What are Current Assets?

Current assets are a major component of the balance sheet and represent assets that are expected to be sold or used, typically within the next 12 months.  They are also an important measure of a companies liquidity position.  Current assets have become a very important factor in evaluating the financial strength of a company, in the event of a weak economic environment or one of lower demand.  Many of the popular financial ratios will utilize the current assets when performing analysis to gauge financial performance and stability.

Current assets are used to fund the everyday operations of the company and fall within one the following five categories:  cash & equivalents, short term investments, inventory, accounts receivable, and prepaid expenses.

Cash & Cash Equivalents

The cash and equivalents are pretty straight foward.  They are what they sound like.  This line item on the balance sheet represents the cash a company holds in bank accounts, savings accounts, CDs, and money market accounts.  For a company, managing this part of the balance sheet is a tricky game; shareholders love to see a large cash position but if it is too large, they start to ask why it isn't being put to better use.

Short-Term Investments

These assets are a little less liquid than cash.  A company typically makes short term investments to earn a better rate of return as compared to a bank account or savings account.  Companies will invest in securities in municipal bonds, treasury bills or other higher yielding vehicles.  These are typically not as readily available as bank funds but can be redeemed if an urgent need arises.

Inventory

Inventory on the balance sheet refers to goods that a company has produced but not yet sold.  Companies include this as a current asset because it is believed that their goods can be sold at some point in the near future.  This can be a dangerous assumption but it is made nevertheless.  Additionally, it is far less liquid than the two assets we just discussed.  In the event of a crisis, a companies inventory would have to be sold at a deep discount to acquire funds in an expeditious manner.

Many investors pay very close attention to a companies inventory turnover to understand the demand for goods and also management effectiveness in production.  When inventories continue to increase over time, a warning flag is thrown.  The longer the assets are held in inventory, the greater the risk of obselscence, damage, and theft.  More importantly, it may be an sign that the companies products are no longer favored in the marketplace. 

Accounts Receivable

A/R, or accounts receivable represents goods and services that have been rendered but not yet paid for by the customer.  They are considered current assets because the company has a full expectation to receive money for these goods in a short term timeframe which has been stipulated in their agreement with the customer.  Typically, a customer must pay within 30 to 45 days of the invoice.

Many investors will look closely at the ratio between the increase in revenues versus the increase in receivables.  What investors do not want to see is this ratio decreasing;  that would indicate that the company is not receiving their funds in an appopriate timeframe from their customers.  This is why it is also important to analyze the companies delinquent account to understand if they are issuing credit lines to worthy borrowers.  A classic example of this can be seen with the mortgage crisis which has hit wall street and main street.  Banks issued mortgages to unqualified buyers during the credit boom and are now experiencing a meltdown in terms of the numbers of delinquencies and defaults from their borrowers.