Current liabilities are financial commitments that mature within an year. In other words they are short-term in nature. Creation of such commitments is natural in the process of conduct of business. A business that offers credit to its customers is also forced to buy its raw materials on credit.
Looking from the angle of financing or funding a business operation, current liabilities are a crucial source of funding the current assets.
Current liabilities are paid off out of trade collections – in other words by realizations of current assets like inventory and receivables.
Current liabilities are the second component in the calculation of the important liquidity ratio – current ratio – it forms the denominator of the formula.
- Trade or supplier or vendor payables
- Short-term bank borrowings in the form of cash credits, bill discounting facilities, factoring arrangements, etc.
- ‘I Owe You’ or IOUs
- Tax dues
It goes without saying that a business should possess adequate current assets, which can be quickly converted into cash, to be able to honor current liabilities on time. The recommended proportions being:
- Total current assets shall be at least double the total current liabilities
- Quick current assets namely cash, bank balances and receivables shall be at least equal to total current liabilities
Inability to meet current liabilities on time indicates lack of liquidity and an organization in such a condition is termed as sick.
Since current liabilities have a short maturity, they should not be used as source to fund long-term assets, say fixed assets. Such a misuse is called diversion of working capital that could result in the business becoming sick and therefore is viewed as a serious violation of financial norms by banks and financial institutions.