What are Current Assets?
Current assets represent all the company’s assets that the company possesses and are expected to be sold with relative ease compared to other assets that the company has. These are the assets exhausted through standard business operations within one year.
Current assets report on the company’s balance sheet, and they present in the order of their liquidity. Examples of current assets include inventory, accounts payable, and cash. Current assets are liquid– which implies that their conversion in cash is much easier than fixed assets.
Importance of Current Assets for an Organization
Current Assets hold tantamount importance for companies, primarily because they are used to fund their day-to-day operations. The business uses the money in the form of current assets to ensure that its operating expenses are properly covered.
Unlike Fixed Assets, the cash conversion of current assets is fairly easy. This is because they are either in cash form or in the form where converting them to cash is not a hassle. For example, selling inventory is easier (and can generate quicker cash) than selling fixed assets.
Example of Current Assets
Most common and typical examples of Current Assets include:
- Cash and Cash Equivalents
- Accounts Receivable
- Prepaid Expenses
- Marketable Securities
What are Current Liabilities?
Current Liabilities are defined as the short-term obligations of a company that is due within a period of one year in the company’s given operating cycle. The operating cycle is also referred to as the cash conversion cycle – i.e., the time consumed by a company to purchase inventory and convert it to cash.
Current liabilities include expenses that have been incurred by the company but have not yet been paid for by the company. They might include payments that need to be paid to the suppliers or utility bills that need to be paid for by the company.
Examples of Current Liabilities
Examples of Current Liabilities include the following:
- Accounts Payable
- Short-term debt payable
- Dividends Payable
- Notes Payable
- Deferred Revenue Payable
- Maturity of long-term debt
- Interest payable on debt instruments
- Accrued Expenses
- Accounts Payable
Importance of Current Assets and Current Liabilities
Current Assets and Current Liabilities hold equivalent value from the company’s perspective. It shows that Current Assets represent the company’s actual cash position and hence, their ability to pay their day-to-day expenses.
The amount of Current Assets on the Balance Sheet is essential for the following reasons:
- From the company’s perspective, current assets represent the company’s cash holdings. It aids in planning cash flows so that all expenses can be adequately met. In case of any shortfall, the company has time to prepare to arrange funds from elsewhere.
- Investors use current assets as a measure of liquidity. Highly liquid businesses are always a positive sign for the investors because the Default Risk minimizes in the case of properly managed current assets. The current asset figure on the balance sheet reflects the company’s cash position. Cash-rich companies are more likely to give out cash dividends simply because they have the resources to do so.
Like Current Assets, Current Liabilities also hold significant value for the company. It gives an idea regarding the accruals that need to be settled by the company over one year. Similar to Current Assets, Current Liabilities also hold enormous value in helping companies plan their cash flows over time.
Analysis and Interpretation of Current Assets and Current Liabilities
Since both, Current Assets and Current Liabilities tend to span over less than one year, their impact on the company’s operations is quite considerable.
Therefore, internal and external stakeholders use these amounts to gauge the company’s performance and future outlook. To do this, they use two ratios: Current Ratio and Quick Ratio.
Current Ratio: Current Ratio is a ratio that uses Current Assets, Current Liabilities. It shows how much Current Assets a company has in exchange for Current Liabilities owed by the company. It calculates using the following formula:
Current Ratios = Current Assets / Current Liabilities
The ideal metric for the Current Ratio is greater than 1. If the current ratio is greater than 1, it implies that the company has sufficient resources to meet its day-to-day obligations.
On the other hand, if the Current Ratio is less than 1, it implies that Current Liabilities are greater than Current Assets. Therefore, the company might find it difficult to meet day-to-day expenses.
Quick Ratios = (Current Asset – Inventory) / Current Liabilities
The idea of a quick ratio for a company is 1. Inventory is subtracted from Current Assets because inventory is a relatively illiquid asset. If the ratio turns out to be 1, it implies that the organization would not have any difficulty meeting its operational expenses.
What does it mean if Current Liabilities are greater than Current Assets?
Suppose Current Liabilities are greater than Current Assets. It simply means that the company has more accruals outstanding than the cash funds they have readily available to settle those dues. The inability of the company to settle these dues implies that they might face production delays and strained relations with their investors.
Therefore, Current Liabilities being greater than Current Assets is a definitive sign of concern for the management and the external stakeholders, including investors and shareholders.
Impact on Liquidity if Current Liabilities are greater than Current Assets
If the Current Ratio and the Quick Ratio turn out to be less than 1, it implies that the Current Liabilities are greater than Current Assets. In case when this happens, this implies that the company might have liquidity issues in the coming future.
The inability of the company to meet its day-to-day expenses might hamper the company from making payments in due time, which might result in an adverse impact on the company’s liquidity.
The organization might have to arrange funds from elsewhere to combat this issue. They might need to borrow more funds from investors or might have to delay their payments. This will incur an additional finance cost to the company, which will eventually impact the company’s profitability.