If you experienced a dramatic shift in revenue, would you still be able to pay your business’s
bills?
To figure that out, you need to use the current assets formula.
The current assets formula, also known as the total current assets formula, is a key
indicator of your business’s short-term financial health.
If your current assets exceed short-term liabilities, you have enough assets to pay off short-term
debts.
But if they don’t, even minor changes in revenue month to month can be disruptive to
your business.
In this video, we’re going to show you how to use the current assets formula to better
manage your business’s finances.
Let’s start by learning the current assets formula.
Your total current assets are the sum of your
Cash + cash equivalents + inventory on hand + accounts receivables + marketable securities
such as stocks or bonds + prepaid expenses + other liquid assets.
That was a mouthful, so let’s break down what each of these assets are.
* Cash and cash equivalents include cash in your business bank account, checks you’ve
received but have not yet deposited, and petty cash.
* Inventory refers to unsold goods that your company keeps on hand to replenish stock.
This may also include supplies that you need to make your product.
* Accounts receivables are pending payments customers owe you for goods or services they’ve
already purchased.
* Marketable securities are financial instruments that can be coverted to cash, like stocks
and bonds.
* Prepaid expenses is a catch-all term for expenses you’ve paid already, but haven’t
yet used or received the underlying asset.
For example, general liability insurance would be considered a prepaid expense.
This is a lot to add up, but it’s actually simpler than you think.
As an example, let’s look at a sample balance sheet for a made up business we’ll call
ABC Business
As you can see, the sum of ABC Business’s current assets, when you factor in their cash
and cash equivalents, inventory, accounts receivables, marketable securities, and prepaid
expenses is $200,000.
These are considered current assets because they can be converted into cash within one
year.
Below that you’ll see current liabilities.
These include accounts payable, accrued wages, unearned revenue, taxes payable, interest
payable, short-term debt, and the current portion of your long-term debt, which adds
up to $120,000.
These are all considered current liabilities because they have to be paid back within a
year.
Because we are calculating the current assets formula, we don’t need to worry about fixed
assets, long-term liabilities, or the owner’s equity.
So, if we just compare the total current assets of ABC Business vs. the total current liabilities,
we’ll see that ABC business has $80,000 more in current assets than current liabilities.
This is a good thing, as it shows ABC Business has ample short-term liquidity.
Therefore, they’ll be able to cover any unexpected short-term debts.
So that’s the current assets formula.
But we’re not just going to stop there.
Knowing your total current assets gives you the ability to use a bunch of other formulas
that will provide you with additional insight into your business’s financial health.
The first such formula is the current ratio formula.
To calculate your current ratio, simply divide your current assets by your current liabilities.
This number tells you the percentage of your firm’s debts that you can pay off with liquid
assets.
So, for example, if we divided ABC Business’s current assets by their current liabilities,
we’d get the number 1.67.x
Next we have the quick ratio.
The quick ratio is similar to the current ratio, but only considers the most liquid
assets, so you would need to exclude inventory and prepaid expenses.
The quick ratio is especially important when figuring out if you have enough to cover quick,
unforeseen expenses.
For ABC Business, the quick ratio is 1.54.
This means they have $1.54 cents on hand to pay off every $1 of debt.
Lastly let’s talk about net working capital.
The net working capital formula tells you whether or not you have enough assets on hand
to pay off all bills and debts due within one year.
If you have a positive amount of net working capital, that means you have excess cash that
you can use toward day-to-day expenses.
To calculate net working capital, simply subtract your current liabilities from your current
assets.
For ABC Business, this means they have $80,000 on hand to pay off all their bills and debts.
For more information, check out our YouTube video on net working capital.
Obviously, having more current assets than current liabilities is a good thing.
For example, if you have more current assets than liabilities, you can pledge some of those
assets as collateral for a loan.
Depending on how much you have in current assets, you may be able to secure a low interest
rate or high loan amount.
Now, at a minimum, you need to have a 1:1 ratio in order to be solvent and continue
operating.
A ratio less than one means you don’t have enough assets to cover your liabilities, which
signals low liquidity.
Ideally, you should have a current ratio between 1.2 and 2.0.
Why not higher?
Well, believe it or not, there can actually be a point where you have too many assets.
If your ratio is greater than 2, it may imply you’re not investing your cash in revenue-generating
opportunities.
If you have a ratio below one, there are some things you can do to balance your assets.
We recommend the following:
1.
Collect your receivables more quickly.
This might mean pestering clients for payment a bit more frequently, or imposing late fees
on invoices.
Generally, you’ll want to collect your receivables within 60 days to maintain cash flow.
2.
Be careful about borrowing money.
Reducing your short-term and long-term debt can improve your current ratio by reducing
current liabilities.
So only borrow what you need, and nothing more.
3.
Liquidate unused assets.
If you have unused equipment lying around, or a portion of your office you’re not using,
sell off or liquidate those assets and convert them to cash.
Doing so will increase your current assets.
4.
Invest wisely.
When choosing short-term investments, like stocks and bonds, make sure you have a good
mix of risk vs. return.
You want to have a balance of high risk, high return investments and low risk, low return
investments.
And that’s everything you need to know about current assets and the current assets formula.
Remember: You need to have a current ratio of 1:1 or greater, but not higher than 2.
Also remember that the current assets formula is a balance sheet calculation, which means
you need to update your balance sheet every month to have an accurate picture of your
current assets.
For more advice on how to help your business succeed, visit fundera.com/blog.
You can also browse our YouTube channel, and subscribe to be notified when we publish new
videos.
Thanks for watching!