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Financial Accounting: Future Obligations Journal

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Financial Accounting: Future Obligations Journal

Kimmel, Weygandt, and Kieso (2010) note that many business owners eschew the use of the word debt in describing their financial positions. However, research indicates that no company can easily function without incurring some debts, which may belong or short-term liabilities. Long-term liabilities are the obligations that take a company more than one year to settle. Current liabilities, on the other hand, are debts or obligations that must be settled within one year of the date of the balance sheet (Kimmel, Weygandt, and Kieso, 2010). These include accounts payables, overdrafts, accrued expenses, bills payables, tax liabilities, provisions, and prepaid incomes. A company must settle these liabilities within one year of a company’s balance sheet. However, for a company to service these obligations, it must convert some of its assets, mainly the current assets, such as inventory and debtors. This implies that the company’s ability to meet its future obligations depends highly on the number of current assets and current liabilities it has at its disposal.

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Kimmel, Weygandt, and Kieso (2010) argue that knowing the current liabilities is very important for business owners because it helps in gauging the financial health of a business since business needs to be liquid enough for being able to meet its obligations in the short term. Therefore, a company that understands its current liabilities will be able to understand the liquidity position of a business by gauging whether the current assets can cover the short-term obligations when they fall due. This analysis is usually carried out using the current ratio and the working capital according to Kimmel, Weygandt, and Kieso (2010).

Therefore, by comparing the current liabilities and current assets, it becomes easy for a company to know the amount of liquid cash it may have in case it needs to pay off its current liabilities today. This is usually carried out by determining the current ratio of the company by dividing the total current assets and current liabilities (Kimmel, Weygandt, and Kieso, 2010). According to Kimmel, Weygandt, and Kieso (2010), a current ratio greater than one is preferable. It shows that the business will be able to meet its current obligations using the current assets when they fall due. In this regard, it becomes clear that a company needs to ensure that its current assets can cover all its short-term obligations; otherwise, the company will default in meeting its short-term obligations. Also, this implies that a company should not hold too many current liabilities than its current assets because this will lead to liquidity problems making it difficult for the company to meet its current obligations when they fall due as noted by Kimmel, Weygandt, and Kieso (2010).

Kimmel, Weygandt, and Kieso (2010) reveal that the company’s ability to meet its future obligations can also be understood by determining the company’s working capital. A company’s working capital is calculated by deducting the company’s current liabilities from the current assets (Kimmel, Weygandt, and Kieso, 2010). The working capital obtained represents the company’s operating liquidity. In this regard, a high working capital shows a company’s ability to meet its short-term obligations and future operating expenses when they fall due. However, if the working capital turns out to be negative where the current liabilities exceed the current assets, this implies that the company may not be able to meet its future commitments as and when they fall due according to Kimmel, Weygandt, and Kieso (2010). This will be very dangerous because this may send bad signals to the creditors and other investors of the company (Kimmel, Weygandt, and Kieso, 2010). Therefore, a company should always ensure that it has enough working capital capable of meeting its short-term obligations, which is healthy for the company.

What the analysis tells of the future obligation of the company

The analysis of the company’s current financial position shows that the company has relatively more current assets than current liabilities. In addition, based on the current assets and current liabilities held by the company, it came out that the company’s current ratio obtained by dividing the current assets by current liabilities was more than 1. This implies, therefore, that the company is adequately liquid to meet its future obligations as and when they fall due. In other words, the company has enough assets that can easily be converted to cash to meet its future obligations. This is indeed a healthy financial position as far as maintaining creditors’ and investors’ confidence in the company. The company is liquid enough to pay off all its debts at any time in the future.

The same has also been reflected through the company’s working capital, which shows that the company has enough current assets capable of being converted into cash and used for servicing its future obligations as and when they fall due. Based on the current liability concept, a high working capital indicates the company’s ability to meet its future short-term obligations as and when they fall due (Kimmel, Weygandt, and Kieso, 2010). Therefore, since the company’s working capital has turned out to be positive, this means that the company is liquid enough to meet all its short-term future obligations as and when they fall due without any difficulty.

Lessons learned from experience

Many business people indeed tend to avoid the use of debts in describing their financial position. However, as earlier indicated, liabilities are a part of business and no business can operate to full capacity without debts (Kimmel, Weygandt, and Kieso, 2010). Nonetheless, from the analysis, I have come to learn of the importance of maintaining the company’s liquidity at a sufficient level that can cover short-term obligations as and when they fall due. In this regard, I have learned that a company must ensure that its current assets are maintained at a level that is higher than the current liabilities. Hence, with enough current assets, the company can easily convert these assets into cash and pay off its short-term obligations without necessarily having to borrow more funds, which only will increase the liquidity problem of a company. This implies that a company should not fear having current liabilities as long as it has enough current assets to cover all current liabilities.

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In addition, I have learned from the analysis that current ratios and working capital are some of the best measures of the company’s ability to meet its future obligations as and when they fall due. This can be explained by the fact that these measures indicate the liquidity position of a business as noted by Kimmel, Weygandt, and Kieso (2010).

Reference

Kimmel, P.D., Weygandt, J. J., & Kieso, D. E. (2010). Financial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons.

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