Contents
- What are current assets?
- Types of current assets
- Current assets in a business
- Current assets – investor use
What are current assets?
Current assets are a category of resources listed on an entity’s balance sheet. According to AASB 101, an asset is classified as “current” if the entity expects to either realise, sell, or use it up within its normal operating cycle. The normal operating cycle is the typical time it takes for an entity to complete its cash-to-cash cycle, which involves buying, producing, selling, and collecting cash from customers.
For example, inventory in a retail business is often classified as current because it’s expected to be sold within the normal operating cycle. Other important considerations are:
- If an asset is primarily held for the purpose of trading, it should be classified as “current.” This means the entity holds the asset with the intention of buying and selling it in the short term to make a profit. For instance, stocks bought for short-term trading fall into this category.
- Any asset that the entity expects to turn into cash or consume within twelve months after the end of the reporting period is considered “current.” This includes assets like accounts receivable, which are typically collected within a year.
- Assets that are in the form of cash or cash equivalents, as defined in AASB 107 (usually highly liquid and easily convertible assets), are classified as “current” assets. However, if these cash assets are restricted and cannot be used to settle a liability for at least twelve months after the reporting period, they can be classified as “non-current.”
All other assets that do not meet these criteria are categorised as “non-current” assets.
Managing current assets effectively is crucial for an entity’s working capital, which ensures that the entity can meet its short term financial obligations and operational costs. A healthy proportion of current assets in comparison to current liabilities indicates the entity’s ability to meet its immediate financial commitments.
These current assets are prominently featured on the entity’s balance sheet, offering a snapshot of its financial standing at a specific moment in time.
Presentation of Current Assets
Assets on a balance sheet are organised based on their ease of conversion into cash, which is referred to as asset liquidity.
Current assets, being the most readily convertible to cash, are positioned at the top of the list. This means that if an entity has urgent expenses to cover or immediate investment opportunities, it can tap into its current assets quickly.
Therefore, maintaining a sufficient level of current assets is essential for ensuring the smooth functioning of a business, as it allows the entity to promptly address its financial needs and seize timely opportunities.
Types of current assets
There are several types of current assets, and they should be arranged on a balance sheet based on their liquidity, with the most liquid assets listed first.
Here are primary types of current assets:
Cash and Cash Equivalents
As per AASB 107, this category includes the actual cash an entity has on hand or in the bank. Cash equivalents comprise of assets that can be quickly converted into cash, such as short term savings bonds, easily traded investments, and foreign currency.
Marketable Securities
Marketable securities are investments made by an entity that are both easily tradable and expected to be converted into cash within a year. These investments include various financial instruments such as treasury bills, notes, bonds, and equity securities.
Initially, these trading securities are recorded on the entity’s balance sheet at their acquisition cost, which includes any associated brokerage fees. However, it’s important to note that the value of these securities can fluctuate rapidly because they are readily tradable in financial markets.
As a result, companies are required to adjust the value of these trading securities to their fair market value after the initial purchase. Any changes in the value of these securities are reflected in the entity’s income statement.
Moreover, additional information and details about these investments are typically provided in the financial footnotes of the entity’s financial statements, offering stakeholders a more comprehensive understanding of the entity’s holdings and their impact on its financial position.
Accounts Receivable
Accounts receivable represent the money that customers owe to an entity for the products or services they have received on credit. When presenting accounts receivable on the balance sheet, they are typically shown at their net realisable value. This value takes into account an estimate for potential bad debt expenses.
An increase in bad debt expenses results in a corresponding increase in the allowance for doubtful accounts. This allowance is set aside to cover the expected losses due to uncollectible accounts.
Therefore, the net realisable value of accounts receivable is determined by subtracting the allowance for doubtful debts from the gross receivables. This net realisable value represents the amount the entity anticipates collecting from its customers.
In certain situations where it becomes evident that accounts receivable cannot be collected from customers, both the gross receivables and the allowance for doubtful accounts need to be reduced on the balance sheet.
Additionally, companies need to monitor their collection policies by comparing the accounts receivable balance with their sales figures to identify potential issues with their credit and collection processes.
Inventory
Inventory, which includes raw materials, components, and finished products, is categorised under the Current Assets account on an entity’s balance sheet. However, it’s important to note that inventory’s liquidity can vary based on the accounting methods used and the nature of the product or industry.
To illustrate, consider two contrasting scenarios: Firstly, a dozen units of high cost heavy earth moving equipment may have an uncertain sales outlook over the next year. In contrast, there’s a relatively high probability of successfully selling a thousand umbrellas in the upcoming rainy season.
Because of these differences, it’s advisable to approach inventory with a degree of caution. It’s valuable to examine entity reports or research industry trends to gain insights into an entity’s inventory management practises. Inventory levels may also align with industry norms or specific operational strategies.
Furthermore, it’s worth noting that inventory can tie up working capital, and unexpected shifts in demand, which can be more prevalent in certain industries, may lead to inventory backlogs. This underscores the importance of closely monitoring and managing inventory levels to optimise working capital and adapt to changing market conditions.
Supplies
Supplies can be a bit complex because they are categorised as current assets only until they are used, at which point they are treated as expenses. If your entity has a stock of unused supplies, they should be listed as current assets on your balance sheet.
Prepaid Expenses
Prepaid expenses include payments made for goods or services that the entity expects to benefit from over time. For instance, if you’ve paid for a year long lease or an extended insurance policy, these are considered prepaid expenses.
It’s important to note that prepaid expenses should be reported on your entity’s income statement over the period during which the payment is expected to provide benefits.
Other Liquid Assets
This category serves as a catch all for any current assets that can be easily converted into cash within a year and do not fit into the previously mentioned categories. Examples might include promissory notes or expected tax refunds, among others. These assets should be listed in the Other Liquid Assets section on the balance sheet.
Current assets in a business
Current assets serve several important purposes within a business:
Financing Daily Operations: They provide the necessary funds for covering everyday operational expenses, such as paying employees’ salaries or purchasing raw materials. This liquidity ensures the smooth functioning of day to day activities.
Supporting Business Growth: Current assets can be allocated to invest in new ventures or expand the entity. This may involve upgrading equipment, opening new locations, or launching new projects, ultimately contributing to business growth and development.
Debt Settlement: They can be used to pay off existing debts and other liabilities, contributing to an improved financial position for the entity. This is essential for preventing defaults on loans and enhancing the entity’s overall financial health.
Hence, current assets play a vital role in an entity’s financial well being by facilitating daily operations, fuelling growth initiatives, and ensuring the entity can meet its financial obligations.
Understanding the various types of current assets and how to calculate them is fundamental for business owners and managers in effectively managing their finances.
Current assets – investor use
Investors use the total current assets figure as a crucial indicator of an entity’s ability to manage its daily operations effectively.
This figure holds significant importance for entity management, especially when it comes to meeting financial obligations such as paying bills and servicing loans. It essentially represents the amount of cash and readily convertible assets an entity has on hand.
This liquidity position enables management to make informed decisions about reallocating and potentially liquidating assets if necessary to sustain ongoing business operations.
Creditors and investors closely monitor the Current Assets account to assess an entity’s capacity to meet its financial commitments. They often rely on various liquidity ratios, which are a group of financial metrics designed to gauge a debtor’s ability to settle current debt obligations without the need for additional capital injection.
Thus, these ratios help creditors and investors determine whether a business is financially sound and capable of fulfilling its short term liabilities.
Financial Ratios using Current Assets
Several financial ratios are commonly employed to evaluate an entity’s liquidity position. These ratios involve comparing various sub accounts within Current Assets to the value of the entity’s Current Liabilities.
These are the key ratios:
Current Ratio: This ratio assesses an entity’s capacity to settle short term obligations and considers the Total Current Assets relative to Current Liabilities. Current Liabilities represent debts that must be settled within one year.
Quick Ratio: The quick ratio evaluates an entity’s ability to meet short term obligations using its most liquid assets. It divides the value of Cash and Cash Equivalents, Marketable Securities, and Accounts Receivable by the value of Current Liabilities. Inventory is excluded from this calculation due to its varying liquidity.
Cash Ratio: This ratio measures an entity’s immediate capability to pay off all short term liabilities using only cash. It is calculated by dividing the value of Cash and Cash Equivalents by Current Liabilities.
The cash ratio is the most conservative, focusing solely on cash and cash equivalents, while the current ratio is more comprehensive, including various assets from the Current Assets account.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.