What is a Current Liability?
A current liability, in the accounting context, falls under the broad category of liabilities, which are the financial obligations of a company to another entity. In other words, if a company has partaken in any transaction that has led another entity to have economic or monetary expectations from such an organisation, it can be considered as a liability.
Financial obligations or economic expectations which a company is expected to meet within one year are known as current liabilities. However, in a broader accounting context, this time frame is not regarded as one year but one business cycle.
Hence, even if an operating cycle extends beyond one year, it shall be considered as the time frame based on which liabilities of a company are categorised.
As current liabilities are short-term obligations, they act as primary determinants of a company’s liquidity. It is because, in a typical financial structure of a company, current liabilities are settled against current assets. In other words, companies utilise their current assets to pay off their short-term financial obligations.
Current liabilities are recorded on the right side of the Balance Sheet of a company and are typically posted before non-current liabilities. A few current liabilities examples are creditors, outstanding overheads, etc.
Relationship between Current Liabilities and Current Assets?
Current assets are those components of a business which form the basis of a company’s liquidity. It represents those assets which an organisation expects to sell, exhaust, or consume within an operating cycle resulting in cash inflow. As these assets are expected to be liquidated within a year, they become the financial foundation on which a company’s day-to-day functions thrive. A few examples of current assets are debtors, inventories, bills receivable, etc.
Hence, its correlation with current liabilities is quintessential to the operating efficiency of a company. The cash inflow generated from current assets is utilised towards writing off current liabilities from the books by meeting those obligations. The difference between current assets and current liabilities is working capital. The formula for working capital thus stands as –
Working capital = Current assets – Current liabilities
It signifies the amount a company is left with after it has settled its current liabilities. Higher working capital represents that a company is equipped with funds to meet its workaday functions without monetary impediments.
An efficient working capital structure would be designed in such a manner where an organisation receives economic benefits from its current assets before it has to pay off its current liabilities. In other words, it shall be designed so that dues from sources such as debtors are cleared before the company is liable to pay its dues to creditors. For this purpose, creditors are treated as one of the most crucial short-term obligations in a company’s books.
Another crucial aspect to the relationship between current assets and current liabilities is the derivation of certain ratios. Analysts consider these ratios as quintessential metrics which allow them to formulate a precise idea about a company’s liquidity or short-term financial standing.
Different Ratios Involving Current Liabilities?
One of the primary reasons why seasoned investors closely follow the current liabilities of a company is because of the impact it has on an organisation’s liquidity. However, monitoring current liabilities independent of current assets does not bear significant results for investors. It shall be viewed in light of current assets; which is why there are ratios that substantiate the relationship between short-term assets and liabilities.
The different types of ratios involving current liabilities are –
- Current ratio or Working Capital ratio
Formula: Working capital ratio = Current assets/Current liabilities
Example – In the books of Company A, the following current liabilities list is shown:
Creditors = Rs. 13,000
Bank overdraft = Rs. 2000
Bills payable = Rs. 5000
Outstanding expenses = Rs. 10,000
The list of current assets is:
Debtors = Rs. 15,000
Inventories = Rs. 12,000
Bills receivable = Rs. 8,000
Prepaid expenses = Rs. 7,000
Cash and cash equivalent = Rs. 8,000
Therefore, Current Ratio = (15,000 + 12,000 + 8,000 + 7,000 + 8,000) / (13,000 + 2,000 + 5,000 + 10.000) or Current ratio = 50,000/30,000 = 1.6
A ratio above 1 demonstrates that a company has sufficient current assets to write off its short-term debts and obligations. Hence, investors shall always examine and assess current ratio to determine its liquidity.
- Quick ratio or Acid test ratio
Formula: Quick ratio = (Current assets – Inventory)/Current liabilities
Example – In the Balance Sheet of Company B, the list of current assets shown are
Debtors = Rs. 18,000
Inventories = Rs. 5,000
Prepaid expenses = Rs. 7,000
Bills receivable = Rs. 5,000
Cash and cash equivalent = Rs. 10,000
The list of current liabilities represented is:
Creditors = Rs. 15,000
Outstanding expenses = Rs. 6,000
Short-term loan = Rs. 4,000
Bank overdraft = Rs. 4,000
Trade payables = Rs. 1.000
Therefore, Quick ratio = (18,000 + 7,000 + 5,000 + 10,000) / (15,000 + 6,000 + 4,000 + 4,000 + 1,000) or Quick ratio = 40,000/30,000 = 1.33
Similar to the current ratio, a result above 1 portrays that a company can meet its short-term financial obligations with its immediate liquid assets. This approach to ratio calculation is comparatively more conservative as it only takes into account an organisation’s immediate assets which it can readily liquidate.
The number is always lower than the current ratio due to the exclusion of inventories. Investors can utilise this ratio to understand a company’s liquid financial strength.
However, it is essential to note that, in case of both these ratios, a number too high might insinuate that such organisation is not utilising its assets to their full potential. Hence, investors shall bear in mind when analysing these ratios that it shall be within reasonable limits to imply that a company’s management is efficiently leveraging its current assets to manage its short-term liabilities.
In addition to the above pointer, it shall also be noted that the decision towards which ratio is good enough to be considered varies from one industry to another.
Types of Current Liabilities?
Essentially, ‘Current Liabilities’ itself is a sub-category in the balance sheet, and hence, there are no defined types to it. Nonetheless, as per accounting standards, there is a subtype to current liabilities which appears in books of companies from time to time. That is –
- Other current liabilities
It is a vague term which covers short-term obligations that cannot be definitively categorised as ‘Current Liabilities’. When recording this type of current liabilities, accountants might sometimes leave a footnote in its regard to explain why that item has been posted under ‘Other Current Liabilities’.
These items or financial events usually are not significant enough because they do not directly contribute to an organisation’s core operations. Hence, for the sake of simplicity and transparency, these items are lumped together sans further classification under this head.
Summarising the core difference between current liabilities and other current liabilities, the former is significant to a company’s core operations and therefore precisely recorded in its books. At the same time, the latter is less significant and ergo lumped together under a single heading.
Difference between the Various Types of Liabilities?
The difference between the three most recognised types of liabilities – current liabilities, non-current liabilities, and contingent liabilities is represented in the table below.
|Parameters||Current Liabilities||Non-Current Liabilities||Contingent liabilities|
|Description||Liabilities that a company is obligated to write off within a single operating cycle.||Financial obligations that a company needs to write-off by a period exceeding one operating cycle.||Tentative financial obligations, the realisation of which depends on the outcome of a particular event.|
|Treatment in books of accounts||Recorded on the right side of a balance sheet, typically above ‘Non-Current Liabilities’.||Posted on the right side of a balance sheet, usually under ‘Current liabilities’.||Recorded twice, first in the Income statement as an expense and then again on the right side of the balance sheet.|
Current liabilities offer a critical view of a company’s liquidity and whether an organisation’s management is efficient enough to settle those obligations with their current assets. This type shall be analysed to understand how well a company is operating and whether a company is too reliant on short-term liabilities to finance its workaday operations and whether their working capital suffices for determining its growth possibilities.