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May 22, 2024

How Understanding Current Liabilities Can Supercharge Your Business

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Pooja Lodariya

CA

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Current liabilities are an essential component, reflecting a company’s short-term financial obligations. These are debts and payables that a business must settle within a year or within its operating cycle, whichever is shorter.

From accounts payable to short-term loans, and accrued expenses to income taxes owed, current liabilities encompass a range of obligations that tell a story about a company’s financial health. They are a snapshot of the commitments that a business must honor in the near term, and they play a pivotal role in the management of working capital and cash flow.

Whether you’re a business owner, an investor, or a student of finance, this blog will equip you with a deeper understanding of what current liabilities mean for a business and how they are managed for sustained growth and stability.

What are the Types of Liabilities?

Let's first discuss general liabilities and what they mean for a business before getting into the details of the current liabilities. The obligations or debts that a business owes, whether in cash or goods, are known as liabilities.

To put it simply, it's the total amount of money that a company will eventually have to pay. It could be anything, such as returning funds to investors or even just unpaid invoices for courier delivery partners. All debts owed by a business to third parties, regardless of size, are regarded as liabilities.

This is accurate, but depending on the type of liability, some may need to be paid off quickly, while others will persist as obligations for a considerable amount of time. The liabilities can be divided into "current liabilities" and "non-current liabilities" based on this nature.

What are Current Liabilities?

A company's short-term debts or obligations that must be paid off within a year are known as current liabilities. Examples of current liabilities include amounts owed to suppliers, salaries that need to be paid, and so forth.

One of the main components of any company's cash outflow is its current liabilities, which need to be effectively managed to maintain control over your cash flow.

Current Liabilities Examples

The following are some examples of current liabilities that must be settled in the short term, typically within a year.

Salary Payable

The amount of money that a company owes its employees for unpaid salaries that are past due is referred to as salary payable.

Creditors

Trade payables, accounts payables, and bills payable are other terms for creditors. They are your suppliers, to whom the business owes money for using credit terms to buy the products or services.

Bank Overdraft

A bank overdraft is a facility that permits a business to take out payments even when there is no money in the account. As a general rule, current accounts are permitted.

Short term loan

A short-term loan is one of those that must be repaid, plus interest, by a specified date within a year of the loan's origin. This kind of loan is typically taken out to meet the needs for working capital.

Interest Payable

A liability for interest costs incurred but unpaid as of the balance sheet date is known as interest payable.

Accrued Liabilities

Expenses that have accumulated but have not yet been paid are referred to as accrued liabilities. Payable wages, rendered services that are not yet reimbursed, and so forth are some examples.

Also Read: How to Keep Your Asset and Liability Management (ALM) from Slowing You Down

High-liquidity assets are those that can be converted into cash in less than a year. These assets are referred to as current assets. Accounts receivable, inventory, marketable securities, prepayment of expenses, cash and cash equivalents are examples of current assets. The debts that a business has to pay off within a specific time frame, usually a year, are known as current liabilities.

The balance sheet includes a detailed list of current liabilities. Accrued expenses, notes payable, accounts payable, accrued interest, and dividends payable are examples of current liabilities. On the balance sheet, current assets and liabilities are displayed.

A company's current assets are used to lower its current liabilities, which is why current liabilities and current assets are related. In other words, current assets can be liquidated and the proceeds used to pay down current liabilities.

Working capital is calculated as follows: current liabilities minus current assets. Organizations must comprehend the connection between working capital and reserves since the former indicates the amount of money available for paying debts and the other is used for investing in organizational expansion.

A company with a high working capital ratio has enough current assets to offset its current liabilities. Because it has the money to support business growth through expansion and other initiatives, it can also consider future investments.

A low working capital indicates that the company has sufficient cash on hand to pay off its current debts but not enough left over for further investments. Experts find it difficult to determine liquidity in the absence of assets, so they frequently take both current assets and liabilities into account.

Different Ratios Involving Current Liabilities

Understanding current liabilities involves examining various financial ratios. Here are three key ratios:

Current Ratio

The current ratio measures a business's short-term liquidity, indicating its ability to pay off debts and obligations. It helps determine if the business is a good candidate for lending or investment.

Formula:

Current Ratio=Current Assets/Current Liabilities

Quick Ratio

The quick ratio assesses whether a business can cover its debts with its most liquid assets, excluding inventory. This ratio is considered a more realistic measure of liquidity compared to the current ratio.

Formula:

Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

Cash Ratio

The cash ratio, which only considers the company's cash and cash equivalents, is the most conservative. It evaluates the company's ability to meet short-term obligations without relying on accounts receivable or inventory.

Formula:

Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities

Also Read: Mark-to-Market Accounting: The What, Why, and How

What are the Types of Current Liabilities?

Here are the most common types of current liabilities:

Accounts Payable

Accounts payable represent the debts and obligations a business must fulfill within a certain period. It is often the highest current liability, especially when businesses delay payments but receive products in advance to maintain inventory.

Income Taxes Payable

Income taxes payable are the taxes a business owes to the government based on its profitability. Tax liability can be reduced with applicable tax credits, but these credits expire quickly, so timely attention is necessary.

Accrued Payroll

Employers owe money to employees for work completed but not yet paid; this is known as accrued payroll. This includes wages, salaries, and bonuses.

Interest Payable

Interest payable is the interest due on borrowed money. This includes interest charged on loans taken for business purposes.

Notes Payable

Notes payable are debts owed by the business. Ideally, these should be lower than the sum of short-term investments, cash, and accounts receivable, indicating a healthy business. Loans can be beneficial if invested wisely for business growth.

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