

Limited Financial Flexibility: Harder to access cash quickly in case of an emergency.

Potential Tax Benefits: Some illiquid investments, like real estate, can offer tax advantages.

Time Risk: Long holding periods can delay access to invested capital and returns.

Example of Financial Assets

Before you decide to buy any type of financial asset, here are some financial assets examples:

Cash and Cash Equivalents

  • Physical Currency: Bills and coins.
  • Bank Deposits: Checking accounts, savings accounts, and money market accounts.
  • Treasury Bills: Short-term government securities.

Marketable Securities

  • Stocks: Shares of ownership in a company.
  • Bonds: Debt securities issued by corporations, municipalities, or governments.
  • Mutual Funds: Pooled investment funds managed by professional managers.
  • Exchange-Traded Funds (ETFs): Investment funds traded on stock exchanges.

Derivatives

  • Options: Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price.
  • Futures: Contracts obligating the buyer to purchase, or the seller to sell, an asset at a predetermined future date and price.
  • Swaps: Contracts to exchange cash flows or other financial instruments between parties.

Loans and Advances

  • Personal Loans: Loans granted to individuals.
  • Mortgages: Loans secured by real estate.
  • Business Loans: Loans extended to businesses for various purposes.

Insurance Contracts

  • Life Insurance Policies: Contracts that pay out a sum of money upon the death of the insured or after a set period.
  • Health Insurance Policies: Contracts that cover medical expenses.
  • Property Insurance Policies: Contracts that provide financial reimbursement to the owner of property in the event of damage or loss.

Key Takeaways

  • Liquid financial assets can be quickly converted into cash with minimal impact on their value.
  • They represent ownership or debt relationships and are typically more liquid than physical assets.
  • Equity stocks represent ownership in a company and the right to receive dividends, while preference shares provide fixed dividends and a higher claim on assets.
  • Illiquid assets, such as real estate and collectables, cannot be easily converted to cash without a significant loss in value.

Conclusion

Financial assets play a crucial role in investment strategies, offering ownership or debt claims rather than physical possession. Their value stems from contractual agreements and their liquidity, often surpassing physical assets. By carefully considering your investment horizon and risk tolerance, you can create a balanced portfolio incorporating liquid and illiquid assets to achieve your financial objectives.

FAQs on Financial Assets

1

Can financial assets be used as collateral?

Yes, many financial assets like stocks, bonds, and mutual funds can be used as collateral for loans, though the loan amount may be limited compared to physical assets.

2

How do you value financial assets?

Financial assets are valued based on various factors like market demand, company performance (for stocks), and interest rates (for bonds).

3

What is the risk associated with financial assets?

Financial assets carry the risk of losing value due to market fluctuations, inflation, or issuer default.

4

Are all financial assets regulated?

No, not all financial assets are regulated. Some alternative investments like cryptocurrency may have less regulation.

5

What are examples of financial assets?

Stocks, bonds, mutual funds, ETFs, and even cash deposits can all be considered financial assets.

- A Consumer Education Initiative series by Kotak Life

Amit Raje
Written By :
Amit Raje

Amit Raje is an experienced marketer who has worked in various Fintechs and leading Financial companies in India. With focused experience in Digital, Amit has pioneered multiple digital commerce in India. Now, close to two decades later, he is the vice president and head of the D2C business department. He masters the skill of strategic management, also being certified in it from IIMA. He has challenged his challenges and contributed his efforts in this journey of digital transformation.

Amit Raje
Reviewed By :
Prasad Pimple

Prasad Pimple has a decade-long experience in the Life insurance sector and as EVP, Kotak Life heads Digital Business. He is responsible for developing user friendly product journeys, creating consumer awareness and helping consumers in identifying need for life insurance solutions. He has 20+ years of experience in creating and building business verticals across Insurance, Telecom and Banking sectors

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