There are different types of financial assets that work in different ways, but all share the same characteristics. They are tangible in the eyes of the IRS, but considered financial assets by companies. The following are listed in order of liquid value.
Money
Money is the first asset that most people think of when they hear financial assets. Money is a tricky asset to explain because it appears that it comes in physical form. But the reality is that each bill of currency that someone holds is a simple contract with a government that declares that they will honor the amount printed on the bill. The paper is not the asset; it's the contract behind it.
But what is currency? Currency is the physical form that represents an agreed on amount of money. There are many different forms of currency including bills, coins and checks. Currency has an agreed on value, but doesn't have to be accepted. There are some foreign currencies that are nearly impossible to use outside their own system.
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Another form of money that is listed as an asset would be the money that comes from taking out a loan or from making money off lending to another party. The bank lends money to another party; they are bringing in additional interest income. That amount is agreed on through the terms of the loan.
Stocks
Stocks are a type of financial asset because there isn't any ownership of a physical asset or resource. A stock is an agreement that the purchaser will be owning interest in a company. If a company buys a lot of stock in real estate, they aren't buying actual properties. They are buying a piece of ownership of that real estate company through an agreed on price at the time of purchase. There is no guarantee of value, just the percentage of ownership. Let's take a look at an example.
Company A buys stock in a pellet stove manufacturer. They purchase 1000 shares at $20 a share. That equals a financial asset value of $20,000. The coming winter is warm and the company sells fewer stoves. Their stock drops to $15 a share. Now the financial assets Company A owns is only worth $15,000 even though they still own the same 1000 shares.
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Bonds
Bonds are similar to a loan, but they are reserved for large corporations and government entities. A bond is actually a promise by the issuer to pay the holder their principal plus interest at some future date. In layman's terms, it's a very large IOU.
A bond is a set principal amount that has an agreed on end date and interest that will be owed. The end date of a bond is called its maturity date. Bonds are different from loans because the borrower doesn't pay back the principal of the loan over time until the balance is paid off like a mortgage or car loan. Instead, the borrower either makes monthly interest payments and pays off the principal on its maturity date, or they pay the entire balance plus the accrued interest on the maturity date.
Bonds are typically used by governments to fund short term projects like infrastructure and companies will use them to make short term upgrades to facilities or production.
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The following are some additional types of financial assets as well as some examples from the categories above.
- Cash - Liquid money that resides in a bank account that can be instantly accessed.
- Certificate of Deposit - A certificate of deposit is an account that earns an annual interest rate for set amounts of money, but the money has to remain in the account for an agreed on amount of time.
- Insurance - Insurance can be considered financial assets if there is a claim that paid out a sum of money.
- Index and Mutual Funds - Instead of purchasing a single stock, the purchase of an index or mutual fund means that the investor is buying into a massive pool of thousands of stocks that are picked by fund managers.
- Accounts Receivable - When a company is owed money from another entity, it is listed as a financial asset known as accounts receivable. An asset will remain in accounts receivable until the balance is paid.
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Financial assets are a category of company assets that are non-physical and derive their value from a contractual or agreed on value. They are one of three types of assets that companies put on their balance sheet. The other two types are tangible and intangible. The IRS considers financial assets a sub-category of tangible assets for the purpose of tax reporting.
There are three main types of financial assets. Money is a liquid asset that doesn't need to be sold or traded. Money is most often held electronically in bank accounts but are repressed physically by currency. The value of currency is in the contractual agreement, not in the physical paper. Stocks are a financial asset that involves the part ownership of a company through a stock. Bonds are similar to loans, but the principal is paid in full after a certain time period. Some specific examples of of financial assets also include cash, CDs, insurance, index and mutual funds, and accounts receivable.
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Video Transcript
Financial Assets: Money, Stocks and Bonds
Before we discuss different types of financial assets, let's make sure we understand what we mean when we say financial asset. To qualify as a financial asset, three important conditions must be met. It must be:
- Something you can own
- Something of monetary value
- That monetary value is derived from a contractual claim
That last condition may be hard to grasp, but it'll be clear in a few minutes.
So, financial assets are different than physical assets, like land or gold. With land and gold, you can touch and feel the actual physical asset, but with financial assets, you can only touch and feel something (usually a piece of paper) that represents the asset of value. The three financial assets we will discuss in this lesson are money, stocks and bonds.
Money
Money is an official medium of exchange consisting of cash and coin defined by a government. Money, currency, cash, legal tender - they all mean the same thing. They are all a symbol of a central bank's commitment to sustain, as best they can, that money's value. Money is a financial asset because the value of the asset itself doesn't come from the paper or metal it is printed on; it comes from the faith and credit of the government that issued that money.
Money is obviously an important financial asset. Without a common medium of exchange, we would all need to barter with one another, trading whatever goods and services we have for something else we need, or trade what we have for something else we could then trade again with someone else who has what we need. Imagine how complicated that can get!
Stock
Another important financial asset in the U.S. economy is stock. Like money, stock is just a piece of paper that represents something of value. That 'something of value' represented by stock is an ownership stake in a business. Stock is also referred to as 'equity' because when you own stock in a company, you have equity in that company's profit.
For the simplest of examples, let's imagine little Jane's lemonade stand. Jane has $4 to start her business, but she needs $10. Jane's parents give her $3 in exchange for 30% of her business, her friend gives her $1 for 10% of her business and her brother gives her $2 for 20%. Now Jane, her parents, her friend and her brother all have stock in her business.
As simple as that example is, it describes stock. Now, the complexities come in when we try and put a value on that stock. The value of a share of stock depends on many factors. One share of stock in one company is not the same as one share of stock in another company. The number of shares each company has issued will impact the value of your share, as will the size and profitability of each company. Anything that may impact a business - good or bad - will change the value of stock.
Those are just very basic, fundamental factors that can impact the value of a share of stock. Macroeconomic trends impact individual stock prices, as well. Thousands of books have been written trying to figure out the golden rule that determines exactly what a share of stock is worth.
The value of stock can vary, minute to minute - even second to second. In 2014, the two largest stock exchanges in the world were the New York Stock Exchange and NASDAQ (both located in the United States).
Bonds
The last financial asset we'll discuss are bonds. In simple terms, bonds are loans. When an organization - perhaps a company, maybe a city or state or even the federal government - needs money, they can issue bonds. There are many different types of bonds, but they are all debt instruments where the holder of the bond is repaid their principle investment, plus interest, at some future maturity date.
The only way a bondholder doesn't get their money is if the entity that issued the bond goes bankrupt. Because bonds are a legal obligation to repay debt and stock represents ownership, which comes with the potential to make or lose money, bonds are generally safer investments than stocks.
Lesson Summary
Let's review. Financial assets are assets that:
- An individual or organization can own
- Have a financial value
- Derive that value from a contractual claim
Money, stocks and bonds are the main types of financial assets. Each is something you can own, and each has some amount of financial value. For money, the contractual claim is against the central bank of the government issuing the money. For stocks, the contractual claim is with the company that issued the stock and with bonds, the contractual claim is with the municipality, corporation or individual that issued the bond.
Money, stocks and bonds are important financial assets that serve different purposes for individuals and organizations. The type of financial asset you need will depend on whether you need a medium of exchange, or a place to let your money grow. But like ingredients in your favorite pastry, each of these financial assets is needed to have a healthy, robust economy.
Learning Outcomes
After completing this lesson, you should be able to:
- Understand what financial assets are
- Identify the main types of financial assets
- Recognize their use in a country's economy
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