Current liability definition
/What is a Current Liability?
A current liability is an obligation that is payable within one year. The cluster of liabilities comprising current liabilities is closely watched, for a business must have sufficient liquidity to ensure that they can be paid off when due. All other liabilities are reported as long-term liabilities, which are presented in a grouping lower down in the balance sheet, below current liabilities.
In those rare cases where the operating cycle of a business is longer than one year, a current liability is defined as being payable within the term of the operating cycle. The operating cycle is the time period required for a business to acquire inventory, sell it, and convert the sale into cash. In most cases, the one-year rule will apply.
Since current liabilities are typically paid by liquidating current assets, the presence of a large amount of current liabilities calls attention to the size and prospective liquidity of the offsetting amount of current assets listed on a company's balance sheet. Current liabilities may also be settled through their replacement with other liabilities, such as with short-term debt.
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Accounting for Current Liabilities
The initial entry to record a current liability is a credit to the most applicable current liability account and a debit to an expense or asset account. For example, the receipt of a supplier invoice for office supplies will generate a credit to the accounts payable account and a debit to the office supplies expense account. Or, the receipt of a supplier invoice for a computer will generate a credit to the accounts payable account and a debit to the computer hardware asset account.
Current Liability Usage in Ratio Measurements
The aggregate amount of current liabilities is a key component of several measures of the short-term liquidity of a business, including the following:
Current ratio. The current ratio measures the ability of an organization to pay its bills in the near-term. It is a common measure of the short-term liquidity of a business. To calculate the current ratio, divide the total of all current assets by the total of all current liabilities. The formula is:
Current assets ÷ Current liabilities = Current ratio
Quick ratio. The quick ratio is used to evaluate whether a business has enough liquid assets that can be converted into cash to pay its bills. To calculate the quick ratio, summarize the totals for cash, marketable securities and trade receivables, and divide by current liabilities. Do not include in the numerator any excessively old receivables that are not likely to be paid, such as anything over 90 days old. The formula is:
(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Quick ratio
Cash ratio. The cash ratio compares a company's most liquid assets to its current liabilities. It is the most conservative of all the liquidity measurements. The formula for the cash ratio is to add together cash and cash equivalents, and divide by current liabilities. The calculation is:
(Cash + Cash equivalents) ÷ Current liabilities = Cash ratio
For all three ratios, a higher ratio denotes a larger amount of liquidity and therefore an enhanced ability for a business to meet its short-term obligations.
Examples of Current Liabilities
The following are common examples of current liabilities:
Accounts payable. These are the trade payables due to suppliers, usually as evidenced by supplier invoices.
Sales taxes payable. This is the obligation of a business to remit sales taxes to the government that it charged to customers on behalf of the government.
Payroll taxes payable. This is taxes withheld from employee pay, or matching taxes, or additional taxes related to employee compensation.
Income taxes payable. This is income taxes owed to the government but not yet paid.
Interest payable. This is interest owed to lenders but not yet paid.
Bank account overdrafts. These are short-term advances made by the bank to offset any account overdrafts caused by issuing checks in excess of available funding.
Accrued expenses. These are expenses not yet payable to a third party, but already incurred, such as wages payable.
Customer deposits. These are payments made by customers in advance of the completion of their orders for goods or services.
Dividends declared. These are dividends declared by the board of directors, but not yet paid to shareholders.
Short-term debt. This is loans that are due on demand or within the next 12 months.
Current maturities of long-term debt. This is that portion of long-term debt that is due within the next 12 months.
The types of current liability accounts used by a business will vary by industry, applicable regulations, and government requirements, so the preceding list is not all-inclusive. However, the list does include the current liabilities that will appear in most balance sheets.