What it is: Current assets are cash and other assets that the company expects to be converted into cash, sold or used in a year or normal operating cycle.
Why it matters: Current assets are useful for meeting liquidity needs and managing the working capital of a company. The company uses them to finance the company’s day-to-day operations, pay off debts that are due in one year, and pay off suppliers. Hence, in your analysis, you should compare them to the company’s current liabilities.
Difference between current assets and current liabilities
The opposite of current assets is the current liabilities. Companies expect to convert current assets, such as inventories and accounts receivable, into cash within one operating cycle (or one year). Instead, they must settle current liabilities at the same time as paying off-trade payables and paying off short-term debts.
The difference in both we call working capital. If working capital is negative, the conversion of current assets into cash cannot cover current liabilities. But, if the working capital level is too high, it might also indicate the company is not using its resources efficiently. That means the company is wasting its resources.
Difference between current assets and noncurrent assets
Noncurrent assets include less liquid assets. Examples of items are:
- Long-term investment such as investment property
- Property, plant, and equipment (PP&E)
- Intangible assets such as goodwill
The company does not expect to convert such assets into cash within one year. Instead, they are the infrastructure to support the company’s long-term operations or investment.
The sum of noncurrent assets with current assets equals total assets. You can find the numbers at the bottom of the balance sheet.
Examples of current assets
Current asset components consist of:
- Cash – includes coins, banknotes, bank deposits, checks, and money orders. Companies can use them immediately, for example, to pay debts or pay suppliers.
- Cash equivalents – are the money that the company invested in short-term financial instruments such as money market instruments. These instruments are highly liquid, have minimal price risk, and easily converted to cash in less than 90 days.
- Marketable securities – financial assets, including investments in debt and equity securities traded on the public market. They are available-for-sale or investments that mature in one year or operating cycle. Compared to cash, this investment may require a little more effort to sell but results in a higher return rate.
- Accounts receivable – the amount owed by customers for shipments of goods that the company has made. This account appears when the company sells goods or provides services on credit and has not received customers’ cash payments.
- Inventory – consists of finished goods, goods in process, or raw materials. The company will convert this into sales and cash within one year.
- Prepaid expense – operating expenses that the company has paid for. For example, the company has paid rent for the next year. At the end of this year, the company will deduct it and record the income statement’s rental expense.
The financial statements present these items in order of liquidity. On the top line is cash, which is the most liquid. The next items are cash equivalents and marketable securities.
Cash equivalents and marketable securities are essential to meet liquidity as well as to obtain returns. Companies can cash both out immediately when they need cash with minimal price risk.
Accounts receivable are another source of cash inflows. The company presents them as net accounts receivable, i.e., gross receivables less bad debts. Bad debts represent estimated uncollectible cash payments from customers. Not all customers can pay for the goods they buy, and hence, the company will estimate how much it is worth and set it aside from the gross receivables.
Inventories are the next source of cash inflows, but they are less liquid than previous accounts. It consists of raw materials, semi-finished goods, and finished goods. It took longer to convert them into cash. How long does it take to get raw materials, process them to convert them into cash, it is the operating cycle, which usually one year.
Finally, prepaid expenses do not represent future cash inflows. It merely constitutes a flow of benefits to the company. They have paid the supplier cash, but have not received the goods or services. So, the cash flow has gone out. The company will receive the benefits (receive input) within one year from the reporting period.
Calculate current assets
Calculating the total current assets is easy. It only requires arithmetic operations, and you only add up the above components plus any other current assets.
Other current assets usually vary between financial statements, so I have not included them as examples. You can see the details in the notes to financial statements.
Analyze current assets
First: Information about current assets is useful for assessing liquidity if you compare it to current liabilities. Ideally, the company has more current assets than current liabilities. That way, they can meet the liabilities when they are due.
But, not all current assets are liquid. The conversion to cash takes time. For inventories, for example, companies must process raw materials into finished goods and sell them. The company may also not receive some money immediately because it sells finished products on credit.
What’s next: the current asset item is also useful for knowing the company’s effectiveness in managing daily operations. For the analysis, you need to relate these items to the sales or cost of goods sold (COGS) on the income statement.
Three indicators to measure liquidity are the current ratio, the quick ratio, and the cash ratio. The calculation for the three is simple. You only need to compare the items in current assets to total current liabilities.
The current ratio evaluates liquidity by comparing total current assets to total current liabilities. The following is the current ratio formula:
Current ratio = Current assets/Current liabilities
What it means: A relatively high current ratio is preferable. The company has sufficient liquidity to pay liabilities that are due in one year.
But, if it is too high, it also shows that the company uses its assets inefficiently. And the current ratio is lower than the industry average, indicating liquidity difficulties.
The quick ratio is more conservative than the current ratio for measuring liquidity. This ratio only uses more liquid items. So, you don’t need to include inventory or prepaid expenses in your calculations. Inventory conversion takes longer. Likewise, prepaid expenses do not represent cash inflows.
The formula for the quick ratio is:
Quick ratio = (Cash and cash equivalents + Marketable securities + Accounts receivable)/Current liabilities
What it means: Just like a current ratio, a high quick ratio indicates a company is more liquid. The company can meet short-term obligations that will mature within one year.
The cash ratio is the most conservative. You compare the most liquid assets with current liabilities. The formula for calculating it is:
Cash ratio = Cash and cash equivalents/Current liabilities
Another financial ratio you can use to analyze current assets is the efficiency ratio (also known as the effectiveness ratio). This ratio tells you how efficient the company is in carrying out its day-to-day operations.
Three of the efficiency ratios are working capital turnover, inventory turnover, and accounts receivable turnover.
Working capital turnover measures the efficiency of a company in managing its working capital to support sales. To calculate it, you compare the revenue on the income statement with average working capital. Working capital equals current assets less current liabilities.
Working capital turnover = Revenue/Average working capital
What it means: A higher working capital turnover ratio is desirable. It shows the company able to pay current liabilities and still maintain day-to-day operations.
Conversely, a negative working capital turnover ratio means that the company does not have enough short-term funds to meet sales made for that period. That will leave the company underfunded and out of cash.
Inventory turnover shows how well the company is managing its inventory levels. The calculations are also simple. You divide the cost of goods sold on the income statement by the average inventory.
Inventory turnover = Cost of goods sold/Average inventory
An alternative to calculating is to use sales as the numerator instead of the cost of goods sold.
What it means: A higher inventory turnover is ideal because it indicates more effective inventory management. For a more objective analysis, you can compare it to industry averages.
Conversely, a lower ratio could be an indication of a problem. Inventories are growing faster than sales, causing an accumulation of goods in warehouses. Firms may have to lower prices to encourage sales – and that leads to lower profits. Also, inventory binds the company’s cash until the company can sell it.
Accounts receivable turnover tells you the effectiveness of the company in collecting accounts receivable. To do this, you divide revenue by the average accounts receivable.
Accounts Receivable Turnover = Revenue/Average accounts receivable
What it means: The company’s credit collection procedure is very efficient when the accounts receivable turnover is high. Accounts receivable grows more slowly than sales, and companies receive money quickly from selling goods or providing services.
But, if it gets too high, it can hurt sales. Company credit policies and terms may be too restrictive, causing customers to switch to competitors that offer more lenient terms. To get a more in-depth insight into the cause, you can examine sales growth over time.
Furthermore, if the accounts receivable turnover ratio is low, it can cause liquidity problems. The company may offer more relaxed credit terms to increase its sales. That can lead to greater difficulty in collecting cash payments from customers.