Contents
- What are current liabilities?
- Types of current liabilities
- Using current liabilities in financial ratios
- Differences between current and non current liabilities
What are current liabilities?
Current liabilities are financial obligations that are expected to be settled within one year.
According to AASB 101, a liability is classified as current when:
- The entity plans to pay off the debt as part of its regular business operations within a specific time frame called the “normal operating cycle.”
- The liability is mainly held for trading purposes, meaning it’s used for buying and selling in the normal course of business.
- The debt is expected to be settled within twelve months after the end of the reporting period.
- The entity doesn’t have an absolute right to delay paying off the debt for at least twelve months after the reporting period. Even if the counterparty has an option to settle the debt with the entity’s equity instruments, this doesn’t change the classification.
Any other liabilities that don’t meet these criteria are classified as non-current, meaning they are expected to be settled after twelve months or are not due for immediate settlement.
Current liabilities are recorded in the liabilities section of the balance sheet and are typically paid using the revenue generated from day to day operational activities.
Analysts, accountants, and investors rely on current liabilities to assess an entity’s ability to meet its short term financial commitments. An entity must generate sufficient revenue and cash in the short term to cover its current liabilities. Consequently, various financial ratios incorporate current liabilities into their calculations to evaluate how effectively an entity is addressing these obligations and how long it may take to settle them.
Types of current liabilities
On a balance sheet there can be several common current liabilities, including the following:
Other Current Liabilities
According to AASB 101, current liabilities that are not settled as part of the normal operating cycle but are due for settlement within twelve months after the reporting period or are held primarily for trading.
Examples include certain financial liabilities, bank overdrafts, current portions of non-current financial liabilities, dividends payable, income taxes, and other non-trade payables.
Accounts Payable
Accounts payable (AP) represent the short term financial obligations that an entity owes to its creditors and suppliers. These liabilities are presented on the entity’s balance sheet within the current liabilities section.
Accounts payable encompass the total amount due to suppliers or vendors for invoices that have not yet been settled. Typically, vendors offer payment terms such as 15, 30, or 45 days, allowing the entity to receive supplies and defer payment to a later date.
This arrangement functions as a short term loan from the vendor, enabling the entity to generate revenue from the sale of supplies while effectively managing its cash flow. Suppliers often prefer shorter terms to expedite payment and may even provide discounts for early settlement.
Accrued Expenses
Accrued expenses are costs or expenses that are recorded in accounting but remain unpaid. They are accounted for using the accrual method, recognising expenses when incurred, not necessarily when paid. These expenses are categorised as current liabilities on the balance sheet because they represent short term financial obligations.
Entities typically use their short term assets, like cash, to settle accrued expenses. Examples include pending invoices for supplies, due interest payments on loans, unpaid warranties on products or services, accrued real estate and property taxes, and accumulated employee wages, bonuses, and commissions that may be paid in subsequent periods.
Taxes Payable
Various types of taxes, which an entity owes and needs to settle in the short term, are recorded as short term liabilities. Common tax liabilities include income taxes owed to the government, payroll taxes withheld from employees but not yet remitted, and sales taxes collected from customers and awaiting payment to the government.
Short Term Debt
Short term debt represents the total of debt payments due within the upcoming year. The ratio of short term debt to long term debt is a significant factor in assessing an entity’s financial health. If an entity’s debt primarily consists of short term obligations, it may face cash flow challenges if its revenue does not suffice to meet these obligations.
Additionally, such financial constraints might result in missed or reduced dividend payments to shareholders. Short term debt can encompass instruments like commercial paper, unsecured debt used to cover current liabilities or inventory purchases, short term bank loans, overdraft credit lines, and the current portion of long term debt due within a year.
Payroll Liabilities
Entities may have payroll liabilities that are due within the year. These can include Medicare payments withheld from employees, contributions to retirement plans, or health insurance premiums on behalf of employees, all of which constitute current liabilities.
Dividends Payable or Dividends Declared
Dividends declared by an entity’s board of directors that have not yet been distributed to shareholders are recorded as current liabilities.
Unearned Revenue
Unearned revenue refers to funds received or paid to an entity for a product or service that has not yet been delivered or provided. It is categorised as a current liability because it represents a debt owed to the customer. Once the entity delivers the service or product, unearned revenue is recognised as revenue on the income statement.
Superannuation Payable as a Current Liability
In Australia, entities are obligated to make superannuation contributions alongside regular salaries and wages for their employees. The portion of superannuation that has been accrued but has not yet been transferred to employee funds constitutes a current liability for the entity.
Bank Overdrafts
Bank account overdrafts refer to short term loans provided by a bank to an entity when their account balance goes negative due to writing cheques or making withdrawals exceeding the available funds. These overdrafts help the entity cover temporary deficits in their account balance.
Using current liabilities in financial ratios
Numerous liquidity ratios rely on current liabilities to assess an entity’s capacity to meet its financial commitments as they become due. Among these ratios, two of the most frequently used are:
Current Ratio
The current ratio compares an entity’s current assets to its current liabilities. This ratio is straightforward to compute since both figures are typically found on an entity’s balance sheet. However, one limitation is that the current asset category encompasses both inventory and prepaid expenses. While these are classified as current assets, they may not be easily convertible into cash to cover short term debt obligations. The formula for the current ratio is:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio
The quick ratio is a more cautious liquidity measure that excludes inventory and prepaid expenses from the current asset figure before comparing it to the entity’s current liabilities. By doing this, it ensures that only the most liquid current assets are considered as potential sources of funds for upcoming debt obligations. The quick ratio is calculated as:
Quick Ratio = (Total Current Assets Inventory Prepaid Expenses) / Current Liabilities
An ideal scenario for both the current and quick ratios involves a value higher than one. This signifies that there are more current assets available to meet immediate short term debts. However, if these ratios become excessively high, it might indicate that the entity is not optimising its assets efficiently. Striking the right balance is crucial.
The assessment of current liabilities holds significant importance for investors and creditors alike. For instance, banks need to evaluate whether an entity is effectively managing its accounts receivable by collecting payments in a timely manner before extending credit. On the flip side, ensuring that the entity pays its payables promptly is also essential.
Both the current and quick ratios serve as valuable tools for analysing an entity’s financial stability and its ability to manage its current liabilities effectively. They provide insights into how well an entity handles its short term obligations, which is crucial information for stakeholders making financial decisions.
Differences between current and non current liabilities
Current liabilities and non current liabilities are distinct categories in an entity’s financial reporting, differing in their settlement timelines and the nature of the obligations. Here’s a concise comparison of these two crucial aspects of an entity’s financial structure:
Current Liabilities
- Definition: Current liabilities are financial obligations due within one year or the entity’s normal operating cycle, whichever is longer.
- Settlement Timeline: These liabilities are expected to be settled in the short term, usually within the next 12 months.
- Payment Source: Current liabilities are typically paid using the entity’s current assets.
- Examples: Common examples include accounts payable (amounts owed to vendors), short term bank loans, employee benefits (to be paid soon), and accrued income taxes.
- Nature: Current liabilities represent immediate financial commitments that the entity must address in the near future to maintain its operations.
Non Current (Long Term) Liabilities
- Definition: Non current liabilities, or long term liabilities, are debts that the entity is not obligated to repay within one year or its normal operating cycle.
- Settlement Timeline: These liabilities have longer repayment timelines and extend beyond the short term horizon.
- Payment Source: Long term liabilities are typically managed over an extended period and are not settled using current assets.
- Examples: Examples include long term debt (e.g., bonds, mortgage loans), leases, pension benefit obligations, post employment benefits, and deferred taxes.
- Nature: Non current liabilities represent the entity’s longer term financial commitments, often requiring planning and management over an extended period, typically exceeding one year.
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.