Cash flow management is one of the most important aspects of running a successful and financially healthy business. You need to make sure you have enough working capital to meet your current liabilities. Current liabilities are the costs your business needs to pay within its current operating cycle. Understanding current liabilities helps you to plan and calculate important ratios that show the financial health of your business.
In this guide, we’ll explore what current liabilities are and take a look at some of the most common examples. You’ll also learn how to calculate the current liabilities ratio and see the strength of your company’s cash flow.
What Are Current Liabilities?
Current liabilities are short-term financial obligations a company needs to meet within the current operating cycle. The operating cycle at your company is the time it takes for you to purchase inventory, sell to your customers, and receive payment.
Most businesses use current assets like accounts receivables to cover the cost of current liabilities. The money generated from sales is used to meet current liabilities; the remaining balance is your profit.
The most significant current liability for SMEs is usually accounts payable. This is the money your business owes to suppliers in the form of unpaid invoices.
A crucial part of cash flow management is timing. For example, it can be important for the financial health of your business that accounts receivables are collected and converted into cash before you need to pay suppliers.
6 Examples of Current Liabilities
Current liabilities can vary depending on the unique circumstances of your business. For example, some industries can involve much higher current liabilities than others.
But there are several current liabilities that almost all businesses incur, including:
1. Accounts Payable
Accounts payable are the payments that your company is due to make to suppliers.
Most suppliers and vendors offer net payment terms that allow customers to receive goods and services before paying for them. Net payment terms act as a line of credit that enables a customer to make a purchase without the upfront cost.
When you purchase inventory on credit terms, the total value of the invoice is listed in your current liabilities.
Many businesses use Trade Finance or other types of funding to increase purchasing power and secure better terms from suppliers. Vendors often provide lower rates and discounts to customers that pay for goods and services upfront.
2. Accrued Expenses
Accrued expenses are costs incurred that your business has yet to receive an invoice for. These current liabilities are used in the accrual accounting method of recording financial transactions. Expenses are recorded when they are incurred instead of when your business settles the unpaid invoice.
The most common accrued expenses include:
- Debt repayments due in the operating cycle
- Tax payments
- Employee wages or commission payments
Accrued expenses are short-term financial obligations. Most companies use their working capital to cover the cost of these current liabilities.
3. Taxes
Taxes are recorded as current liabilities if the payment date falls within your business operating cycle. This can include income tax payments that have yet to be paid and other tax contributions. For example, your business must cover state or territory payroll taxes and pay as you go tax deducted from employee taxable wages.
You may also need to collect and pay Goods and Services Tax (GST) if you sell directly to consumers. Depending on your turnover and tax arrangements, you will be required to report GST and make monthly, quarterly, or yearly payments.
4. Short-Term Debt
Current liabilities include the short-term debt your business is due to repay within the current operating cycle. This could consist of bank loan repayments, overdrafts, lines of credit, and other types of Business Finance. It doesn’t include the total value of long-term loans or other debt commitments. But it does include all repayments that fall in the operating cycle.
For example, any scheduled business loan repayments in the operating cycle would be recorded as current liabilities.
5. Payroll Liabilities
All payroll costs during your operating cycle are recorded as current liabilities. This includes the cost of wages but also employee benefits like super contributions, medical insurance, and other expenses.
6. Unearned Revenue
Sometimes, you may receive payment upfront for goods or services your company has yet to provide. The money received from these upfront customer payments is categorized as unearned revenue.
Unearned revenue is recorded as a current liability as it is a form of debt that your business owes to your customer. If the delivery of the goods or services falls in the current operating cycle, it is registered as a current liability.
How to Work Out Your Current Liabilities Ratio/Quick Ratio
Calculating the current assets to current liabilities ratio shows how well your business can meet its debts as they become due. It’s a valuable tool to help you predict your cash flow and financing needs. Most businesses use the current ratio to measure their ability to meet financial obligations.
The current ratio is calculated by dividing current assets by current liabilities. This will reveal if you have enough assets on your balance sheet to meet your debt repayments and other payables. For example, let’s say your business has assets of $400,000 and liabilities of $250,000.
Current Assets / Current Liabilities = Current Ratio
$400,000 / $250,000 = 1.6
Some SMEs use the quick ratio instead of the current ratio. The formula for the quick ratio is the same, but the total value of inventory is subtracted from the current assets before the calculation.
Suppose your company had $400,000 in current assets, but $100,000 was tied up in inventory. You would deduct the $100,000 from your current assets before calculating the quick ratio.
Current Assets – Inventory / Current Liabilities = Current Ratio
$400,000 – $100,000 / $250,000 = 1.2
The quick ratio is more conservative than the current ratio as it only includes current assets that you can quickly convert into working capital.
What Is a Good Current Liabilities Ratio?
A number above 1 is generally considered a “good” current or quick ratio. If you have a ratio of 1, it indicates that you have $1 in current assets for every $1 you owe in current liabilities. A ratio of 5 means you have $5 in current assets for every $1 in liabilities.
If you have a ratio of less than 1, it shows that your current liabilities are larger than your current assets. This could indicate that your company may struggle to meet its financial obligations during the operating cycle.
But it doesn’t always mean that a business isn’t profitable.
Invoice Finance Solutions
One of the most significant issues SMEs face is the financial burden of net payment terms. In many cases, accounts payable will be due before your company receives payment for the goods and services you have already sold. This is where cash flow funding solutions like Invoice Finance can help.
Invoice Finance allows a business to use its outstanding sales invoices as collateral for financing. You can get paid faster and speed up your cash inflows.
According to the May 2022 Xero Small Business Insights, the average time a small business needs to wait for payment increased by 0.8 days to 23.7 days. SMEs are now facing the longest wait time to receive payment since September 2020.
With Invoice Finance, you can access a cash advance of up to 95% of the invoice value within 24 hours. Then, when your customer pays, you get the remaining balance, less the fees charged by the financing company. You can use Invoice Finance to get paid faster and ensure that working capital meets your cash flow needs. Learn more about this type of business funding in our guide, What is Invoice Finance?.
ScotPac Business Cash Flow Solutions
Invoice Finance can provide an immediate cash flow boost for your business. You can use your outstanding invoices to secure a cash advance within 24 hours so you can pay suppliers, cover wages, and keep your business moving.
If you’d like to find out how Invoice Finance can work for you, speak to our friendly team of Business Finance experts today. Use our simple online enquiry form or give us a call for a chat with a member of our award-winning funding team.