Understanding Current Assets, their key components, and ratios
Whether a multinational company or a mid-size enterprise, current assets are crucial to every business because they are used to finance day-to-day business functionalities and pay the operating expenses.
Introduction to current assets
Current assets constitute all a company's assets, which, if needed, can be converted into cash within a year to settle liabilities. For example, cash, cash equivalents, inventory, accounts receivable and other liquid assets. Therefore, current assets are regarded as one of the most essential financial metrics.
Types of current assets
Here are the different types of current assets that are referred to while evaluating the annual operation cycle of a company.
- Cash and Cash Equivalents
- Accounts Receivable
- Prepaid Expenses
- Marketable Securities
- Other Liquid Assets
Important ratios that use current assets
Below mentioned are some essential current assets ratios -
A cash ratio is a current asset ratio used for computing the company’s ability to meet its short-term obligations. This ratio indicates the company’s capability of fulfilling its ongoing liabilities with cash or cash equivalents without the sale or liquidation of other assets.
Hence, Cash Ratio = Cash and Cash Equivalent / Current Liabilities
A Quick Ratio is usually referred to as the acid-test ratio. It is a current asset ratio used to analyse a company’s capability to face short-term monetary liabilities with assets that are easily converted to cash within ninety days. These include marketable securities and accounts receivable apart from cash and cash equivalents.
Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities
A Current Ratio is used for computing a company’s ability to meet all its short-term obligations using all of its current assets.
Hence, Current Ratio = Current Assets / Current Liabilities
Key components of current assets
Current assets are listed on a company’s balance sheet. Some common examples of current assets are:
Cash and cash equivalents:
The term "cash equivalents" refers to short-term investments of a company, which can be effortlessly converted into cash or are sufficiently near to their maturity date, usually within 90 days, so that their market value is not affected by changes in interest rates. Often, stock holdings and equity are not included in cash equivalents due to the frequent fluctuation in their value.
Treasury bills, short-term government bonds, and commercial papers close to the maturity date of ninety days or less are examples of cash and cash equivalents. Cash equivalents are the most liquid current assets.
These include cash accounts, money market funds, treasury bills, notes, commercial papers, certificates of deposits, cash management pools, etc.
This includes the stocks of raw materials and finished goods. For instance, for a shoe manufacturer, inventory includes elements such as leather, rubber, PVC as well as finished goods, packaging materials, etc.
Inventory is regarded as the primary and the most critical asset of any company because it includes the goods and items sold within a year or less, which are the essential sources of the company’s revenue. Comparatively, inventory is less liquid than cash or cash equivalents.
The revenue the company expects to receive from customers for products and services sold.
Accounts receivable are listed as current assets on the balance sheet because it is regarded as the money due to a company within a year or less. In simple words, accounts receivable is the claimable amount by the company for the goods or services delivered to a client. For example, a software solution company that bills its clients after they receive their software products is considered as accounts receivable.
Payment made for goods and services to be received in the future by the company. For instance, employee insurance policies, advance tax, rent for offices, bulk orders etc.
Prepaid expenses are the payments made by a company in advance for the goods or services to be received later. As a result, a reduction of cash takes place on the balance sheet when such payments are made. This is accounted as a current asset of the equivalent amount by the name of prepaid expenses on the balance sheet.
These consist of equity securities, hedge fund investments, money market instruments, etc.
Marketable securities are investments involving buying, selling and trading on an exchange. If needed, these commercial investments are expected to be exchanged for cash within a year. Stocks, treasury bills, bonds, notes, and equity securities are the most common examples of marketable securities.
Other liquid assets:
Deferred assets are a part of other current assets. For example, when a company makes excessive payments in the name of taxes which lessens the taxable income in the future, then such deferred tax assets are accounted as an asset on the balance sheet.
Current Assets vs Non-Current Assets
Non-current assets are also known as fixed assets because they are deliberately used for long-term liabilities and assets with value that can’t be estimated until after one year, such as machinery and property. Often, it’s arduous to liquidate these assets. In contrast, current assets can be easily liquified and used for short-term responsibilities.
The current assets determine the financial foundation or the worth of the company. Thus, current assets are a very important metric for understanding any company. Furthermore, a solid asset base is crucial for scaling up businesses and succeeding. Therefore, in order to measure a company's financial well-being, asset accounts are used. The financial strategists of the company are responsible for maintaining an ideal balance between assets and liabilities. A financially healthy company attracts more shareholders.
The gross profit ratio and net profit ratio are used by equity analysts to measure a company's profitability. They are analysed over a period to see whether a company has been able to consistently generate healthy profit levels as well as to compare the performance with its peers.
A dividend is a reward that a company gives its shareholders after setting aside capital to meet its expenses and growth aspirations. It shows that a company is profitable and has healthy cash flows.