An Explanation of Current Assets
The asset side of the balance sheet is divided into 3 major sections. They include current assets, fixed assets, and other assets. Current assets carry the most value to the small business entrepreneur because of the cash conversion requirement. Cash is the blood that keeps a business alive. What are current assets? How do you rank their respective value to the owner? What should an owner of a small business look for in current assets to assist him in the decision process?
The following describes each of the above and the impact they have on any business:
Current Assets – Definition
There are three primary current assets; cash, receivables and inventory. Other current assets include prepaid expenses, short-term notes receivable and some deposits. But the primary current assets are the most noteworthy for the purpose of this article. Below is a brief description of each asset in order of importance (the ability to turn into cash in the least amount of time).
Cash and Cash Equivalents
- Cash, Checking, & Savings – this section includes the cash in the till box and the cash in the bank account. There is no turnover time to turn these items into cold hard cash.
- Bank Notes, CD’s, & Mutual Investments – these items are easy to turn into cash but sometimes there is a fee associated with the transaction. Often banks will charge some type of conversion fee for a bank note or a Certificate of Deposit (CD’s).
- Stocks & Bonds – these two items are easily convertible to cash, there is usually a five day delay to complete the transaction and a significant fee to carry out the transaction.
Account Receivables
- Current Receivables – those accounts whereby the customers pay within thirty days.
- Extended Receivables – those accounts whereby the customer has been granted an extended period of time to pay their account. Many organizations have a cycle time beyond the traditional monthly timeframe. Examples of customers using extended time to pay their receivables (it is due to extended procedures the organization uses to authorize, process, and issue payment) include hospitals, non-profit charity organizations, small social/athletic groups, local and state government departments. These types of operations generally take 60 to 90 days to pay on their accounts. To complicate matters, many local and state governments lock out payments for two to three weeks at the end of their fiscal years.
- Aged Receivables – a term used to identify those accounts greater than 90 days old where issues may exist as to the date of payment.
Inventory
- Raw Resources – often many small businesses use raw resources to produce a product. A good example is a road construction company. Here the company may own sand, fill dirt, different grades of gravel, and asphalt. Each of these raw materials is used to produce the final product. These resources could be sold to customers for cash or in an emergency sold back to the supplier for credits or cash. Other examples of companies that utilize raw resources include food processors, (bakeries, beer companies, frozen food manufacturers etc.), glass plants (bottle makers, flat glass and kitchen wares producer), nurseries (soil, seeds, plants,), farmers and power companies (coal, uranium, and oil).
- Work in Process (WIP) – Most commonly used in construction, it is the buildup of costs associated with the product or project. In manufacturing where it takes days to weeks to complete an item for sale (autos, boats, RV’s etc.) it is the dollar value of those goods uncompleted and no longer raw materials.
- Processed Goods – the final product produced is included in the inventory calculation. The drawback here is that the final product is not as easy to turn into cash quickly as raw resources can be turned into cash.
Each of these forms of current assets has a dollar value related to them. In the next section, the meaning of this to the owner is explained.
Current Assets Ranking
The key for any owner of a small business is having cash available to run the company. From having cash in the till to make change in the retail environment to having access to cash in an instant to deal with an unforeseen situation can make or break a small business operation. Cash is the life of any operation. Without cash you are dead in the water. Not only is it embarrassing but employees, vendors and customers can lose faith in your ability to manage a business if you do not have cash available to deal with your day-to-day operations. To have cash available, you need to understand the ranking of the current assets so you can make sure you have enough cash each day to deal with your day-to-day operations. Let’s rank the current assets:
1) Of course, having cash in the till box and bank account are of the most important value in any business. Both are these are of the most importance in any business. Cash in the till is critical just to make change for a sale. Cash in the bank allows you to pay any immediate needs including purchasing inventory or raw goods (especially if you operate a restaurant).
2) Current receivables are the next source of cash for the small business owner. He should be aware of the cycles of his primary customers. Regular payments from the ongoing customer are essential to maintaining the level of cash in the company.
3) Other forms of quick cash include the bank notes and investment related items. If in a pinch, the owner should resort to using these sources of funds for cash, however, there will be a fee to convert bank notes, CD’s, and investments into cash.
4) Extended receivables are another source of cash. However, the planning aspect comes into play when the owner reaches this far into his current asset portfolio for sources of available cash. It is wiser and easier to use other forms of cash sources and payment deferrals before reaching this level of current assets for cash.
In general, cash is ranked from the most liquid to the least liquid in availability. This is one of the many definitions of liquidity in business. See Liquidity – What does this mean? for further understanding of the concept of liquidity. All cash in the till and bank account is liquid, but depending on the nature of your business operation, the issue of ranking liquidity between receivables and inventory is strictly attributed to your operation. If in retail, inventory can be turned into cash faster than collecting receivables. If you are in the service industry, you will have very little to no inventory and must rely on receivables to inject cash into your operation. For some businesses, you have both available and there is a mix of the two current assets to generate cash. Each owner has to look at his current assets in his own way to determine cash availability.
Current Assets – Decision Model
The primary business concept for the owner is to review the business cycle to relate needs to resources. Current assets are resources for cash. The highest value resource is the inventory as it is sold generates immediate or future cash. The cycle is inventory into sales, sales into receivables, receivables into cash, and then cash is used to buy new inventory. This is the business cycle.
There are several tools available to help the small business owner understand his cycle. A good tool is a historical record of retail sales based on the time of year to collections of receivables. Use your past as a guide for the future. Other timing factors can be used too. As an example, if you are a seasonal operation, you will have strong sales for a short period of time, as you collect this money, reserve some money by purchasing CD’s that will mature during the business lean months. This way cash is readily available by exercising cash inflow throughout the entire calendar year.
The best tool is planning. Use a simple spreadsheet weekly to determine sources of cash for the upcoming week, two weeks out, one month out and then for the three-month window. Look for the payment schedules for your receivables especially the extended and aged accounts (sometimes referred to as the book of receivables). By reviewing and staying on top of the resources of cash, the owner of the business will always have cash available when it is needed. Again, relate the needs to the resources.
Summary – Current Assets
One of the major sections of the balance sheet is current assets. There are generally three groups of current assets: cash, receivables, and inventory. These three groups form a part of the business cycle of inventory to sales, sales to receivables, and then receivables to cash. When an owner understands his business cycles, relates these cycles to the concept of liquidity and uses planning and accounting tools to help him, he can always ensure enough cash is available to meet the day-to-day needs of his business. Act on Knowledge.