What are Current Assets
The term current assets represents all the assets of a company that are expected to be conveniently sold, consumed, utilized or exhausted through the standard business operations which can lead to their conversion to a cash value over the next one year. Since current assets is a standard item appearing in the balance sheet, the time horizon represents one year from the date shown in the heading of the company's balance sheet. Current assets include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities and other liquid assets. In a few jurisdictions, the term is also known as current accounts.
The term contrasts with long-term assets, which represent the assets that cannot be feasibly turned into cash in the space of a year. They generally include land, facilities, equipment, copyrights, and other illiquid investments.
BREAKING DOWN Current Assets
Current assets are important to businesses because they can be used to fund day-to-day business operations and to pay for the ongoing operating expenses. Since the term is reported as a dollar value of all the assets and resources which can be easily converted to cash in a short period of time, it also represents a company’s liquid assets.
However, care should be taken to include only the qualifying assets that are capable of being liquidated at the fair price over the next one year. For instance, there is a high chance that a lot of commonly used FMCG goods produced by a company can be easily sold over the next one year which qualifies inventory to be included in the current assets, but it may be difficult to sell land or heavy machinery easily which are excluded from the current assets. Depending on the nature of the business and the products it markets, current assets can range from barrels of crude oil, fabricated goods, work in progress inventory, raw material, or foreign currency.
Key Components of Current Assets
While cash, cash equivalents and liquid investments in marketable securities (like interest bearing short term Treasury bills or bonds) remain the obvious inclusion in current assets, the following are also included in current assets:
Accounts receivable, which represents the money due to a company for goods or services delivered or used but not yet paid for by customers, are considered current assets as long as they can be expected to be paid within a year. If a business is making sales by offering longer terms of credit to its customers, a portion of its accounts receivables may not qualify for inclusion in current assets. It is also possible that some accounts may never be paid in full. This consideration is reflected in an allowance for doubtful accounts, which is subtracted from accounts receivable. If an account is never collected, it is written down as a bad debt expense, and such entries are not considered for current assets.
Inventory, which represents raw materials, components and finished products, is included as current assets, but the consideration for this item may need some careful thought. Different accounting methods can be used to inflate inventory, and at times it may not be as liquid as other current assets depending on the product and the industry sector. For example, there is little or no guarantee that a dozen units of a high-cost heavy earth moving equipment may be sold for sure over the next year, but there is a relatively higher chance of successful sale of a thousand umbrellas in the coming rainy season. Inventory may not be as liquid as accounts receivable, and it blocks the working capital. If the demand shifts unexpectedly, which is more common in some industries than others, inventory can become backlogged.
Prepaid expenses, which represent advance payments made by a company for goods and services to be received in the future, are considered current assets. Though they cannot be converted into cash, they are the payments which are already taken care of. Such components free up the capital for other uses. Prepaid expenses could include payments to insurance companies or contractors.
On the balance sheet, current assets will normally be displayed in order of liquidity, that is, the items which have higher chance and convenience of getting converted into cash will be ranked higher. The typical order in which the constituents of current assets may appear is cash (including currency, checking accounts, and petty cash), short term investments (like liquid marketable securities), accounts receivable, inventory, supplies and prepaid expenses.
Current Assets Formula and Example
The current assets formula is a simple summation of all the assets that can be converted to cash within one year:
Current Assets = Cash + Cash Equivalents + Inventory + Accounts Receivables + Marketable Securities + Prepaid Expenses + Other Liquid Assets
All of these assets typically appear on a business’s balance sheet.
For example, leading retailer Walmart Inc.'s (WMT) Total Current Asset for the fiscal year ending January 2018 is the summation of cash ($6.76 billion), Total Accounts Receivable ($$5.61 billion), Inventory ($43.78 billion) and Other Current Assets ($3.51 billion), which comes to $59.66 billion.
Similarly, Microsoft Corp. (MSFT) had Cash & Short Term Investments as $133.77 billion, Total Accounts Receivable as $26.48 billion, Total Inventory as $2.66 billion and Other Current Assets as $6.75 billion for the fiscal year ending June 2018. It takes the technology leader's Total Current Assets to $169.66 billion.
Uses of Current Assets
Current assets figure is of prime importance to the company management with regards to the daily operations of a business. As payments towards bills and loans become due at regular frequency (like, at the end of each month), the management must be able to arrange for the necessary cash in time to pay its obligations. The dollar value represented by the current assets figure provides a general insight into company’s cash and liquidity position, and allows the management to remain prepared for the necessary arrangements to continue business operations.
Additionally, creditors and investors keep a close eye at the current assets of a business to assess the value and risk involved in its operations. Many use a variety of liquidity ratios, which represent a class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Such commonly used ratios include current assets, or its components, as a key ingredient in their calculations.
Ratios using Current Assets or their Components
Owing to different attributes attached to the business operations, different accounting methods and payment cycles, it often becomes a challenging exercise to correctly categorize what all components can be termed as assets over a given time horizon. The following ratios are commonly used to measure a company’s liquidity position with each one using a different number of asset components against the current liabilities of a company.
The current ratio measures a company's ability to pay short-term and long-term obligations and takes into account the current total assets (both liquid and illiquid) of a company relative to the current liabilities.
The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. It considers cash and equivalents, marketable securities and accounts receivable (but not the inventory) against the current liabilities.
The cash ratio measures the ability of a company to pay off all of its short-term liabilities immediately, and is calculated by dividing the cash and cash equivalents by current liabilities.
While the cash ratio is the most conservative one as it takes only cash and cash equivalents into consideration, the current ratio is the most accommodating and includes a wide variety of components for consideration as assets. These various measures are used to assess the company’s ability to pay outstanding debts and cover liabilities and expenses without having to sell fixed assets.