Every business, at some point, has checked its books of accounts to realize that its revenue expenditure is impossible to meet due to the lack of liquidity of current assets. As it will lead to hindrances in their day-to-day operations, the management has to work on this issue in accordance with all other departments.
After all, even if the company is on track to achieve long-term growth but fails to have enough money to cover short-term expenses, it is going to fall short. To avoid such a crisis, the assessment of current assets becomes crucial for the steady performance of the company. It is also essential for the analysis of a company’s financial standing.
Before diving deep, let’s find out what are current assets.
Current assets are all those assets of a company that can be readily traded, used, utilized, or expended within one year of normal business activities. Assets are classified into two categories in financial terms: current assets and non-current assets. Unlike current assets, non-current assets (also known as long-term or capital assets) can’t be used right away. Even if an organization’s operational cycle is longer than a year, an asset will still be considered current if it is transformed into cash within one year.
This article discusses the types and importance of current assets and how they represent the backbone of a company’s financial stability.
How are Current Assets Different from Non-Current Assets?
Current assets are presented on the balance sheet, which is a vital financial statement of the company that is completed each year. All assets of an organization that they can sell, use, or trade immediately or within an accounting year in any way are known as current assets. They comprise cash and cash equivalents, accounts receivable, inventory, short-term loans and advances, and current investments.
Non-current assets examples are those that a company can’t convert into cash within a year. Non-current assets include manufacturing plants, property, machinery, and equipment category (PP&E), non-current investments, long-term loans, and advances. The sum of current and non-current assets of a business makes the total assets listed in the balance sheet at the end of each accounting period.
List of Current Assets
Current, physical, operating, intangible and non-operating assets are all common assets kinds. The ability to correctly identify and categorize asset kinds is crucial to a company’s existence, particularly its liquidity and related risks. Here are some examples of current assets.
Cash and Cash Equivalents
Companies require cash to operate daily. Checking accounts, cash in hand, uncleared invoices, and bank transfers are all examples of cash. A cash surplus is typically invested in low-risk, highly liquid securities to produce additional income. These are referred to as cash equivalents, and these are equivalents in money. Examples of cash equivalents would be money market mutual funds, commercial papers, treasury bills, and bank certificates of deposits, which can be readily converted into cash if needed.
Marketable Securities or Current Investments
Marketable security would be an effortlessly exchanged investment that can be turned into cash quickly, generally due to the asset’s strong secondary market. These securities are usually transacted publicly with easily available price quotations. The low return from marketable securities is frequently a trade-off for the high degree of liquidity. Examples of marketable security include bonds, treasury bills, notes, and equity securities.
Accounts Receivable
Accounts Receivables are the credits issued to customers. This indicates that the business has provided services or delivered a product to a consumer. However, the money has not yet been entirely collected. A part of the company’s accounts receivables might not even be eligible for consideration into current assets if it makes sales by giving customers extended terms of credit.
Inventory
Inventory, which includes raw materials, components, and completed goods, is considered a current asset, although its assessment may require some thinking. Businesses can inflate inventory using various accounting procedures, and it may not always be as liquid as the other current assets, depending on the product and industrial sector.
Prepaid Expenses
These represent advance payments that a company makes for goods and services to be received in the future. These are the transactions that have already been paid; thus, cash is reduced in the balance sheet when such expenses are paid off during the start of the accounting period. At the same time, the current asset of the same amount is made in the balance sheet naming it prepaid expenses, as the benefit from such expenditure is yet to be consumed.
It is a future expense that the company has already paid for, and it is recognized as a current asset on the balance sheet until the expense is consumed. For example, rent or insurance contracts have been paid for, and the business is expected to reap the benefits within 12 months. They are categorized as current assets since the business is yet to use them for the entirety of the year. As the premises remain occupied for each month, the corresponding prepaid expense would turn into expenditure from the current asset accordingly. This continues for the whole year.
Non-Trade Receivables
Non-trade receivables are invoices of workers, suppliers, or other agencies or individuals that pay for non-business purposes. These receivables may include loans or salary advances owed by employees, prepaid deposits owed by vendors, tax refunds owed by tax authorities, and insurance claims owed by insurance companies. Since they are expected to be paid within a year, these are presented as current assets on the balance sheet. Although if the payment delays more than a year, then it turns to a non-current asset.
How to Calculate Current Assets?
The current assets formula is very simple. Current assets (CA) are simply the sum of all the liquid assets. The current asset formula is:
CA = C + CE + MS + AC + I + PE +OCA
Where,
- C=Cash,
- CE= Cash equivalent,
- MS= Marketable securities,
- AC= Accounts receivable,
- I= Inventory,
- PE= Prepaid expenses,
- OCA = Other current assets.
For example, in September 2020, Microsoft Corps assets were as follows:
C, CE = Rs 17,205
MS = Rs 120,772
AC = Rs 22,851
I = Rs 2,705
Other = Rs 13,544
CA = C + CE + MS + AC + I + PE + OCA = Rs 177,077
How do Businesses Use Current Assets Information?
Businesses make use of the current asset balance to determine the current assets to current liabilities ratio. This ratio is important to creditors because it reflects a business’s short-term liquidity. For example, if a company’s current assets exceed its liabilities, it must meet its immediate payments. Several ratios, such as the cash ratio, quick ratio, and current ratio, can be used in this form of liquidity analysis.
- Cash Ratio – The cash ratio, or the ratio of a business’s overall cash and cash equivalent to its current obligations, is a measure of its liquidity. Although there is no perfect ratio, a ratio of at least 0.5 to 1 is often suggested.
- Current Ratio – The current asset to current liability ratio, or current ratio, is typically at 2:1. Because the major purpose of current assets is to meet a company’s day-to-day costs, all companies must correctly manage their current assets.
The biggest issue with using current assets as a liquidity measure is that some of the asset parts of this category are not particularly liquid. Similarly, the accounts receivable amount may contain some late bills. There should be an adjustment figure in the provision for suspicious accounts to indicate the amount that is not likely to be collected. It is important to scrutinize the composition of current assets extensively to determine a company’s genuine liquidity.
The Bottom Line
The ability of a company to transform the value of its assets into cash within a year is termed its liquidity. Current assets greatly influence the liquidity position of a business. If a business generates cash, trade receivables, and marketable securities, it may create greater yields just by using them. The current assets also help define the organization’s worth and financial health. As a result, utilizing such assets is a great approach to assessing a company’s capacity to support its operations.