Current Assets

What are current assets?

Current assets (German: Umlaufvermögen) are the assets of a company that are consumed, processed, sold or converted into means of payment in the ordinary course of business. Unlike fixed assets, they are not intended to serve the business permanently. Current assets include inventories, receivables and other assets, securities, and cash in hand and bank balances. In a bakery, for example, the oven and the shop fittings are fixed assets, while flour, bread rolls and the day's takings in the till are current assets.

The German Commercial Code (Handelsgesetzbuch, HGB) defines only fixed assets (Section 247 (2) HGB). Current assets therefore include every asset that is not a fixed asset. In the assets section of the balance sheet, it is shown after fixed assets, broken down under Section 266 (2) HGB and measured under Section 253 (1) and (4) HGB. In practice it is the starting point for the analysis of liquidity and working capital and for the purchase price adjustment in a business acquisition. Banks use it to size working capital loans, that is, loans for day-to-day business.

Components of current assets with examples

• Inventories: raw materials, consumables and supplies, work in progress and unfinished services, finished goods and merchandise, and prepayments made on inventories. Examples are components in the warehouse of a hardware manufacturer or the merchandise of an online retailer.
• Receivables and other assets: above all trade receivables, that is, open customer invoices, alongside receivables from affiliated companies and other assets such as tax refund claims.
• Securities: shares and securities held only temporarily, for example money market funds or short-dated bonds for investing surplus funds.
• Liquid funds: cash in hand, balances with the Bundesbank (Germany's central bank), balances with credit institutions and cheques.

Formula: Current assets = inventories + receivables and other assets + securities + liquid funds

Without inventories, what remains is monetary current assets consisting of receivables, securities and liquid funds. It feeds into the liquidity ratios, which set short-term available funds against short-term liabilities.

At software and consulting companies, inventories often consist only of unfinished services, that is, projects not yet accepted. Under the HGB they stand in the balance sheet at their production cost until acceptance; a profit share is realised only on acceptance. Prepayments received on them may be openly deducted from inventories (Section 268 (5) HGB).

Measurement of current assets: the strict lower of cost or market principle

The starting point is acquisition or production cost. If the stock exchange or market price on the reporting date is lower, the asset must be written down to this lower value (Section 253 (4) HGB). If there is no such price, the attributable value (beizulegender Wert) takes its place, that is, the value the asset has for the company on the reporting date. This principle is called strict because, unlike for fixed assets, it applies even if the impairment is expected to be only temporary.

If the value rises again later, the write-down must be reversed, but only up to the original cost (Section 253 (5) HGB); higher values are disregarded. A trader who bought goods for EUR 100 and can only realise EUR 70 on them on the reporting date after deducting selling costs carries them at EUR 70. If the achievable price rises to EUR 120 in the following year, the trader may carry them at no more than EUR 100 again. For tax purposes, a write-down to the lower going-concern value (Teilwert) is permissible only if the impairment is expected to be permanent (Section 6 (1) no. 2 of the German Income Tax Act, EStG). In simplified terms, the Teilwert is the amount that a buyer of the whole business would attribute to the individual asset.

For inventories, the comparison value for raw materials, consumables and supplies is based on replacement cost, and for finished goods and merchandise on the achievable selling price less the costs still to be incurred (loss-free measurement). Items with low turnover are written down using marketability discounts. For inventories of the same kind, measurement simplifications such as average values or consumption-sequence methods are permissible (Section 256 HGB), for example the assumption that the items bought first are used first.

Receivables are carried at nominal value and adjusted for identifiable default risks: individually for specifically endangered receivables, and by a general allowance for the general default risk of the remaining portfolio. The basis of assessment is the net amount, because VAT is corrected if the receivable proves uncollectible under Section 17 of the German VAT Act (Umsatzsteuergesetz, UStG). Liquid funds are carried in the balance sheet at their nominal value; balances in foreign currency are translated at the closing rate.

Current assets and working capital

Working capital is derived from current assets (see working capital). On the balance sheet, it is current assets less short-term liabilities. For management and business acquisitions, management and buyers usually use the operational measure: inventories and trade receivables less trade payables, excluding liquid funds. Capital tied up is measured in days: receivables days, inventory days and payables days towards suppliers, summarised in the cash conversion cycle. Inventory days are the counterpart to inventory turnover: 365 days divided by the number of turns per year.

If revenue grows, operational current assets grow in roughly the same proportion, with unchanged terms. This funding need arises before the growth delivers surpluses and is easily overlooked in earnings planning. It is financed through own funds, an overdraft facility or the sale of receivables in factoring.

Current assets in due diligence and purchase price

In financial due diligence, current assets are checked for recoverability and normal level. The buyer's side analyses the ageing structure of receivables using the open items list, the statement of all invoices not yet paid. It also reviews stocktake results and the marketability of inventories, as well as effects at the reporting date, such as a sale of receivables carried out shortly before. A normalised working capital is derived from monthly figures, usually of the last twelve months.

The purchase agreement fixes this value as a target; if working capital at closing deviates from it, the purchase price is adjusted (working capital adjustment). Liquid funds enter the purchase price bridge separately, the reconciliation from enterprise value to the purchase price for the shares, and only to the extent they are freely available. A buyer often does not recognise pledged balances, rent deposits or the minimum liquidity needed for ongoing operations as increasing the purchase price.

Worked example: calculating current assets and working capital

A provider of measurement technology with its own software achieves annual revenue of EUR 14,600,000 with a cost of materials of EUR 7,300,000. Per day, that corresponds to EUR 40,000 of revenue and EUR 20,000 of cost of materials (each divided by 365). For simplicity, VAT is disregarded in the terms.

• Trade receivables: EUR 2,400,000, receivables days 2,400,000 / 40,000 = 60 days
• Inventories: EUR 1,800,000, inventory days 1,800,000 / 20,000 = 90 days
• Trade payables: EUR 900,000, payables days 900,000 / 20,000 = 45 days
• Operational working capital: 2,400,000 + 1,800,000 minus 900,000 = EUR 3,300,000
• Revenue and cost of materials grow by 25%, the terms in days remain the same: 3,300,000 × 1.25 = EUR 4,125,000, additional funding need EUR 825,000
• Same growth, but receivables days 45 instead of 60; per day EUR 50,000 of revenue and EUR 25,000 of cost of materials
• Receivables 45 × 50,000 = EUR 2,250,000, inventories 90 × 25,000 = EUR 2,250,000, suppliers 45 × 25,000 = EUR 1,125,000
• Working capital in this case: 2,250,000 + 2,250,000 minus 1,125,000 = EUR 3,375,000, additional need only EUR 75,000

In due diligence, the buyer also checks the measurement:

• Inventories: Items with a book value of EUR 300,000 have not moved for more than twelve months; a marketability discount of 50% reduces inventories by EUR 150,000.
• Receivables: A receivable of EUR 119,000 including VAT against an insolvent customer has not been written down. If a complete default is expected, the specific allowance is based on the net amount of 119,000 / 1.19 = EUR 100,000.
• Adjusted operational working capital: 3,300,000 minus 150,000 minus 100,000 = EUR 3,050,000

Both corrections reduce equity at the reporting date. The example shows two things: faster payment receipts save EUR 750,000 of funding need during growth, and measurement gaps of EUR 250,000 are noticed in due diligence. For the purchase price adjustment, the target value and the value at closing must be determined under the same measurement rules; otherwise adjustments arise that follow only from the method.

Distinction: current assets, fixed assets and working capital

• Fixed assets: assets intended to serve the business permanently. What matters is the intended purpose in the individual company, not the nature of the asset.
• Working capital: a difference figure derived from current assets. In the operational version, liquid funds are disregarded, because they go into net debt.
• Liquidity: the ability to make payments as they fall due. Current assets contribute to it, but only liquid funds and unused credit lines are available immediately.

Common mistakes

• Growth planned without working capital need. Earnings planning without changes in receivables and inventories underestimates the funding need precisely in the phase in which the company grows fastest.
• Overdue receivables not written down. Receivables that have been open for many months stand in the balance sheet at full value and are written down in due diligence.
• Slow-moving stock at cost. Inventories with no movement for a long time require a write-down under the lower of cost or market principle.
• Restricted funds shown as freely available. Rent deposits, pledged balances and balances with restrictions on disposal do not belong in freely available liquid funds.
• Reporting date optimised. A sale of receivables or delayed supplier payments shortly before the reporting date improve the figures of one day; buyers strip out such effects using monthly averages.

Frequently asked questions

How do current assets differ from fixed assets?

In their intended purpose, not in useful life. Fixed assets are meant to serve the business permanently, while current assets are consumed, processed or sold. The same asset can therefore belong to one or the other depending on the company.

Do liquid funds belong to working capital?

On the balance sheet yes, in the operational view no. In a business acquisition, freely available liquid funds are netted against financial liabilities, while operational working capital is regulated through its own target value.

Are current assets depreciated?

Not on a scheduled basis, because they are not used over several years. If their value on the reporting date is below acquisition or production cost, however, they must be written down to the lower value, even if the impairment is only temporary. If the reason ceases later, the write-down is reversed, at most up to the original cost.

Is there such a thing as long-term current assets?

Yes. Under the HGB, the purpose decides, not the term: a customer receivable that is paid in instalments over three years remains a current asset. The amount with a remaining term of more than one year must, however, be noted (Section 268 (4) HGB). IFRS (International Financial Reporting Standards), by contrast, separate short-term and long-term assets (current and non-current assets), as a rule by a period of twelve months or the operating cycle.

How much current assets are appropriate?

That depends on the business model. A trading company ties up a lot of capital in inventories, a software provider with advance payments hardly any. More informative than the absolute amount are the terms in days and their development over several quarters.

The Roemer Capital view

In the financial model, we do not plan current assets as a residual figure but through terms in days: receivables days, inventory days and payables days towards suppliers. This makes visible which part of a funding round is tied up in pre-financing and which is actually available for growth. With a runway, that is, the reach of liquid funds, of 12 to 18 months at the start of the process, this difference can amount to several months.

In the sales process, we derive a normalised working capital from monthly data early on with the management and adjust receivables and inventories in advance for identifiable write-downs. The target value negotiated in the purchase agreement is then based on figures that the buyer can confirm in due diligence.