Why are current assets important?
Current assets are defined as assets that can be converted into cash within one year or less. Knowing this amount will help you understand how well your business is running and how well you will be able to meet your current liabilities.
The accounts considered to be current assets include:
- Accounts receivable
- Cash and cash equivalents
- Marketable securities
- Other liquid assets.
- Prepaid expenses
Anything else that can be converted quickly into cash, such as short-term investments, should also be classified as a current asset.
The current assets formula
You can calculate current assets using the following formula:
Total current assets = Accounts Receivable + Cash and Cash Equivalents + Inventory + Marketable Securities + Prepaid Expenses + Other Liquid Assets
Now that we have the formula, we’ll take a closer look at the items that go into it.
This is the amount that’s owed to your business. If you offer payment terms, you will have accounts receivable. It’s the sum of all outstanding invoices. Typically, outstanding invoices are collected between 15 and 90 days from the invoice date, so the fall within the one-year criterion as current. Some businesses, such as retail shops and restaurants, don’t offer payment terms so don’t have accounts receivable. In these cases, the amount will simply be zero. .
Cash and cash equivalents
This includes a number of items including petty cash, notes, coins, undeposited cheques, money in bank accounts, and short-term investments that will mature within 90 days.
This refers to raw materials, components, products in production, and items ready for sale. Inventory is classified as a current asset because it typically can be sold within one year.
These are short-term investments or financial instruments that can be sold within a year. Typically, marketable securities are traded on the open market, such as the ASX in Australia. Shares not publicly traded might not be sellable in the short run so aren’t in this category.
Other liquid assets
These include all other assets that can be turned into cash within one year, such as maturing investments, machinery and equipment, and property.
These are expenses that have been paid in advance. Examples include rent for business premises that has been paid in advance and insurance that has been paid in advance. For example, if a business pays $2,000 for an insurance bill that is invoice every six months, that will be a prepaid expense until the next bill arrives.
Reasons to keep track of your current assets
Knowing this figure will help you understand the overall health of a business.
In order to be viable, a business needs to be able to cover its short-term obligations. Knowing current assets is also required to calculate key financial ratios such as the current ratio which measure’s a company’s working capital and its ability to cover its short-term liabilities. The quick ratio uses this figure as well. Learn more about financial ratios in How Financial Ratios Can Help You Measure Your Business Performance.
This figure also appears on the balance sheet. The balance sheet equation is Assets = Liabilities + Equities. Current assets appear at the top left-hand side of the balance sheet followed by long-term assets below them.
Businesses that don’t have sufficient cash flow to cover their short-term obligations often use unsecured business loans to overcome this issue.