What it means
A business needs two kinds of assets: those it uses for years (buildings, machines, software) and those that flow through it continuously (cash, stock, money owed by customers). Current assets are the second kind.
Cash is spent on inventory, inventory is sold to customers on credit, receivables are collected as cash, and the cycle repeats. At any moment the balance sheet captures how much sits at each stage.
The components differ in quality. Cash is immediately available.
Marketable securities can be sold in days. Receivables depend on customers paying, which most do but not all, and not always on time.
Inventory must first be sold, and some of it may be obsolete or damaged. Prepaid expenses are not really convertible to cash at all; they represent services already paid for that will be consumed.
Analysts therefore look not just at the total but at the mix, and the quick ratio strips out inventory and prepayments to test whether the most liquid assets alone can cover current liabilities. Current assets are not free.
Every dollar of inventory and receivables has been paid for, either with the owners' money or with borrowings, and earns nothing while it waits. Businesses therefore try to hold the minimum current assets consistent with serving customers: enough stock to avoid stockouts but no more, receivables collected promptly, and cash invested rather than idle.
The cash conversion cycle measures how long the money is tied up. The one-year rule has an important exception.
Businesses with a long operating cycle, such as distillers, shipbuilders or property developers, classify inventory as current even though it may take several years to sell, because it is part of the normal trading cycle. Conversely, a receivable due in eighteen months is non-current even though it is money owed to the business.
In practice
Real-world examples.
Example
A manufacturer's current assets include $2 million of raw materials, work in progress and finished goods, and $3 million of receivables from customers on 60-day terms.
Example
A software company's current assets are almost entirely cash and receivables, because it holds no inventory; its quick ratio and current ratio are nearly identical.
Example
A whisky distiller classifies spirit maturing in casks as a current asset even though it will not be sold for ten years, because maturation is its normal operating cycle.
Think of it
“Current assets are like the money and items in your wallet and checking account-resources you can access and use right away for everyday needs.
Formula
Calculation
Current Assets = Cash + Short-term Investments + Accounts Receivable + Inventory + Prepaid Expenses + Other short-term assets
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets minus Inventory minus Prepayments) / Current Liabilities
Worked example. A kitchenware retailer's balance sheet at year end:
- Cash: $120,000
- Short-term deposits: $50,000
- Accounts receivable (trade customers): $90,000
- Inventory: $410,000
- Prepaid rent and insurance: $30,000
- Total current assets: $700,000
- Current liabilities: $400,000
Current ratio = $700,000 / $400,000 = 1.75
Quick ratio = ($700,000 minus $410,000 minus $30,000) / $400,000 = $260,000 / $400,000 = 0.65
The current ratio looks comfortable, but the quick ratio shows that without selling stock the retailer could cover only 65% of its short-term obligations. For a retailer with fast-moving stock and cash sales that is normal; for a manufacturer with slow-moving inventory it would be a warning. If $60,000 of the inventory is a discontinued range that will only sell at cost, the real cushion is thinner still.Case study
Seen in the real world.
A sporting goods wholesaler reported current assets of $6.2 million against current liabilities of $3.5 million, a current ratio of 1.8 that satisfied its bank's covenant. When sales slowed, the company found it could not pay suppliers on time. The finance director's analysis showed why.
Of the $6.2 million, $3.9 million was inventory, and a third of that was last season's stock that would only move at heavy discounts. Receivables of $1.6 million included $400,000 from a chain that had entered administration. Cash was $300,000.
The quick ratio, once doubtful items were excluded, was about 0.4. The company sold the old stock to a discounter at 40% of cost, wrote off the failed customer, and negotiated an extension with its main suppliers.
The current ratio fell to 1.3 after the write-downs, but for the first time it described assets that could actually pay bills. The bank replaced the current ratio covenant with a quick ratio covenant and a monthly inventory ageing report.
Watch out
Common mistakes.
- Treating all current assets as equally liquid. Obsolete stock and doubtful receivables are current assets on paper only.
- Judging liquidity on the current ratio alone. The quick ratio and the ageing of stock and receivables tell you whether the ratio is real.
- Holding excess current assets as a comfort. Idle cash, excess stock and slow receivables all cost money.
Questions
People also ask.
What is the difference between current and non-current assets?
Current assets will be converted to cash or used within a year or one operating cycle. Non-current assets support the business for longer.
Is inventory a current asset?
Yes, because it is held for sale in the normal course of business, even if some items take longer than a year to sell.
Are prepaid expenses really assets?
Yes. They represent the right to receive services already paid for, such as insurance cover or rent for future months, and they reduce cash payments in the coming period.
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