What Are Current Assets?
Current assets are those that can be quickly converted into cash or used up within a year. Year can be the calendar year or financial year, both can be used as a frame of reference. The time taken to purchase or produce inventory, sell the final goods, and receive payment for them is referred to as the operational cycle in this context.
Typically, a business’s operational cycle lasts for a year. However, some businesses have operational cycles which last more than a year. For example, alcohol businesses consider their inventories, as current assets. Despite the fact that such inventories continue to age for a period longer than two years, and in some cases for a period longer than 10 years.
Some of the most common types of current assets are mentioned below:
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Cash
Since cash is an entity’s most liquid asset, it is crucial for the business’s short-term viability. The amount accessible to the business is represented by the cash balance under the head-current assets. An enterprise can use this money on an immediate basis to cover its ongoing expenses. Coins, different currencies, money deposited in the current account in a bank, cheques, and money orders are typically considered part of cash.
As an enterprise’s most liquid asset, cash is included as the first item under the account heading “current assets” on the balance sheet. This is so because the current assets account category’s entire contents are listed in the assets’ order of liquidity.
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Cash Alternatives
Cash invested by the corporations in relatively short-term, interest-earning financial products are classified as ‘cash equivalent’. These financial products can be easily turned into cash, often within 90 days, and are very liquid and secure. These securities include money market funds, treasury notes, and commercial paper. Additionally, it is simpler to trade these assets on the stock market and also to estimate their current value.
One of the fundamental principles of cash management is that idle funds shouldn’t be kept in accounts that aren’t being used. Instead, extra money needs to be invested in these tradable assets.
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Inventory or Stock
Anything constituting inventories is either:
- stocked with the intention of selling them during the course of regular business (finished goods);
- being processed will finally be sold (work-in-progress);
- soon be used up in the production of products that would be processed at a later stage (raw material)
It is crucial to remember that overall the goods included in the inventory are those that would typically be sold during the course of normal business operations. Thus, in the case of merchandising enterprises, items that are available for resale are included in inventory. While in the case of manufacturing enterprises, inventory includes raw materials, things that are in-process/incomplete, and finished goods.
Goods that are utilized to make products make up raw materials. Work-in-process refers to products that are still being manufactured and have not yet been finished. The term “finished products” describes items that have been completed and are available for purchase.
The costs associated with getting the goods to a particular location and condition where they can be sold further are now included in the cost of inventory. This indicates that the cost of inventory includes all expenses related to the aforementioned regulation, such as freight in, conversion fees, and purchase costs. However, the costs listed below are not included in the cost of inventory:
● anomalous waste in labour, overhead, and raw materials
● storage expenses,
● administrative expenses,
● selling expenses
Once the unit cost of the inventory is established, multiple inventory costing techniques must be applied. With the aid of these techniques, the cost of inventory can be determined in a methodical manner. This is so because the cost of each inventory unit varies.
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Debtor’s Account
The amount that consumers owe a business for the products and services it provided on credit is known as accounts receivable. The balance sheet shows the receivables at their net realisable value. These sums are established after taking the cost of bad debt into account.
The difference between gross receivables and the amount marked as doubtful debts is what is known as the accounts receivable’s net realisable value. The company anticipates receiving payment from its clients in the form of these accounts receivable at net realisable.
Accounts receivable may occasionally need to be eliminated from the balance sheet because they cannot be collected from the consumers. Therefore, in such circumstances, it is necessary to lower both gross receivables and the allowance for questionable accounts. Companies must also compare accounts receivable with sales to find problems with their collection policies.
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Securities That Can Be Sold
The investments in long-term securities that the corporation has made are classified as marketable securities. These investments can be easily sold and are typically anticipated to be liquidated within a year. Treasury bills, notes, bonds, and equity instruments fall under this category.
As a result, once obtained, these securities are accounted for at cost plus brokerage fees involved in purchasing them from the market. The value of these securities, however, could fluctuate drastically. This is due to the ease with which these securities can be sold and purchased on the market. As a result, after the initial acquisition, these trading securities must be recorded at their fair value from time to time. Therefore, the company’s income statement from time to time shows the change in their value.
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Prepaid Bills
Operating costs for a business that have been paid in advance are referred to as prepaid expenses. As a result, when these expenses are paid at the start of the accounting period, cash is reduced on the balance sheet. At the same time, prepaid expenses, a current asset with a value of the same amount, is formed in the balance sheet.
These pre-paid expenses do, however, eventually become current asset expenses.
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Deferred Assets
Deferred assets are among the other category of current assets. When the tax liability exceeds the amount of income tax cost reported by the company on its income statement, these assets are formed. This may occur in circumstances where before they can be deducted from taxes or before they are taxed, revenues or gains are reflected in the income statement as expenses or losses. As a result, over time, this deferred tax asset is reversed. When the expense is written off for tax reasons, it is reversed.
Now that we have understood the categories of current assets, we will try to elaborate on some of the most important ratios relevant to current assets.
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Current Ratio
The ability of a corporation to satisfy its short-term obligations, which are normally due within a year, is assessed by its current ratio. A current ratio which is below the industry standard denotes a higher likelihood of the company defaulting. Similarly, businesses with current ratios that are excessively high compared to the industry average may not be making the most use of their resources.
(Current Assets/Current Liabilities) is the formula for the current ratio.
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Quick Ratio
The quick ratio is a more conservative method of assessing a company’s ability to meet its short-term obligations. The only assets included are the company’s most liquid assets.
Quick Ratio Formula = (Marketable Securities + Receivables + Cash and Cash Equivalents)/ (Current Liabilities)
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Cash Ratio
The company’s total cash and cash equivalents are compared to its current obligations to get the cash ratio. This ratio shows how well a corporation can use its most liquid assets to pay its short-term debt obligations.
The formula for Calculating Cash Ratio: (Cash + Cash Equivalents/Current Liabilities).
What Are Fixed Assets?
Long-term tangible assets employed in corporate operations are referred to as fixed assets. They are categorized as property, plant, and equipment (PP&E) on the balance sheet because they offer long-term financial benefits and have a useful life of more than a year.
The following is a list of a fixed asset’s essential characteristics:
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They have a long life.
Fixed assets are non-current assets with a shelf life of more than a year that show up as property, plant, and equipment on a company’s balance sheet (PP&E).
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They may lose value.
Fixed assets, with the exception of land, are depreciated to account for normal wear and tear from use.
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They are used to company activities and offer long-term financial rewards.
The business produces goods and services and makes money using fixed assets. They are not held as investments or sold to customers.
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They lack liquidity.
On a company’s balance sheet, fixed assets are classified as non-current assets because they are not quickly convertible into cash.
Value Of Fixed Assets:
Any business must have fixed assets. In addition to being utilised to assist a business in generating money, investors carefully consider them before determining whether to invest in a firm. For instance, the efficiency of fixed assets in generating sales is assessed using the fixed asset turnover ratio.
Businesses have an advantage over rivals by using their fixed assets more effectively. Investors must have a clear knowledge of what constitutes a fixed asset since it affects how they assess a company.
Illustrations of fixed assets:
● Buildings and infrastructure for land machinery.
● Vehicles (company cars, trucks, forklifts, etc.).
● Furniture.
● Computer hardware tools.
Even though the list above contains illustrations of fixed assets, not all businesses will necessarily use them. In other words, what one corporation considers a fixed asset may not be the same for another.
For instance, a delivery service might classify its fleet of cars as fixed assets. However, a business that makes cars would list the same cars as inventory. Therefore, when classifying fixed assets, take into account the nature of a company’s activity.
Financial Statements And Fixed Assets
The following effects of a fixed asset are shown in a company’s financial statements:
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Account Statement
Capitalizing a fixed asset. When a business buys a fixed asset, they don’t record it as an expense in the balance sheet; instead, they record the cost as an asset on the balance sheet. Fixed assets are first capitalized on the balance sheet and then gradually depreciated over the course of their useful lives because they are used in business activities to generate revenue. On a company’s balance sheet, property, plant, and equipment (a non-current asset) represents fixed asset.
For instance, a corporation that spends INR 3,000 on a printer would include the printer as an asset on its balance sheet. The printer would gradually decapitalize itself from the balance sheet throughout the course of its useful life.
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Revenue Statement
Fixed assets, with the exception of land, are depreciated. This is done to account for the damage caused by using the fixed asset for business purposes. The income statement item for depreciation shows up and lowers the company’s net income.
For instance, a corporation that spends INR 3,000 on a printer with a 10-year life and INR 0 residual value would deduct INR 300 annually from its income statement.
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Summary of Cash Flows
The cash flow statement’s investment activities section will show any cash used by the business to buy or sell fixed assets. Fixed asset purchases are classified as “capital expenditures,” whereas their sales are classified as “proceeds from the sale of property and equipment,” which is an inflow of cash.
For instance, a business that pays cash for INR 3,000 printer would show INR 3,000 in capital expenditures on its cash flow statement.
What Is The Difference Between Fixed Assets and Current Assets?
Now that we are clear with the meaning of fixed assets and current assets, let’s understand the key differences between them:
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Nature
The assets that can be converted into cash more quickly than fixed assets are the current assets. Long-term fixed assets (PP&E) with a useful life of more than a year are known as fixed assets.
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Period
Fixed assets are often long-term investments because they have a useful life of more than a year.
Contrarily, current assets have a liquidity period that is typically less than a year. For instance, inventories fall under the category of current assets because they are typically sold within a year.
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Depreciation
According to accounting practices in force in India, there are specific ways to compute the depreciation on fixed assets as they tend to deteriorate over time. While current assets do not lose value or deteriorate. Accounts receivable are, however, modified for any uncertain recovery.
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Liquidity
It might be difficult to turn noncurrent assets (fixed assets) into cash rapidly enough to pay for short-term operational expenses or investments. The conversion of current assets into cash can be done within a year and they are more liquid.
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Reserve for Revaluation
When the value of fixed assets increases, the company establishes a revaluation reserve. The main distinction between a fixed asset and a current asset is that in the case of a current asset, no such reserve is formed.
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Finance
A company’s long-term funds or debts are often used to finance its fixed assets, while its short-term funds or debts are used to finance its current assets.
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Pledge
When a business seeks to receive any financial assistance from banks or other sources, fixed assets help supply the pledge as security. You cannot, however, use present assets as collateral for any loan.
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Selling An Asset
When fixed assets are sold, either a capital gain or loss is realised depending on whether they were sold for a profit or a loss. Such a profit or loss is recorded on a company’s profit and loss statement under the extraordinary items.
However, when current assets are sold, the outcome is revenue, profit, or loss, and depending on whether profit or loss is created, the result is reported under various income or cost titles.
Conclusion
In essence, current assets are those assets which have a shorter shelf life than fixed assets. However, what is important to consider here is that these two asset classes are treated differently, as described in detail in the blog above.
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