The term ‘current assets’ is used when analysing the finances of a business. Here we cover the factors that comprise current assets and how they are defined.
Current assets are defined as assets that can be converted into cash within one year or less. Knowing this amount will help you understand how well your business is running and how well you will be able to meet your current liabilities.
The accounts considered to be current assets include:
- Accounts receivable
- Cash and cash equivalents
- Inventory
- Marketable securities
- Other liquid assets.
- Prepaid expenses
Anything else that can be converted quickly into cash, such as short-term investments, should also be classified as a current asset.
You can calculate current assets using the following formula:
Total current assets = Accounts Receivable + Cash and Cash Equivalents + Inventory + Marketable Securities + Prepaid Expenses + Other Liquid Assets
Now that we have the formula, we’ll take a closer look at the items that go into it.
This is the amount that’s owed to your business. If you offer payment terms, you will have accounts receivable. It’s the sum of all outstanding invoices. Typically, outstanding invoices are collected between 15 and 90 days from the invoice date, so the fall within the one-year criterion as current. Some businesses, such as retail shops and restaurants, don’t offer payment terms so don’t have accounts receivable. In these cases, the amount will simply be zero. .
This includes a number of items including petty cash, notes, coins, undeposited cheques, money in bank accounts, and short-term investments that will mature within 90 days.
This refers to raw materials, components, products in production, and items ready for sale. Inventory is classified as a current asset because it typically can be sold within one year.
These are short-term investments or financial instruments that can be sold within a year. Typically, marketable securities are traded on the open market, such as the ASX in Australia. Shares not publicly traded might not be sellable in the short run so aren’t in this category.
These include all other assets that can be turned into cash within one year, such as maturing investments, machinery and equipment, and property.
These are expenses that have been paid in advance. Examples include rent for business premises that has been paid in advance and insurance that has been paid in advance. For example, if a business pays $2,000 for an insurance bill that is invoice every six months, that will be a prepaid expense until the next bill arrives.
Knowing this figure will help you understand the overall health of a business.
In order to be viable, a business needs to be able to cover its short-term obligations. Knowing current assets is also required to calculate key financial ratios such as the current ratio which measure’s a company’s working capital and its ability to cover its short-term liabilities. The quick ratio uses this figure as well. Learn more about financial ratios in How Financial Ratios Can Help You Measure Your Business Performance.
This figure also appears on the balance sheet. The balance sheet equation is Assets = Liabilities + Equities. Current assets appear at the top left-hand side of the balance sheet followed by long-term assets below them.
Businesses that don’t have sufficient cash flow to cover their short-term obligations often use unsecured business loans to overcome this issue.
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Current assets are assets that are expected to be consumed or sold within a fiscal year. They can be both tangible and intangible. Current assets are shown in the assets section of a company’s balance sheet. They can be a useful indicator of a business’s liquidity.
Examples of current assets
In accounting, cash and near-cash assets are always considered to be current assets. Examples of near-cash assets include:
- Cash Equivalents (such as short-term bonds and marketable securities)
- Prepaid Expenses
Similarly, other liquid assets will also be classed as current assets. These would typically include accounts receivable and inventory. There can, however, be nuance here.
For example, if a business has a long-term relationship with a client, it is possible that they might be given more than a year to pay for products and/or services. In this instance, some or all of the credit line would have to be classed under non-current assets (also known as long-term assets).
Alternatively, there might be some doubt over whether a customer will actually pay their bill in full and on time. In this instance, some or all of the credit line would be moved to the allowance for doubtful accounts.
Similarly, if a company’s inventory includes a lot of niche, tangible assets, it might be more reasonable to treat them as illiquid assets. This is because it will probably be difficult for them to be converted into cash both quickly and at a fair value.
Listing assets on a balance sheet
The standard accounting convention is to list assets in order of most liquid to most illiquid. This means that current assets are shown before noncurrent assets. Both current assets and long-term assets are usually further broken out into their component parts.
For current assets, the first item will always be cash (assuming the company has it). This is generally followed by cash equivalents. Listing the non-cash assets is often a matter of judgement. In general, however, intangible assets will be listed higher than tangible assets.
Long-term assets follow the same pattern. They are unlikely to include cash but may contain some cash equivalents such as long-term bonds. Similarly, they won’t have marketable securities but may have long-term investments.
The bulk of a company’s tangible assets will probably be under the long-term assets section of its balance sheet. It will certainly include any fixed assets such as real estate. It can, however, also include intangible assets such as goodwill.
Current assets vs current liabilities
Although current assets are important, they are just one part of a company’s overall financial position. They only really have meaning when looked at in context. In particular, they need to be compared to a business’ current liabilities.
Current liabilities are the obligations a business must meet within a fiscal year. Most current liabilities are costs related to business operations. For example, they would include payments to employees and suppliers as well as dividends to shareholders and company taxes.
Stakeholders will often compare current assets to current liabilities to help them understand a company’s actual liquidity. They may extend this to looking at non-current assets and non-current liabilities to get an idea of a company’s future prospects.
The importance of accurate valuation
In addition to making sure that assets are put into the right section of the balance sheet, it’s vital to make sure that they’re valued accurately. This is probably more of a concern for long-term assets as their values could be influenced by appreciation, depreciation and/or amortisation.
Once you have determined a strategy for valuing your assets (and liabilities) accurately, it’s important to use it consistently. This is the only way stakeholders will be able to judge your company’s performance over time.
This article is for informational purposes only and does not constitute legal, employment, tax or professional advice. For specific advice applicable to your business, please contact a professional.