Ever wondered what defines a financially successful business?
The answer may surprise you - it's not just about revenue or profits. Instead, it lies in the very foundation of the company, its assets. Assets are more than just entries on the balance sheet; they are the cornerstone of business operations. The purpose of understanding assets goes beyond mere financial stability. It is necessary for effectively managing risks, making strategic decisions, fostering sustainable growth, and ensuring continued success.
Current and non-current (fixed assets) are the two primary types of assets. In this article, our focus will be on current assets and their pivotal role in business. We'll unravel their distinctive characteristics, dissect the pros and cons, and provide insights on how to calculate and harness their potential, empowering you to manage your working capital effectively.
What is a current asset?
Resources that are readily available for conversion to cash, or to be used within one year/single operating cycle, are viewed as current assets. They are listed at the top of a company’s balance sheet, in order of their liquidity.
But what other traits are important when looking at current assets? Let’s find out.
Key characteristics of current assets:
Liquidity
It is simply the ease with which resources can be converted into cash without affecting their market price. Most current assets are highly liquid and are even sometimes referred to as liquid assets. It is this ability of assets that empowers businesses with immediate funds to fulfil their operational needs.
Short-term nature
Current assets are inherently short-term in nature, a defining feature that sets them apart. They are anticipated to be utilised or converted into cash, typically within 12 months.
Working capital
Working capital is the fuel that powers business operations and current assets contribute significantly to it. Deducting current liabilities from the total value of current assets leaves you with working capital.
Fluctuating values
A current asset’s value may vary owing to market conditions, shifts in customer demand, or changes in the economic environment. For instance, the cost of inventory might be influenced by high demand and inflation.
What are the different types of current assets?
Assets can be tangible, with physical form like machines, or intangible, without a physical form like goodwill and digital assets. Current assets are a mix of both where cash, inventory, and accounts receivable fall into the tangible category, while prepaid expenses and deferred charges belong to the intangible category. Let's look at each of these forms.
- Cash: Listed first on the balance sheet, it is the most liquid of all the current assets. It comprises of domestic and foreign currency, a business checking account used to pay expenses and receive payments, and any other cash on hand. Imprest accounts used for small, routine transactions such as purchasing office supplies are also included here.
- Cash equivalents: Closest to cash in terms of liquidity, cash equivalents are easily convertible resources, including marketable securities, certificates of deposit, money market funds, treasury bills, and short-term government bonds, as long as there are no restrictions on their short-term liquidity
- Accounts Receivable: Accounts Receivable is the total value of money owed to a company, by their customers for goods or services already delivered. Also known as trade receivables, they are documented as a current asset only if the settlement of money owed is anticipated to be done within a year. If the conversion to cash extends beyond a year, they are classified as a long-term asset and reported under non-current assets. For instance, consider a catering company that makes food arrangements for customers with an agreement to bill upon delivery. The resulting payment obligation can be accounted for under accounts receivable.
- Inventory: Raw materials, components, and manufactured products, all these items are part of inventory and are listed under current assets. However, certain inventory may be less liquid and may not qualify. The determination to be a current asset depends on the type of product and industry. For instance, selling a thousand T-shirts in a year is more likely than high-end CT-scan machines; the latter thus not being counted as current assets in that case.
- Prepaid expenses and liabilities: This includes advance payments for future goods or services, such as insurance or pre-paid rent. While these payments can't be turned into cash right away, they demonstrate proactive financial management, improving stability by handling fixed costs in advance.
Capital, not to be confused with working capital, represents the long-term financing and ownership stake in a business, including initial investments, additional contributions, and retained earnings. It is recorded under the owner's equity section on the balance sheet and is not considered as current asset.
How do current assets differ from non-current assets
The key difference between current and non-current assets lies in their liquidity. Current assets are either converted into cash or are used up within a year, whereas non-current assets or fixed assets are long-term resources that are difficult to liquidate and take time to sell. Another important differentiating factor is depreciation. Non-current assets are valued at their acquisition cost and experience depreciation due to wear and tear. In contrast, current assets are appraised at fair market value and do not undergo depreciation.
Advantages of current assets
While we’ve looked at how current assets differ from non-current, what benefits might they bring about for businesses?
1. Liquidity and cash flow support
Due to their fluid nature, current assets significantly contribute to positive cash flow. This capability allows companies to manage day-to-day operations, covering expenses like payroll and raw material purchases without depending on long-term or external financing.
Moreover, this liquidity empowers companies to capitalise on unexpected opportunities requiring immediate cash investment, such as favourable market conditions or strategic acquisitions. It also helps mitigate cash flow variations and disruptions.
2. Operational efficiency
Timely collection of receivables and effective management of other current assets ensure a steady stream of cash to support ongoing operations. Sufficient cash is necessary for purchasing essential inventory, sustaining production, and driving sales. Moreover, cash is crucial for minimising downtime caused by machine breakdowns and ensuring a continuous supply of necessary resources.
3. Credibility with creditors and investors
Holding a healthy current asset position represents a business’s strong cash flow, ability to fulfil short-term financial needs, position to grow, and creditworthiness to both lenders and investors.
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Better risk management
Current assets act as a financial buffer, providing a safety net so that companies can navigate economic downturns, industry challenges, and unforeseen circumstances.
The funds they offer are crucial for addressing unexpected expenses without compromising the organisation's financial health. Thus, businesses with robust current asset positions are better equipped to handle market disruptions and have a better chance of achieving financial stability.
Disadvantages of current assets
While highly beneficial, they have their limitations too. Let's understand their potential drawbacks.
1. Low return on investment
Cash assets generate lower returns compared to long-term investments. Holding excess cash can result in missed expansion and investment opportunities that might offer higher returns.
2. High associated risks
Mismanagement of current assets can lead to higher expenses, lower cash flow, and operational disruptions. To illustrate, consider inventory; it can become obsolete, get stolen, or damaged. Products can also become outdated and unsellable, all of which decrease their value and lead to potential losses. Furthermore, the upkeep of inventory incurs expenses related to storage, handling, and potential deterioration. Excessive inventory levels can contribute to heightened carrying costs, diminishing overall profitability.
Similarly, with accounts receivable, there is a risk of customers delaying or not paying their debts. This negatively impacts cash flow and company's profits.
3. Market volatility
The value of current assets, like marketable securities, is subject to market fluctuations and can drop significantly with market conditions, potentially causing losses to the company. Additionally, market conditions like inflation pose a threat of diminishing the purchasing power of cash and reducing the real value of certain assets over time.
How to calculate current assets
Calculating current assets is a straightforward sum of all the current assets recorded on the balance sheet. Typically, the total is already provided on the balance sheet under 'Total Current Assets.'
The formula is as follows:
Current assets = Cash + Cash Equivalents + Accounts Receivable + Inventory + Prepaid Expenses + Short-Term Investments + Other Current Assets
The above formula may vary in elements depending on the industry or business. If a subcategory is not listed, you can include it under the 'Other Liquid Assets' category.
Example of current assets calculation
To illustrate the calculation of current assets, let's consider a company with the following values:
- Cash: £20 million
- Cash Equivalents: £5 million
- Accounts Receivable: £15 million
- Inventory: £30 million
- Prepaid Expenses: £8 million
- Short-Term Investments: £10 million
- Other Current Assets: £7 million
Now, let's calculate the Total Current Assets using the above-mentioned formula:
Total Current Assets = £20M + £5M + £15M + £30M + £8M + £10M + £7M = £95 million
Therefore, the total current assets for the said company amount to £95 million.
What are current assets used to calculate?
Essential for evaluating a company's financial health, liquidity, efficiency, and operational ability, current assets serve as key financial metrics. They are used in various financial computations, including working capital and various ratios.
One such calculation is the Current Ratio. A positive current ratio denotes a robust liquidity position and the company's adeptness in meeting short-term obligations. It is derived by dividing total current assets with the company's current liabilities.
The Quick Ratio, a more conservative measure of liquidity, also incorporates the value of current assets but excludes inventory, which might pose challenges in swift conversion to cash. A Quick Ratio exceeding one implies a relatively robust capacity to cover short-term liabilities without relying on inventory sales.
Similarly, the Cash Ratio, determined by dividing the value of cash and cash equivalents by current liabilities, and the Working Capital Turnover Ratio, revealing the efficiency of utilising working capital to generate sales, both include current assets in their calculations.
When should a business have more or less current assets?
The response to this question varies greatly based on factors such as industry nature, business type, and economic conditions. Industries experiencing cyclical or seasonal demand, like retail or agriculture, find higher current assets advantageous during peak seasons. Similarly, businesses in highly competitive markets benefit from maintaining more current assets to swiftly respond to opportunities and changing demand.
During economic downturns and recession, having higher levels of current assets is particularly beneficial as it strengthens the company's ability to withstand challenges.
Businesses with stable cash flow and efficient cost management can operate with lower levels of current assets. Similarly, companies with high liquid investments, low working capital requirements, and a strong financial position can choose to leverage their capital in long-term, high-return investments rather than holding excess liquidity in the form of current assets.
Current assets are important for investors
Investors closely analyse current assets and related ratios to gauge a company’s ability to grow, providing valuable insights into the overall risk and stability of their investment.
How technology helps businesses better leverage their current assets
In this technology-driven world, businesses certainly enjoy an edge using tech solutions for managing and maximising the benefits of current assets. For example, utilising inventory management systems allows for real-time tracking and management of inventory levels, minimising excess stock, reducing holding costs, and preventing stockouts to optimise the use of working capital. Inventory levels can be further optimised by determining optimum levels using data analytics and forecasting tools.
Utilising financial management software is beneficial in handling receivables and payables, thereby simplifying cash management. Furthermore, automating finance functions such as invoicing and accounts receivable enhances the efficiency of billing processes and expedites cash inflows. The integration of Cloud technology elevates these advantages by facilitating collaborative efforts through real-time access to financial data and reports.
How Advanced Financials can help you keep on top of your current assets
Advanced Financials is a Cloud-based financial management system that empowers you to effectively manage your current assets through its comprehensive modules for inventory and fixed asset management. The inventory module ensures accurate stock values in the balance sheet, maintaining a single version of the truth.
With features like automated invoice processing, PDF invoicing, and universal invoice capture, it enhances accuracy in accounts payable and receivable functions, reducing operating costs and minimising human error. It produces real-time business insights automatically through powerful reporting and analytics tools, enabling you to make informed decisions and proactively manage your current assets.
Safeguard your business with trustworthy data and allow your finance team to confidently stay on top of current assets with Advanced Financials