Calculating if you have sufficient assets to fulfill the respective commitments as a company is pivotal if you want to uncover the potential cash flow constraints that could create trouble in maintaining liquidity.
This is why knowing your current and long-term debts, as well as every additional financial commitment that you have as a business, is one of the best ways to gauge your current short-term financial standing.
The more current liabilities, the more assets you'll need to subsidize them. Taking that into account, in this guide, we'll explain what current liabilities are, how to calculate them, and how each calculation can ultimately benefit your company in the long run.
What Are Current Liabilities?
Before we define current liabilities and what they represent, let's discuss liabilities as a whole. According to Investopedia, a liability represents:
In a broader sense, based on the time in which they must be written off, liabilities can be divided into two main types; current and non-current liabilities.
Each financial obligation that a given company must meet within one business cycle is known as a current liability, and the opposite is applicable for non-current liabilities.
Investopedia also has an excellent definition of what current liabilities represent.
They can differ depending on the nature of a given company. Current liabilities help accountants and economic analysts assess a company's power to meet its short-term financial obligations. Your business has the right amount of working capital if it is able to process its current liabilities without any hassle.
Financial ratios use current liabilities for determining the company's time and efficiency for paying them off. Typically, a current ratio of 2:1 is considered the standard for properly maintaining current assets and liabilities.
Both current liabilities and the current ratio assist creditors in analyzing cash flow situations and current liabilities management. For example, a bank would want to know if your company collects or pays accounts receivable regularly before approving or extending your credit.
Current Assets and Current Liabilities
In essence, current assets are the components that regulate the company's liquidity and the groundwork on which each company works and thrives. Inventories, bills receivable, and debtors are just a few examples of current assets.
Both current assets and liabilities are significant for the company's working capital, which is the amount you're left with after you write off the current liabilities.
Working Capital = Current Assets – Current Liabilities
For example, if X owns $260,000 of current assets and $195,000 in current liabilities, the working capital would be $65,000.
The higher the working capital, the better your company is prepared to perform the everyday business processes without monetary constraints.
A streamlined working capital should help you generate enough cash inflow from your current assets before writing off the current liabilities (short-term obligations).
Types of Current Liabilities
Your balance sheet is the main overview of your business assets, liabilities, and equity for a specific period. The liabilities are always disclosed in a separate balance sheet section, distinguishing between short-term (current) and long-term liabilities.
Current liabilities always have the first claim on the balance sheet, since in most cases, they’re due in the current accounting cycle or within one year, thus written off with other liabilities.
Typically, the balance sheets include the following types of short-term liabilities.
Accounts payable are short-term company debt obligations appearing on the balance sheet under current liabilities. They represent the amount you owe to vendors for the invoices that you haven't paid yet.
In most cases, vendors provide specific timeframes for the client to pay, which means that you'll receive the goods and services on time, but you're allowed to pay for them later, within the specified period.
Accounts payable act as short-term loans. With the time that vendors give you to pay for the invoice, you can use the pre-purchased goods and services to generate revenue and manage your cash supply more efficiently before writing off the short-term debts.
Managing accounts payable is critical for an efficient cash flow. If they continue to rise, it means that you're buying too many goods and services on credit that you can't pay for in the near term.
Conversely, when the accounts payable are in decline, your business has the liquidity to pay off short-term debts much faster than purchasing goods on credit.
Each account payable is credited as soon as the invoice is received. For example, let's say that BMW received an automotive interior electronics shipment from its vendor Dräxlmaier Group for which it must pay $2,000,000 in the next two months.
Since BMW won't use each interior electric component right away, the accountants would have to make an initial entry by debiting the inventory and crediting $2,000,000.
When the payment is finally made to Dräxlmaier Group, BMW's accounting team will write off the $2,000,000 liability by debiting accounts payable and crediting the cash:
- [DR]Accounts Payable: $2,000,000
- [CR]Cash: $2,000,000
A potent accounts payable management can help you foster greater trust with suppliers which is essential in the business world. No vendor wants a delayed payment, and everyone wants to work with someone that pays on time, as agreed in the first place.
In a nutshell, you must always focus on optimizing your accounts payable and free up more working capital for growing your business as a result.
In a given accounting period, accrued liabilities are the company's recorded expenses before they've been paid for. Since they act as an obligation for making future payments, they are presented as current liabilities on an entity's balance sheet.
Typically, accrued expenses provide an estimate that could be different from the exact invoice that will arrive afterward, and the expenses are recognized only when incurred.
For example, if XY buys supplies but doesn't get the purchase invoice from the vendor yet. Then, when the debt is finally paid off, the accounts payable account is debited, and the cash account is credited afterward.
Examples of accrued expense can include:
- Salaries and wages payable
- Bonuses and sick days payments
- Customer warranty and repair payments
- Expenses to be billed the following month
- Purchases with delayed invoices
Let's say you've rented a great parking space for the company car near the office, and you've already signed a lease for which you must pay $600 a month.
Of course, you start using the space immediately. But, as the end of the month approaches, you still haven't got an invoice for the parking space.
Since it's apparent that you won't be able to pay immediately, the accounting team will have to register the parking expense and make adjustments in the books.
When you finally get in touch several days later with the company that rented you the parking space, and after you've received the invoice, the following adjustment must be made once the invoice is paid.
Notes payable is a bill of exchange issued from the lender that obliges the borrower to pay the amount to the lender within the agreed time, coupled with an interest.
There are two types of notes payable:
- Short-Term Notes Payable: They're current liabilities issued when a note payable, its principal amount, and its interest are repayable within one year.
- Long-Term Notes Payable: If a note payable is due to be paid after 12 months, it is considered a long-term liability.
As current liabilities, short-term notes payable can significantly affect the company's net cash and liquidity positions.
When a business decides to borrow money with a note payable, the cash account gets debited for the received amount. The notes payable account is credited to record the liability.
For example, if company XYZ loans $2,600,000 from a bank, XYZ can record that entry as follows.
If the note has a 3% interest rate that must be paid every quarter, XYZ should record the following entry afterward.
Interest payable is the company's interest on its debt and capital leases that it owes to its lenders and providers from the balance sheet date.
This is a critical section of the financial statement analysis. If the interest payable is higher than the standard account, the business retrogrades its debts.
Suppose you owe $500,000 to your lenders at a 7% interest rate, and you must pay the interest every quarter. After one month, you have an interest expense of $6,000 as a debit to the expense and a credit to the interest payable account.
Following the second month, you register the same entry, accumulating an interest payable account balance of $12,000. After the third month, if you re-record the same entry, the total interest payable account balance will be $18,000.
When you pay the interest for the given period, the interest payable account balance will be brought to zero. A greater than average unpaid interest indicates that a given entity is losing money on its debt liabilities, undermining its liquidity position as a result.
Accruing unpaid interest is done by debiting the interest's expense and crediting its payable account.
- [Dr]Interest expense
- [Cr]Interest Payable
The liability is registered on the balance sheet, and the associated expense is invoiced to the income statement.
Income Taxes Payable
Income tax payable is a current liability section that consists of governmental taxes due to be paid within 12 months. The income tax payable is calculated according to the company's home country tax laws and net income.
Income Taxes Payable = Net Income x Tax Rate
It is classified as a current liability because the income tax debt must be written off within a year.
However, if a part of the income tax payable isn't scheduled for payment in the next 12 months, it is considered a non-current (long-term) liability.
The income tax payable liability includes federal, state, local charges, and the dollar amount you'll owe would be the accumulated sum since your last tax return.
Wages payable is a current liability that registers salaries owed to all employees for their work in earlier periods. To put it differently, it's the amount that a given company hasn't paid to employees for their work.
Most often, the wages payable account is activated at the end of the year. However, in some cases, there are days of the week that are not the end of a payroll period.
For example, if you pay employees at the end of each workweek and December 31st falls on Friday, employees will have to wait until January 3rd to get their full wage for December.
This means that you'll owe the employees two more days of salary for December, and you must record that liability within your financial statement by debiting the wages expense and crediting the wages payable for the next available date in January.
Dividends payable are dividends that you designate as payable to shareholders. Until you pay shareholders, the cash from the dividend should be recorded in a dividends payable account as a current liability.
For example, on July 1st, the board of directors of company XYZ designates a $10 dividend to the shareholders of 150,000 ownership shares to be paid on September 30th.
In July, accountants will record a credit to the dividends payable account and a debit to the earnings account, shifting $1,500,000 of equity into current liabilities.
That will remain a liability until September 30th, the maximum allowed time for XYZ to pay the dividends. During payment, XYZ deficits the dividends payable account and credits the cash account, writing off the liability by reducing cash in the process.
Dividends payable are different from other current liabilities because companies are obligated to pay their shareholders. In contrast, the rest of the current liabilities involve third parties such as supplies and lenders.
A large dividend liability can be considered a profitable indication since the company can afford to contribute to the shareholders.
How to Calculate Current Liabilities
Calculating the total current liabilities is really straightforward. All you have to do is calculate the sum of each of the current liabilities applicable to your entity.
Start by reviewing each current liability and include only the ones applicable to your business. Then, add the amount you owe lenders for each of the liabilities for the specific accounting period.
Current Liabilities = Accounts payable + Notes Payable + Accrued expenses + other short-term debts
For example, company X can have the following current liabilities:
- Notes Payable: $1,000
- Accounts Payable: $2,000
- Accrued Expenses: $500
- Other short-term debts: $600
Total Current Liabilities = $1,000 + $2,000 + $500 + $600
Current Liabilities = $4,100
Importance of Calculating Current Liabilities
Current liabilities are an integral part of the current ratio calculation, as the ratio of the company's total value of current assets to the total value of current liabilities.
Current Ratio = Current Liabilities / Current Assets
For example, total current assets of $95,000 and total current liabilities of $35,000 form a current ratio of 2.71, indicating that the given company can pay its current liabilities almost three times by utilizing its current assets.
Financial analysts use the current ratio coupled with the quick ratio, which measures the entity's capacity to meet its liabilities with its current assets.
However, the current ratio does not always paint a clear picture.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Namely, if most of your current assets are in company inventory, it will be much harder to convert them into cash. For example, if your company has:
- $10 million in cash
- $4 million in marketable securities
- $5 million in inventory
- $10.5 million of short-term debt
- $10.5 million in accounts payable
Current assets = 10 + 4 + 5 = $19 million
Current liabilities = 10.5 + 10.5 = $21 million
Current ratio = 19/21 = 0.9x
Thus, if you need immediate funds to write off current liabilities, you'll be strapped with assets that wouldn't be helpful in the long run. Ratios less than one almost always indicate a working capital issue.
However, even higher than average current ratios can pinpoint situations in which companies cannot correctly allocate their assets and liabilities.
With a net working capital of less than zero, businesses need to fix the deficit with long-term borrowings or issuing securities for achieving a much smoother operation.
How to Determine Average Current Liabilities?
Your company's average current liabilities are the average value of the entity's short-term liabilities from the start of the balance sheet period to its end. To successfully calculate the average current liabilities for a given period, start adding the total value of current liabilities on your balance sheet for the start of the specific period to its total value when the period ends, and divide by 2:
Average Current Liabilities = (The total current liabilities when the period starts + Total current liabilities when the period ends) / 2
Current liabilities allow a detailed overview of your company's short-term debts. They remain critical for financial analysts and executives that assess the entity's liquidity and if the working capital is enough for business growth or if the company can settle the debts with its current assets.