What Are Short Term Assets?
Short term assets refer to assets that are held for a year or less, and accountants use the term “current” to refer to an asset expected to be converted into cash in the next year or liability coming due in the next year. The accounting profession uses current assets and current liabilities to perform analysis, and in the investing industry, a security with a holding period of one year or less is considered a short-term security.
- Short term assets refer to assets that are held for a year or less, with accountants using the term “current” to refer to an asset expected to be converted into cash in the next year.
- Both accounts receivable and inventory balances are current assets.
- Short-term or current assets are applicable when calculating several important financial ratios, such as the current ratio, turnover ratio, and measuring the liquidity of a company.
How Short Term Assets Work
Short term is defined as current by accountants, so a current asset equals cash or an asset that will be converted into cash within a year. Inventory, for example, is converted into cash when items are sold to customers, and accounts receivable balances are converted into cash when a client pays an invoice. Both accounts receivable and inventory balances are current assets.
Liquidity and Short Term Assets
Liquidity refers to a company’s ability to collect enough short-term assets to pay short-term liabilities as they come due. A business must be able to sell a product or service and collect cash fast enough to finance company operations. Managers must focus on liquidity as well as solvency, which is the process of generating sufficient cash flow to purchase assets over the long term.
Examples of Short-Term Financial Ratios
As managers make decisions with financial ratios, there are several keys ratios used to make decisions about liquidity. The current ratio, for example, is calculated by dividing current assets by current liabilities. This resulting ratio measures the ability of a firm to pay its liabilities in the short term. Companies also use turnover ratios to calculate how quickly current assets can be converted into cash in the short term.
As an example, the inventory turnover ratio compares the cost of sales with inventory to measure how often the business sells its entire inventory in a year. Businesses also use the accounts receivable turnover ratio to analyze the number of days it takes to collect the average accounts receivable balance. If managers can effectively monitor short-term cash flow, the firm needs less cash to operate each month.
Short-Term Periods and Taxes
Investors need to be clear about whether a capital gain is on a short term or a long term asset because taxation of the gain or loss is treated differently. For tax purposes, a long-term gain or loss means the security is held for a year or longer before being sold. In addition, this has implications because long-term trading activity is typically separated from short-term transactions on tax forms.