Current assets are a business's resources that can be easily liquidated. Businesses of all sizes must keep a healthy level of current assets in order to function properly. In this article we explain current assets and their purpose for small and medium enterprises (SMEs).
Running a small business can be difficult. The day-to-day operational tasks may be so demanding that SME directors have little time to study financial analysis in order to realise their businesses' full potential. Here, we outline an important financial accounting term "current assets" and explain its importance for growing SMEs.
What Are Current Assets?
A business's current assets consist of its cash and equivalents plus any assets that can be converted to cash within a year. Cash and equivalents include physical currency, undeposited checks, money in bank accounts, money market accounts, and highly liquid investments.
Examples of assets that can typically be liquidated within 1 year include marketable securities (e.g. stocks, bonds), accounts receivable (i.e. invoices for products or services produced), inventory and prepaid expenses (e.g. insurance, rent).
On the other hand, current liabilities are financial obligations due within 1 year. Examples of current liabilities include short-term debt (e.g. current portion of long-term debt), accounts payable (e.g. bill from supplier, rent owed to landlord) and accrued liabilities (e.g. accrued wages, interest expense).
Why Should SME Directors Care About Current Assets?
First and foremost, current assets are important to small business owners and directors because these are the assets that allow businesses to operate on a daily basis. In particular, cash is required for wages, rent, utilities and other essential business costs. Simply put, a business's existence relies on having a healthy level of current assets.
Additionally, prospective lenders or investors will almost certainly consider current assets and other factors that indicate a company's short-term financial health when evaluating small businesses and startups. Because funding and lending require thorough financial analysis, a business's current assets and related ratios will likely be critically evaluated. This makes it essential for SMEs to monitor their balance sheet when applying for financing.
Does My SME Have a Good Amount of Current Assets?
There are a few ratios used gauge a company's to pay its bills based on its current assets. For example, the current ratio, quick ratio and net working capital all give some indication of how well a company will be able to meet its short term obligations based on its current assets compared to its current liabilities.
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Current Assets - Inventory - Prepaid Expenses) / Current Liabilities
- Net Working Capital = Current Assets - Current Liabilities
The quick ratio does not include inventory or prepaid expenses, which are considered as more difficult assets to liquidate. This is a more narrow view of current assets and therefore a more conservative estimate of a company's ability to meet its short-term obligations compared to the current ratio.
Current and quick ratios of greater than 1.0 and positive net working capital generally indicate that the business can meet its short-term financial obligations. Values below 0 indicate a shortage of current assets (e.g. cash) and are a red flag for business owners and investors.
Current ratios that are much higher than 2.0 indicate that a business could be using its capital more aggressively to grow. However, this is generally best assessed on a case-by-case basis. For reference, the graph below shows current ratios by industry in Singapore.
How Can Small Businesses Increase Current Assets?
There a few ways for SMEs to increase their current assets. First, businesses that are able to increase profits by cutting costs or increasing production will be able to increase their cash-on-hand. Of course, this is often much easier said than done.
Secondly, SMEs can seek business loans to increase their cash and grow their business. It can also allow the business to pay down short-term debt. While this would not directly increase current assets, it would benefit current asset ratios by shifting the business's current liabilities to long-term debt.
Third, companies that have long-term or fixed assets (e.g. equipment) that can be sold without harm to the business could choose to sell these assets in order to hold more liquid assets such as cash.
Other Helpful Cash Management Tips
Managing working capital isn't just about increasing current assets while decreasing current liabilities. Sometimes, it also requires managing your cash balance efficiently by actually reducing net working capital.
For example, businesses that have bargaining power with customers or suppliers could attempt to negotiate more favorable payment terms with these parties. They could also try to lengthen their period of their payables to suppliers or incentivize customers to pay more promptly. While these strategies won't actually increase current ratios, they will benefit businesses by providing more positive cash flow.
Another helpful technique for freeing cash for operational costs involves optimising inventory stock. For example, businesses should try to reduce inventory that remains unused. This can be achieved by optimising the amount of inventory purchased or produced to more closely match the amount of inventory required to meet customer demands.
Additionally, businesses can try to shorten production or sales processes so that inventory is converted to cash more quickly. This could decrease your level of inventory and have a negative impact on your current assets, but this could be more than offset by an increase in your overall cash balance.
This was first published at Value Penguin's website, "What Are Current Assets and Why Do They Matter to Your SME?".