What it is: Current liabilities are part of liabilities which due within one year or the normal operating cycle. You can find them in the balance sheet section.
Current liabilities reduce financial flexibility because the company will pay them immediately. It requires payment using current assets or other liabilities to arise. Liquidity is under pressure if the company doesn’t have sufficient cash or current assets.
Examples of current liabilities
Liabilities represent claims on company assets. And for the current liabilities, they could be:
- Accounts payable – occurs when the company has received the goods or services from suppliers, but not paid in cash. It is the opposite of accounts receivable.
- Deferred revenue (or unearned revenue) arises when the company has received payment in cash but has not delivered goods or services to customers.
- Short-term debt – such as a note payable, an interest loan with a maturity of one year or less.
- Current portion of long-term debt – the part of long-term debt which due within one year.
- Income tax payable – arise when the company has not paid income tax to the government.
Why current liabilities matter
Analyzing working capital management
The company should have sufficient liquidity to pay off liabilities when they fall due. That way, the company can pay off suppliers or pay off short-term debt.
To do that, a company must manage its working capital properly – working capital is the difference between current assets and current liabilities. Companies rely on liquidation of current assets to pay their current liabilities. Therefore, if current liabilities are more significant than current assets, it can indicate a liquidity problem.
Indeed, companies can settle obligations by replacing them with other obligations, such as short-term debt. However, if it continues continuously, it can cause a buildup of problems in the future.
For liquidity analysis
You can use several financial ratios to assess the liquidity condition of a company. Three of these liquidity ratios are the current ratio, the quick ratio, and the cash ratio.
- Current ratio = Current assets/Current liabilities. The current ratio of less than one is a signal of liquidity problems because the current assets are not sufficient to settle current liabilities.
- Quick ratio = (Cash and cash equivalents + Short term investment + Accounts receivable)/Current liabilities. It omits illiquid components such as inventory. It also excludes prepaid expenses since they don’t represent potential cash inflows in the short term.
- Cash ratio = Cash and cash equivalents /Current liabilities. It is the most conservative liquidity ratio and only uses the most liquid assets to pay off current liabilities.
For all three, a higher ratio indicates sufficient liquidity to pay short-term obligations.
Evaluating how fast the company pays off its suppliers
You can use accounts payable turnover to see whether the company is having credit problems with suppliers or not. This ratio tells you how fast the company pays its suppliers.
Accounts payable turnover = Purchases/Average accounts payable
You calculate purchases during the reporting period by adding the ending inventory to the cost of goods sold and then subtracting the result with the beginning inventory.
Purchases = Ending inventory + Cost of goods sold – Beginning inventory
Low accounts payable turnover is desirable. That indicates the supplier’s credit terms may be looser. Companies can use cash for other purposes before giving it to suppliers.
Conversely, if the accounts payable turnover ratio is high, the company pays suppliers earlier. It reduces financial flexibility. Reasons why the company pay sooner:
- Companies cannot take advantage of suppliers’ credit facilities and pay them too earlier.
- Suppliers have an overly strict credit policy, requiring companies to pay immediately to avoid penalties.
- Companies make prepayments to get discounts from suppliers.
Finally, a decreasing ratio may indicate the company is experiencing financial difficulties. Or, it may indicate the company could delay payment of its accounts payables for a more extended period without being penalized by the supplier.
Potential revenue in the future
Increased unearned revenue leads to higher revenue in the future. Even though it is classified under current liabilities, they don’t require future cash outflows. The company has received payment from the customer, it just hasn’t shipped the product to them. When it has sent the product, the company will finally recognize it as revenue in the income statement.