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.