CURRENT ASSETS & CURRENT LIABILITIES

CURRENT ASSETS
In accounting, a current asset is an asset on the balance sheet which is expected to
be sold or otherwise used up in the near future, usually within one year, or one
operating cycle whichever is longer. Typical current assets include cash, cash
equivalents, accounts receivable, inventory, the portion of prepaid accounts which
will be used within a year, and short-term investments.

Operating cycle is the average time that is required to go from cash to cash in
producing revenues.

On the balance sheet, assets will typically be classified into current assets and long-
term assets.

Current Assets = Cash +Bank + Debtors + Bills Receivable + Short Term

Investment + Inventory + Prepaid Expenses

The items included in current assets should be:

(a) Cash and bank balances available for current operations. Cash or bank balances
whose use for current operations is subject to restrictions should be included as a
current asset only if the duration of the restrictions is limited to the term of an
obligation that has been classified as a current liability or if the restrictions lapse
within one year;

(b) Securities not intended to be retained and capable of being readily realised;

(c) Trade and other receivables expected to be realised within one year of the
balance sheet date. Trade receivables may be included in their entirety in current
assets, provided that the amount not expected to be realised within one year is
disclosed;

(d) Inventories of merchandise, raw materials, goods in process, finished goods,

operating supplies, and ordinary maintenance material and parts ,

(e) Advance payments on the purchase of current assets; and

(f) Prepaid expenses such as insurance, interest, rents, taxes, unused royalties,
current paid advertising services not yet received, and operating supplies.

Inventories are usually included in current assets in their entirety, notwithstanding

that they may include items not expected to be realised within one year or within the
normal operating cycle
Prepaid expenses are not current assets in the sense that they will be converted into
cash, but in the sense that, if not paid in advance, they would require the use of
current assets during the operating cycle.

The first thing listed under the asset column on the balance sheet is something
called "current assets". This is where companies list all of the stuff that can be
converted into cash in a short period of time, usually a year or less. Because these
assets are easily turned into cash, they are sometimes referred to as "liquid". They
normally consist of:

Cash and Cash Equivalents

Cash and Cash Equivalents is the amount of money the company has in bank
accounts, savings bonds, certificates of deposit, and money market funds. It tells you
how much money is available to the business immediately. How much should a
company keep on the balance sheet? Generally speaking, the more cash on hand
the better. Not only does a decent cash hoard give management the ability to pay
dividends and repurchase shares, but it can provide extra wiggle-room when times
get bad.

There are some cases where cash on the balance sheet isn't necessarily a good
thing. If a company is not able to generate enough profits internally, they may turn to
a bank and borrow money. The money sitting on the balance sheet as cash may
actually be borrowed money. To find out, you are going to have to look at the amount
of debt a company has (we will be discussing this later on in the lesson). The moral:
You probably won't be able to tell if a company is weak based on cash alone; the
amount of debt is far more important.

Short Term Investments on the Balance Sheet

These are investments that the company plans to sell shortly or can be sold to
provide cash. Short term investments aren't as readily available as money in a
checking account, but they provide added cushion if some immediate need were to
arise. Short Term Investments become important when a company has so much
cash sitting around that it has no qualms about tying some of it up in slightly longer-
term investment vehicles (such as bonds which have maturities of less than one
year). This allows the business to earn a slightly higher interest rate than if they
stuck the cash in a corporate savings account.
CURRENT LIABILITIES

In accounting, current liabilities are often understood as all liabilities of the

business that are to be settled in cash within the fiscal year or the operating cycle of
a given firm, whichever period is longer. A more complete definition is that current
liabilities are obligations that will be settled by current assets or by the creation of
new current liabilities.

An operating cycle for a firm is the average time that is required to go from cash to
cash in producing revenue.

For example, accounts payable for goods, services or supplies that were purchased
for use in the operation of the business and payable within a normal period of time
would be current liabilities.

Bonds, mortgages and loans that are payable over a term exceeding one year would
be fixed liabilities or long-term liabilities. However, the payments due on the long-
term loans in the current fiscal year could be considered current liabilities if the
amounts were material.

The proper classification of liabilities provides useful information to investors and

other users of the financial statements. It may be regarded as essential for allowing
outsiders to consider a true picture of an organization's fiscal health.

The items included in current liabilities should be obligations payable at the demand
of the creditor and those parts of the following obligations whose liquidation is
expected within one year of the balance sheet date:

(a) Bank and other loans. If a loan is repayable in accordance with a schedule of
repayment agreed with the creditor, the loan may be classified in accordance
therewith, notwithstanding a right of the creditor to demand current payment;

(b) The current portion of long-term liabilities.

(c) Trade liabilities and accrued expenses

(d) (d) Provision for taxes payable

(e) Dividends payable;

(f) Deferred revenues and advances from customers;

(g) Accruals for contingencies

Current liabilities are the debts a company owes which must be paid within one year.
They are the opposite of current assets. Current liabilities includes things such as
short term loans, accounts payable, dividends and interest payable, bonds payable,
consumer deposits, and reserves for Federal taxes.

Let's take a look at some of the most common and important current liabilities on the
balance sheet.

Accounts Payable - The Most Popular Current Liability

Accounts payable is the opposite of accounts receivable. It arises when a company
receives a product or service before it pays for it. Accounts payable, or A/P as it is
often shorthanded, is one of the largest current liabilities a company will face
because they are constantly ordering new products or paying vendors for services or
merchandise. Really well managed companies attempt to keep accounts payable
high enough to cover all existing inventory, meaning that the vendors are paying for
the company's shelves to remain stocked, in effect.

Accrued Benefits and Payroll as a Current Liability

This item in the current liabilities section of the balance sheet represents money
owed to employees as salary and bonus that the company has not yet paid.

Short Term and Current Long Term Debt

These current liabilities are sometimes referred to as notes payable. They are the
most important item under current liabilities section of the balance sheet and most of
the time, they represent the payments on a company's bank loans that are due in the
next twelve months. Borrowing money in itself is not necessarily a sign of financial
weakness; an intelligent department store executive may work out short term loans
at Christmas so she can stock up on merchandise before the Holiday rush. If
demand is high, the store would sell all of its inventory, pay back the short term
loans, and pocket the difference. This is known as utilizing leverage. The department
store used borrowed money to make a profit.

So how can you ever hope to tell if a company is wisely borrowing money (such as
our department store), or recklessly going into debt? Look at the amount of notes
payable on the balance sheet (if they aren't classified under 'notes payable', combine
the company's short term obligations and long term current debt). If the amount of
cash and cash equivalents is much larger than the notes payable, you shouldn't have
any reason to be concerned.

If, on the other hand, the notes payable has a higher value than the cash, short term
investments, and accounts receivable combined, you should be seriously concerned.
Unless the company operates in a business where inventory can quickly be turned
into cash, this is a serious sign of financial weakness.
Other Current Liabilities
Depending on the company, you will see various other current liabilities listed.
Sometimes they will be lumped together under the title "other current liabilities."
Normally, you can find a detailed listing of what these "other" liabilities are buried
somewhere in the annual report or 10k. Often, you can figure out the meaning of the
entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a
current liability, you can be fairly confident the amount listed is what will be paid out
to the company's bond holders in the short term.

Consumer Deposits Are Liabilities to Banks

If you are looking at the balance sheet of a bank, you will want to pay close attention
to an entry under the current liabilities called "Consumer Deposits". Often, they will
be will lumped under other current liabilities. This is the amount that customers have
deposited in the bank. Since, theoretically, all of the account holders could
withdrawal all of their funds at the same time, the bank must list the deposits as a
current liability.

Current ratio:

One of the most commonly used ratios to measure the short term liquidity position of
a business is the current ratio. It measures the ability of a business to pay its short
term obligations (generally less than a year) with its short-term resources. The
current ratio is computed as:

Current Assets
Current Liabilities

Current Assets include inventories, sundry debtors, cash and bank balances,
receivables/accruals, loans and advances, disposable investments, etc.

Current Liabilities include creditors for goods and services, short-term loans, bank
overdraft, cash credit, outstanding expenses, provision for taxation, proposed
dividend, unclaimed dividend, etc.

A current ratio of 2 to 1 is generally considered good/acceptable. However, this

depends more on the type of industry in which the company operates. A ratio of less
than 1 indicates that the company does not have enough liquid assets to settle its
current obligations. While a ratio of less than 1 is definitely not a good sign for the
business, it does not indicate that the company will be bankrupt as it may still have
alternative sources of finance to tap to pay its obligations. Current ratio also provides
an indication of the efficiency of the operating cycle of the business. In interpreting
the current ratio care should be taken in looking into composition of current assets. A
firm which has a large amount of cash and account receivable is more liquid than a
firm which has high amount of inventories in its current assets, though both the firm
may have the same current ratio. To overcome this is a more stringent form of
liquidity ratio referred to as quick ratio cab be calculated.

An Example

Compute Current Ratio from the information given below:

Current assets: Current liabilities:

Inventories 20,000 Accounts payable 18,000

Sundry debtors 5,000 Short-term loan 15,000

Cash on hand 12,000 Bank overdraft 5,000

Outstanding
Cash at bank 8,000 3,000
expenses
Accounts Provision for
35,000 10,000
receivables taxation
Short-term Proposed
15,000 12,000
investments dividends

95,000 63,000

Current assets / Current liabilities

Current ratio: 95000 / 63000
= 1.51

Calculating Working Capital Needs

The calculation of working capital requirements involves the estimation of current
assets and current liabilities. This process includes estimation of working capital and
its components by taking into account the period for which the various items remain
as stock or as outstanding, the cost structure of production and annual production.

Computation of working capital requirement essentially involves : -

1) Estimation of current assets
2) Estimation of current liabilities.

Estimation of Current Assets

Current assets estimation includes:

a. Raw materials Requirement cost

b. Work-in-Progress stock requirement cost

This is computed by multiplying the daily requirement of various sub-

components of WIP by the age of WIP.

c. Finished goods – Inventory requirement cost

This is computed by multiplying the daily requirement of various sub-

components of finished goods by the age of finished goods.

d. Debtors – Value of outstanding debtors

This is computed by multiplying the daily requirement of various

components of selling price by the age of debtors.

2. Estimation of Current Liabilities

Current liabilities estimation includes

a. Value of outstanding creditors

This is computed by multiplying the daily requirement of raw materials

by the age of creditors.

b. Outstanding Wages

This is computed by multiplying the daily wages by the age of wages or

outstanding period of wages in days.

c. Outstanding Production overheads

This is computed by multiplying the daily production overhead

expenses by the age of expense creditors.

d. Outstanding selling overheads

This is computed by multiplying the daily selling overhead expenses by

the age of expense creditors.
Now that we have estimated the various current assets and current liabilities, we can
compute the working capital requirements.

Computation of Working Capital

Current Assets

Less: Current Liabilities

Gives=Net working capital

Some companies may add some percentage of amounts to meet contingencies. In

those cases, the working capital estimated above can be adjusted for contingencies.
If the above company would like to allow 10% for contingencies.

Managing current assets and current liabilities

Liquidity, you will recall, is a firm's ability to meet its short-term debts, and cash is the
most liquid asset, because it can be spent immediately. Non-cash current assets,
mainly receivables and inventory, are less liquid because it may take time to turn
them into cash. For example, ratios measuring receivables collection periods and
inventory turnover rates, estimate how long it is taking to convert receivables and
inventory into cash. In general the more current assets a firm holds the greater its
liquidity (measured by the current ratio). If liquidity is, or becomes, very important
managers may decide to hold proportionately more cash and/or marketable
securities (measured by the quick ratio) than non-cash assets, receivables and
inventory.

There is always a trade-off in holding high levels of cash assets because they earn
very little return. In general, managers can only reduce the risk of becoming less
liquid by reducing the overall return on current assets, and on total assets (the ROA
measure).

Another factor affecting net working capital is the firm's use of current versus long-
term debt. Again, this poses the risk-return trade-off. All else being constant, the
more that managers rely on short-term debt or current liabilities to finance
investment in assets the lower will be the firm's liquidity.

However, using current liabilities costs less (in interest) than long-term debt and is a
flexible means of funding fluctuating needs for assets.
The major disadvantage of short-term debt is that it must be repaid or 'rolled over'
more often, and any deterioration in the firm's overall financial condition may be
made worse if the firm can't refinance the short-term debt. So liquidity and longer-
term solvency are linked.

Another risk is linked to the interest rates. Every time funding arrangements are
renewed the interest rates will also be reviewed. Any change in the lender's
perception of the firm's riskiness will lead to higher interest being charged. So short-
term interest rates are likely to change more often than interest on long-term loans.

Where possible cash should be held in interest bearing accounts and drawn on only
when actually needed to pay accounts, otherwise there is an unnecessary
opportunity cost in terms of lost interest.

Importance of Current Assets and Current Liabilities

When you study the figures of a target company it is worth examining its current
assets and current liabilities.

Current assets represent assets that can be quickly transferred into money. Some
of them are:

 Cash
 Cash equivalents
 Inventories
 Accounts receivable (these are the money that customers owe to the
company for services or products provided)

Current liabilities represent the short term obligations of the company. Some of
them are:

 Accounts payable
 Short term debt

Current assets and current liabilities should be compared over periods of time. It is
good if the current assets have increased significantly over longer periods of time.
This means that the company generates cash. On the other hand, it can be also
interpreted as the company not being able to collect the money it has to take from its
accounts receivable. If the current liabilities of the company are growing at a fast
pace, then there might be some problem with the company. However, this is not
always bad since the company may incur higher liabilities since it needs money to
finance some of its goals.
Finally, you should carefully study these indicators of the target company in order to
determine its future potentials. You can quickly and easily obtain this information
from financial statements.

CONCLUSION

Thus, the first major component of the balance sheet is current assets. These
assets can easily be converted to cash within one operating cycle -- the amount of
time the company needs to sell a product and collect cash from that sale, often
anywhere between 60 and 180 days.

Companies need current assets to fund their day-to-day operations. If current assets
fall short, the company will have to scramble for other sources of short-term funding,
either by taking on debt (hello, interest payments) or issuing more stock (hello,
shareholder dilution).

There are five main kinds of current assets:

 Cash and equivalents

 Short- and long-term investments
 Accounts receivable
 Inventories
 Prepaid expenses

And, current liabilities are what a company currently owes to its suppliers and
creditors. These are short-term debts, all due in less than a year. Paying them off
normally requires the company to convert some of its current assets into cash.

Beyond simply being bills to pay, liabilities -- confusing as this might sound -- are
also a source of assets. Any money that a company pulls from a line of credit, or
postpones paying from its accounts payable, is an asset that can be used to grow
the business.

There are five main categories of current liabilities:

 Accounts payable
 Accrued expenses
 Income tax payable
 Short-term notes payable
 Portion of long-term debt payable