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Managing Liquidity and Cash Flows in Financial Accounting
The primary reason a company incurs current liabilities is to meet its needs for cash during the operating cycle. The operating cycle is the length of time it takes to purchase inventory, sell the inventory, and collect the resulting receivable. Most current liabilities arise in support of this cycle, as when accounts payable arise from purchases of inventory, accrued expenses arise from operating costs, and unearned revenues arise from customers’ advance payments. Companies incur short-term debt to raise cash during periods of inventory buildup or while waiting for collection of receivables. They use the cash to pay the portion of long-term debt that is currently due and to pay liabilities arising from operations.
Failure to manage the cash flows related to current liabilities can have serious consequences for a business. For instance, if suppliers are not paid on time, they may withhold shipments that are vital to a company’s operations. Continued failure to pay current liabilities can lead to bankruptcy. To evaluate a company’s ability to pay its current liabilities, analysts often use two measures of liquidity—working capital and the current ratio. Current liabilities are a key component of both these measures. They typically equal from 25 to 50 percent of total assets.
As shown below (in millions), Johnson’s short-term liquidity as measured by working capital and the current ratio was positive in 2008 and improved somewhat in 2009.
The increase in Johnson’s working capital and current ratio from 2008 to 2009 was caused primarily by a large increase in cash and short-term investments. Overall, Johnson is in a strong current situation and exercises very good management of its cash flow.
Current Liabilities Topics
Managing Liquidity and Cash Flows
- Accounts payable
- Discounts in Current Liabilities
- Notes Payable
- Accrued Liabilities (Accrued Expenses)
- Current Maturities/Portion of Long-Term Debt
- Taxes Payable
- Accrued Restructuring Costs
- Advance Payments from Customers
- Obligations for Warranties
Commitments, Contingencies and Risks
