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Current assets - what are they? - Views on News from Equitymaster
 
 
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  • Aug 27, 2009

    Current assets - what are they?

    In the previous article of this series, we discussed one of the components of the 'Application of funds' side of the balance sheet - Fixed assets. In this article we shall take a look at another component - current assets.

    As compared to fixed assets, which are relatively more difficult to liquidate, current assets are easier to convert into cash. The reason why fixed assets are less liquid in nature is because of their influence on a company. The usage of current assets on a company is more short term in nature (usually a period of one year) as against that of a fixed asset. Current assets are assets that are used to fund day to day operations and pay ongoing expenses of a company.

    The most common current assets include sundry debtors, inventories, cash and bank balances, loans and advances, amongst others. We shall briefly discuss some of the key current assets one by one.

    What are inventories?
    Inventories are goods that are in different stages of production and have not yet been sold. As such, they could be finished or semi-finished products. As you may be already aware, goods when manufactured go through various processes - from being a raw material to a semi-finished good (work-in-progress) to a finished good. Inventories would also include packaging material. Many a times, you may also find an entry such as good-in-transit under inventories. These are goods that have departed from the dispatch point but have not yet arrived at the delivery point.

    An interesting tool that would help understand and analyse the inventory position of a company is 'Inventory turnover'.

    Inventory turnover is calculated by dividing the sales by the inventory of a particular period (usually a year).

    As such, Inventory turnover = Net sales/ inventory

    Let us explain this with the help of an example. FMCG major Nestle had inventories worth Rs 4.4 bn at the end of CY08, i.e. 31st December 2007. The company reported a topline (net sales) of Rs 42.2 bn. As such, the company had an inventory turnover of 9.6 times. This means that, the company will be able to sell the current level of inventory nearly 9.6 times each year. The higher the inventory turnover ratio, the better it is for a company.

    Let us take an example. Suppose company XYZ reported a topline of Rs 5 bn and had an inventory of Rs 15 bn. This means that if company XYZ maintains the level of inventory throughout the year, it will take nearly three years to clear the inventory level it currently has. This indirectly indicates that the inventory management has been poor as the company's management has locked in a lot of funds towards inventories.

    It may be noted that one could also calculate inventory turnover by dividing the inventory by the cost of goods sold (COGS) during the year. The reason we can calculate it with COGS is because the inventories are valued at cost and not on sale prices.

    Another popular metric that is used is that of 'inventory days'. This is calculated as follows:

    Inventory days = 365/ Inventory turnover

    or

    Inventory days = 365/ (Sales/inventory)

    As such, Inventory days = Inventory/Sales *365

    While inventory turnover measures the number of times (on an average) the inventory is sold during the period, inventory days is a ratio which indicates the number of days it takes a company to sell its inventory. That is the reason for the division of 365/inventory turnover.

    Before we move on to the next current asset, we would like to mention that it would only make sense for one to compare this parameter between companies that are present in the same or similar businesses.

    What are sundry debtors?
    In simple terms, debtors are persons who owe money to the company. Typically, such debts are on goods and services that are sold on credit. Sundry debtors can also be termed as 'accounts receivable'. The reason sundry debtors are recorded as assets to a company is because the money belongs to the company, which it expects to receive within a short period.

    From an investor's perspective, it would help to analyse the speed at which a company is able to collect the money from its debtors. If a company's collection period is long or is expanding, it is not a good sign. Apart from meeting daily expenses, a company would also prefer having low debtor days (mentioned below) to avoid the risk of defaults.

    Similar to inventory days, there is a ratio which helps in analysing the number of days it takes a company to collect payments from its debtors. This ratio is termed as 'debtor days'. The formula for the same is:

    Debtor days = Debtors/Sales * 365

    Let us take up an example to understand this further. At the end of CY08, sundry debtors on Nestle's books stood at Rs 455.9 m. The company had reported net sales of Rs 43,242.5 m. As such, by using the above formula, the outcome is 3.8 days. This means that the company is able to collect its payments within an average period of 3.8 days, which is a very low period.

    Let's compare this to an engineering company such as Punj Lloyd. At the end of FY09, the receivables on the company's books stood at Rs 26.7 bn, while it reported a topline (net sales) of Rs 119.1 bn. As such, the company had average receivable days of 81.8 days during the year.

    We would like to reiterate that these figures (inventory days and debtor days) should be compared to companies within a particular sector. Comparing companies across industries would throw up different numbers, purely due to the nature of the respective businesses.

    What are cash and cash equivalents?
    As you may be aware, cash and cash equivalents are the most liquid assets found in any company's balance sheet. As an investor, you must have heard experts recommend investing in cash rich companies (especially in recent times). Why would this be the case? This is simply because it would allow companies to meet expenses in a downturn when the business is slow.

    Cash does not only offer protection against difficult times, but also gives companies more options for future growth. Companies could grow by acquiring companies. If they do not find a company that meets their criteria, they could pay their shareholders through dividends.

    However, a big cash balance is not always a good sign. What would be an optimum cash balance that a company must have depends from sector to sector. Sometimes, it differs between companies within a particular sector.
    One could analyse cash levels as a percentage of sales. We ran a query on CMIE Prowess to study some of these figures between companies that form part of the BSE-IT and BSE-FMCG indices.

    During the last five years, the average cash balance as a percentage of sales (standalone figures) stood at about 4% for companies that form part of the BSE-FMCG Index. On comparing the same parameter on companies that form part of the BSE-IT Index, the figure stood at an average of 24%.

    For instance, during the period between CY99 to CY04, Nestle maintained cash to sales average of 0.4%. During the last four years it has increased to an average of 2.4%. During CY08, the company's cash balance stood at 4.5% of its full year net sales.

    What are loans and advances?
    Loans and advances include various items such as advance to suppliers and vendors (in accounting terminology it is known as 'advances recoverable'), advance tax payments (income tax, wealth and fringe benefit tax), loans to employees, deposits, balance with customs, amongst others.

    In the next article, we shall take a look at current liabilities and also briefly glance through the topic of working capital.

    Investing: Back to Basics Article Series - Previous article | Investing: Back to Basics Article Series | Next article

     

     

    Equitymaster requests your view! Post a comment on "Current assets - what are they?". Click here!

    2 Responses to "Current assets - what are they?"

    Deb

    Sep 1, 2009

    Dear K D Vartik The last line of the article gives
    link to previous articles. The link Investing back to
    basics

    Like 

    K.D.Vartak

    Aug 30, 2009

    The article is very useful to a layman like me. Please let me know if I can access the previous articles in the series, Thanks. I have sent you this request a few days ago but you have not responded, Thanks

    Like 
      
    Equitymaster requests your view! Post a comment on "Current assets - what are they?". Click here!
     

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