Current assets include cash and other assets that will be converted into cash within 12 months. The current assets that your business generates are used to pay off current liabilities, and smart decisions about cash management reduce the need to borrow money to fund business operations.
To understand current assets, it’s important to analyze how these amounts are presented in the balance sheet.
Balance Sheet Components
Assets, which include current assets, represent one component of the balance sheet, and this financial statement has three categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder’s equity) is the difference between assets and liabilities, and equity includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.
The three components of the balance sheet are driven by the balance sheet formula:
Assets – liabilities = equity
Both assets and liabilities separate account balances between current and non-current amounts. All equity accounts, however, are considered to be long-term balances.
Current vs. Non-Current Assets
Assets are categorized in the balance sheet as either current or non-current assets:
- Current assets: Cash, and assets that will be converted into cash within 12 months. Accounts receivable is a current asset account because receivables are expected to be collected from clients within 12 months. In the same way, a business expects to sell inventory items within 12 months, which makes the inventory account a current asset.
- Non-current assets: These assets will not be converted into cash within 12 months, and this category includes machinery, equipment, and other fixed assets.
The terms current and non-current are also used for liabilities. Current liabilities must be paid in cash within 12 months, while non-current liabilities are paid over a longer period.
Liquidity and Solvency: Two Key Concepts
The balance sheet is used to generate many financial ratios to make business decisions, and two important analysis concepts are liquidity and solvency. Liquidity measures a firm’s ability to produce enough current assets to pay current liabilities.
The term solvency, on the other hand, refers to a company’s ability to generate enough sales and profits to purchase expensive assets and pay down debt over the long term. Financially healthy businesses must address both liquidity and solvency.
Working capital is a tool to assess a firm’s liquidity, and the formula includes current assets.
Why Working Capital Is Important
Working capital is defined as (current assets less current liabilities), and working capital measures how well a company manages cash inflows and outflows. The working capital ratio is another measure of cash management, and the ratio is (current assets divided by current liabilities).
To use the working capital formulas to make business decisions, consider the current assets and current liabilities for Standard Furniture Company and Allied Furniture Company:
|Account||Standard Co.||Allied Co.|
|Total current assets||140,000||170,000|
|Total current liabilities||90,000||150,000|
|Working capital(CA – CL)||50,000||20,000|
|Working capital ratio(CA / CL)||1.56||1.13|
Working capital operates on the assumption that all current assets will be converted into cash within 12 months. In addition to cash, a company will collect all of its accounts receivable balance within a year, and sell all of its current inventory balance within a year.
Once all current assets are converted to cash, the dollars are used to pay all current liabilities. Note the differences between the two company’s results:
- Working capital: Standard has $50,000 more in current assets than current liabilities, which means that they have a “cushion”. If the firm is not able to generate the same level of current assets in the next month, they may still be able to pay their current liabilities. Allied’s cushion, however, is only $20,000. The working capital balance should always be a positive number.
- Working capital ratio: Viewed as a ratio, Standard has $1.56 in current assets for every $1 of current liabilities, and every business should have a working capital ratio of at least 1:1. You can see that Allied is close to that 1:1 ratio, which creates the risk that all current liabilities cannot be paid in future months.
Some business owners use working capital as a dollar amount, while others use the working capital ratio. Decide which metric works for you, and monitor your company’s performance.
Improving Business Results
If you convert current assets into cash faster, you have more dollars available to pay current liabilities. To improve cash collections, focus on accounts receivable and inventory.
Your business, for example, can implement a plan to increase cash collections by emailing and calling customers who have unpaid invoices. This strategy reduces accounts receivable and increases cash.
Analyze your inventory and invest in marketing to increase sales of slower moving inventory items. If some inventory items are not selling well, offer price discounts to entice buyers. These efforts can reduce your inventory balance and increase cash collections.
Use these tips to convert current assets into cash faster, and improve your company’s cash flows.