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The Advantages Of Financial

Topics: Finance, Credit & Payments, Management

Being able to use cash for smaller, noncapital purchases in a business avoids having to finance those purchases. This reduces overall cost of purchases. It can provide other opportunities as well such as discounts for paying in full with cash.

We're going to look several advantages of current assets and how managing them well can help a businesses overall financial liquidity and help with growth.

Liquidating Current Assets

Current assets are those that can be easily converted into cash. They are found on the balance sheet under current assets and listed in order of liquidity. Current assets include:

  • Checking accounts and petty cash
  • Short-term investments
  • accounts receivable
  • inventory
  • prepaid expenses

Basically, any asset that is expected to have a lifetime of less than one year is a current asset.

Liquidating a current asset should not take much effort. Although it doesn't mean you can convert the asset into cash immediately. For example, short-term receivables might take a 60 to 90 days to liquidate since you must wait for customer payment.

Other assets such as checking and petty cash (often called currency) are readily available as cash and are the most liquid assets.

Liquidity Ratios

Current asset ratios provide insight into a company's health. Specifically, its ability to pay short-term liabilities. The higher a liquidity ratio, the better a company is able to meet its short-term obligations. The opposite can be said for companies with low liquidity ratios.

Cash Ratio

The cash ratio removes receivables and inventory, which allows it to target the most liquid current assets. This ratio is also used by banks when applying for a business loan.

The ratio is calculated as follows:

= [cash + short-term investments] / current liabilities

Current liabilities are those coming due within 12 months.

Current Ratio

Moving to a less liquid ratio but still dealing within the 12 month timeframe, we have the current ratio. It demonstrates a company's ability to pay its current liabilities using all of its current assets (including receivables and inventory). While receivables and inventory can take longer to convert to cash than cash and short-term investments, we have 12 months to liquidate receivables and inventory.

The formula is calculated by:

= [current assets] / [current liabilities]

Acid-Test Ratio

This ratio demonstrates a company's ability to pay all of its current liabilities without the use of inventory. In this case, we are still within the 12 month short-term time frame but want to retire all current liabilities as fast as possible. Since inventory can take the longest to liquidate out of our current assets, we leave it out of the calculation.

The Acid-Test Ratio is calculated as follows:

[cash + receivables + short-term investments] / [current liabilities]

Risks Involved With Liquidating Receivables And Inventory

Of all the current assets, receivables and inventory can take the longest to liquidate and carry the most risks.

With receivables, there will almost always be an amount we can't collect on. Allowance for doubtful accounts should offset the receivables lost amount so we aren't depending on the receivables value as the full cash conversion.

In regards to liquidation time with receivables, we are really at the mercy of the customer. Customers may pay on time, late or not at all.

Inventory is a more involved process than receivables when it comes to liquidation. We depend on customers purchasing our product at the stated price. There is a journey first in getting customers into the store and then making an actual purchase. Much can go wrong within that journey.

Assuming a customer does make the purchase, we have to factor in a percentage for returned or damaged items.

It's very common to allow purchasing on credit. In this case, once the sale is made, we have to wait some predefined period to collect on payment. This introduces the same risk as receivables of course (i.e., no payment).

In some cases, certain inventory is difficult to move (i.e., sale). A first attempt might be to mark the inventory down at a discount for customers. Failing that, we then need to consider selling to a wholesaler. This will usually mean marking the inventory down even further. At this point, the inventory is going for well below its original value.

Moving From Fixed Assets To Liquidity

Some industries are heavy at the bottom of their balance sheets. Meaning fixed assets. Construction is a great example. With capital expenditures going toward machinery. This machinery use to be appealing as collateral for a loan.

The banking industry has now shifted toward liquidity rather than collateral. This means companies heavy on fixed assets may want to consider leasing instead of purchasing. Renting existing equipment is another great way to build up liquidity.

Working capital (current assets - current liabilities) is another measure of liquidity. It's also a source of funds for growing the business. Working capital is usually maintained as a percentage of sales, which is based on the respective industry's average.

Financial liquidity allows a company to take advantage of opportunities as they arise. Because the company is able to quickly deploy cash when needed, this can also become an advantage over its competitors.

Net terms accounts receivable


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