Calculating your current assets gives you a measurable means to gauge the stability of your business. It’s also something you need to know if you need to secure a loan. The precise definition according to Merriam-Webster is, “assets of a short-term nature that are readily convertible to cash.”
Short-term, in this case, means within one calendar or fiscal year. That’s a key factor in determining this figure. We’ll begin with a discussion of the calculation along with the sources that go into it.
Current Assets Calculation
A good analogy for arriving at this number is that getting there is easy, but finding it is hard. The formula is straightforward, but it requires some research to know what to include and what not to use. The simplest calculation is the following:
Current Assets = Inventory + Accounts Receivable + Prepaid Expenses + Short-Term Investments + Cash + Other Liquefiable Assets
Let’s review each of these sources in detail as they apply to it.
What Are Current Assets?
The current assets for your business will depend on the nature of your company. It isn’t just what you have in your bank accounts though that is a part of the equation too. Simply, they are anything that you can liquidate for cash. You can think of it as a kind of security to pay your operating expenses. Other types of assets include:
- Long-Term Investments
- Property and Equipment
- Intangible Assets such as copyrights or trademarks
The calculation doesn’t consider these components in the final figures. But even the known factors have some nuances to them.
Inventory, of course, are the products that your business keeps on hand for resale, if this applies to your company. The chances are that it is often more difficult to cash out on this item than others. There’s also a matter of whether or not its value is inflated based on the accounting method used. It includes both raw materials and final products available for sale.
Accounts receivable refers to the monies owed to your business for services or products it has delivered. It can be invoices or purchase orders that you have yet to receive payment. The expectation, naturally, is that you will get paid within a year’s time.
Prepaid expenses differ from the other elements of the calculation in that it’s not cash in your pocket. Rather, it’s money that you’ve freed up by paying them off such as an insurance policy or loan. They are not, however, a fixed value. Instead, they decrease over time, a process called amortization.
Typically, short-term investments or marketable securities are things that you can turn over fast. Current assets consider held-to-maturity sources like bonds that you hold until this time. There are other types that may or may not fall under this definition such as stocks or available-for-sale equity securities. Your business is obligated to report trading securities.
Cash is the monies on hand such as a petty cash fund or bank accounts. It also includes cash equivalents which you can liquidate quickly, usually within three months. All are the most liquid of your current assets.
Other Liquefiable Assets
This is a catch-all term that applies to other components that don’t fit into any of the other categories of current assets such as short-term loans.
Using Your Current Assets
Calculating it is simply a matter of adding up all the subtotals from each group. As you may expect, liquidating is something that’s easier said than done. It reflects a best-case scenario. For example, you may not receive all the monies you are owed from accounts receivable. Some you may write off as bad debt.
A similar situation applies to inventory too. Some raw materials may become unusable or sellable. The same thing can happen with stock. Trends and technologies constantly evolve which can make some products outdated or out of fashion. That’s why it’s essential for your business to reevaluate it each quarter.
You’ll use this figure in your business’s balance sheet. In essence, it’s a summary of your financial state. It will list both current and noncurrent assets such as we detailed above along with equity and liabilities. But it isn’t just a line in your ledger. It’s also used in other calculations. Each one considers different aspects of your current assets.
The cash ratio measures your ability to meet your financial obligations using only the cash and cash equivalents of your business. Liabilities include accounts payable, taxes, and long-term debt. You calculate it by dividing the figure for those assets by your total liabilities. The closer it is to 1 or over, the better since you could easily take care of your debt quickly.
As you can see, it is a conservative measure because it involves the least amount of risk for both you and investors. Essentially, it says that a business is solvent and on a strong financial footing. Not only can you pay off liabilities, but you can do it in the short term since these assets are the most liquid.
The current ratio is the total of your current assets divided by your liabilities. It gives banks or investors a measure of your risk regarding your ability to meet your financial obligations. The higher the figure, the better. It’s preferable to have ready monies on hand than to be forced to liquidate fixed assets to pay off debt. Ideally, this figure is at least 1 or more.
The acid-test or quick ratio gauges what the term suggests. In this case, quick means 90 days. It takes the total of the cash, cash equivalents, marketable securities, and current receivables and divides it by your total liabilities. Again, it’s a measure of your financial state and risk but focuses on specific aspects of your total current assets.
If you don’t have a line item for all components of your assets, you can still arrive at this number by subtracting your prepaid assets and value of your inventory. You’ll get the same thing but with a slightly different approach.
As with the other two figures, a higher number is more favorable. It signals to investors that you can pay off your debt without having to resort to liquidating other fixed assets. Your company is making enough profit to keep it running.
Of this three ratios, the last one, the acid-test, provides what is probably the most accurate assessment of the state of the business. It removes the uncertainties and unknown factors of the accounts receivable and inventory.
Determining your total current assets gives you and your investors the information they need to evaluate your financial risk and stability realistically. While the calculation is simple, there are several important nuances to bear in mind to make sure it is a true picture of your business. That’s where the different ratios come into play.
By balancing your currents assets with your total liabilities, you can get a better idea of the future of your company and identify areas where you need to make adjustments. It is one of the most basic and powerful of the accounting equations that you need to know whether you’re a sole proprietor or a partner.