A current asset is also known as a liquid asset. It is an asset that businesses can convert into cash or sell within a year. The concept of current assets is crucial in financial matters. Whether you are a business professional or an investor, learning about current assets is important for you.
Definition of current assets
By definition, a current asset is one that a company or enterprise can hold, easily sell, or further turn into liquid cash. In simple words, business assets that are temporary or are meant to be used within one year are called current assets.
Importance in financial management
For any company, the current asset is crucial, because it helps the company have liquid cash for day-to-day basics and to fund regular business expenses. The concept of current assets thus plays a pivotal role in financial management. It helps both businesses and their investors gain useful insights into asset and expense management.
Types of current assets
They come in seven different types, of which four are the major types. These are cash and cash equivalents, accounts receivable, inventory, and prepaid expenses.
A. Cash and cash equivalents
Cash and cash equivalents are a type of current asset that companies need to manage and maintain on a regular basis.
1. Explanation
Cash is the money a company has in its account. On the other hand, cash equivalents are those assets that are not currently in cash form but can be converted into cash quickly. Both cash and cash equivalents fall under the current asset category.
2. Examples
An example of cash is the money a company has in the bank or physically. Examples of cash equivalents are government bonds, certificates for deposit, money market funds, etc.
B. Accounts receivable
Another major type of current asset is account receivable.
1. Definition
By definition, accounts receivable are the total amount of money that customers or consumers owe for a service they have used or goods they have received but haven’t paid yet. It is also a major type of current asset.
2. Real-life instances
Real-life instances of accounts receivable include the outstanding debts of a business or IOUs of a business. However, you must remember that not all revisables are supposed to be collected. The ones that are not to be collected are called allowances for doubtful accounts.
C. Inventory
Among the top four current asset types, inventory is another one worth mentioning in detail.
1. Understanding inventory as a current asset
Inventory refers to the collection of finished products, raw materials, and components that fall under the category of current asset account. Different types of accounting methods can be used to manage inventory. However, this kind of current asset may not be as liquid as other types. Whether it is depends on the type of inventory and industry.
2. Illustrative examples
Examples of inventory can include the storage capacity of raw materials or ready-to-sell goods of a company or goods supplier.
D. Prepaid expenses
Lastly, prepaid expenses are also a type of current asset that companies account for.
1. Defining prepaid expenses
By definition, prepaid expenses represent the advance payments made by a company for goods or services that they are supposed to receive in the future. These types of expenses also fall under current assets. Although these types of assets cannot be converted into cash, they can help clear up capital for other uses.
2. Instances in different sectors
Instances of prepaid expenses include leased office equipment, advertisement costs, esteemed taxes, and advance rents.
Significance in financial analysis
Calculating current assets is crucial for financial analysis. It helps to understand the financial health of a company and is related to the working capital and liquidity of the company.
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A. Working capital calculation
Working capital refers to the current asset of a company after deducting the current liabilities. It helps in managing the cash flow, financial analysis, and financial modeling of a company.
1. Formula
The relationship between working capital and current assets is represented as follows:
Current Assets – Current Liabilities = Working Capital
To find out a company’s current assets, use the formula mentioned below:
Cash + Cash Equivalents + Inventory + Marketable Securities + Supplies + Prepaid Expenses + Accounts Receivable + Other Liquid Assets = Current Assets
Read More: Current Liabilities: What it is, meaning, examples, and formula
2. Practical Application
Working capital, as we have seen above, can be understood as the difference between a company’s current assets and its current liabilities. Its practical applications can include:
● Paying short-term debts
● Purchasing inventory
● Paying current bills
● For a company’s day-to-day expenses, and many more
B. Liquidity measurement
A company’s liquidity can be measured by using various ratios. Each of these ratios helps to compare a current assets subaccount against a current liabilities subaccount.
1. Quick ratio and current ratio
Quick ratio and current ratio play important roles in measuring the liquidity position of a company.
● Current ratio: The current ratio compares a company’s total assets against the total current liabilities to understand its ability to pay off short-term obligations, usually within a year.
● Quick ratio: Quick ratio considers the most liquid assets of a company. It compares the value of the current assets, such as cash and cash equivalent accounts, accounts receivable accounts, and marketable securities accounts against the value of the total current liabilities of a company.
2. How they reflect a company’s health
These ratios are important in reflecting the financial health of a company. They help to understand a company’s ability to cover current liabilities, pay outstanding debts and loans, and manage day-to-day expenses without liquidating the fixed or non-current assets. Since they are related to current assets, this goes to show how current assets indirectly help gain a view of the company’s health.
Managing current assets
Managing current assets has a lot to do with financial management. It helps businesses calculate their finances and current assets in a meaningful way. There are several ways you can manage your current assets efficiently.
A. Strategies for optimization
There are two useful strategies you can use to optimize or manage your current assets and utilize them for the best.
1. Efficient cash management
The first and foremost important way you can manage your current assets is by efficiently managing your company cash. This may include the release of salaries, receiving due payments, clearing dues on a timely basis, etc.
2. Streamlining inventory
Not to mention streamlining inventory. This is another effective strategy that helps to manage and maintain current assets easily. You can achieve this by regularly monitoring your inventory stocks and releasing them.
B. A balancing act
Another essential thing that you must consider while managing your company’s current asset is the balancing act. In simple terms, the balancing act refers to the process or act of balancing the current assets with other financial matters of a business, such as working capital, current liabilities, and more.
1. Achieving optimal working capital
As a business, you must consider your working capital, current liabilities, etc., while maintaining the right current asset. Achieving optimal working capital is essential to maintain a positive current asset ratio. Remember you must have enough working capital in hand that is, a sum sufficient to carry on your day-to-day operations—after handling your current liabilities.
2. Pitfalls to avoid
There are certain pitfalls or mistakes that you should avoid while managing your current assets. Make sure that your current liabilities ratio does not exceed the ratio of your current assets. Also, strictly monitor and regulate your current assets to avoid unnecessary or additional expenses.
V. Conclusion
A current asset is a crucial subject. It is a temporary or short-term asset that is either already in cash, can be quickly converted into cash, or an asset that can be liquidated within a year. Whether you are a business professional, investor, or creditor, learning about current assets, their meaning, examples, real-life applications, and of course management methods is essential.
A. Recap of current assets
A current asset is basically a type of asset a company holds to sell, consume, or further lead to liquidation within one year. It can be divided into four major types: accounts receivable, inventory, cash and cash equivalents, and prepaid expenses.
B. Key takeaways for financial health
So, current assets are company assets that businesses can convert into money within a year. They generally appear in the company’s publicly traded balance sheet’s current asset account. Current assets and their calculation play a vital role in a company’s financial health.
FAQs
What is meant by a current asset?
Knowing the meaning of a current asset is important. A current asset refers to a company’s liquid assets at the end of an accounting year. It must be used within the year.
What are current and noncurrent assets?
While current assets can be easily converted into cash and must be used within a year, non-current assets cannot be converted into cash within a short time as they have longer life spans.
What does current liability mean?
Current liability refers to the amount a company must pay within a short period (a year). Examples of current liabilities are short-term loans, payable accounts, accrued expenses, etc.
What are current and total assets?
The current assets of a company are meant to be used within a year. On the other hand, total assets include current assets, non-current assets, fixed assets, and intangible assets. Thus, a current asset is only a part of a company’s total assets.
