Balance Sheet – Assets

Assets are things that a company owns that have value which are expected to provide future benefits. This usually means that they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property such as plants, trucks, equipment, and inventory. They also include things you can’t touch but still exist and have value, such as trademarks and patents. And cash itself is an asset. The same applies to investments that a company makes. To qualify as an asset, the following requirements must be met:

• A company must own the resource
• The resource must be of value
• The resource must have a quantifiable, measurable cost

Assets are generally listed based on how quickly they can be converted into cash.

1. Current Assets are things that a company expects to convert to cash within a year. A good example is inventory. Most companies expect to be able to sell their inventory for cash within a year.
2. Noncurrent (or long-term) Assets are things that a company does not expect to be able to convert to cash within one year or would take longer than one year to sell. Noncurrent assets include fixed assets. Fixed assets are assets that are used for the operation of the business but are not for sale, such as trucks, office furniture and other property.

Current Assets

Current assets are assets that are highly liquid and intended to be used during the course of the next year or during the current business cycle, whichever is longer. Current assets are typically listed in order of liquidity, beginning with cash and cash equivalents. Cash is the most liquid asset.

Cash and Cash Equivalents

This item doesn’t necessarily refer to actual bills sitting in a cash register or vault. Generally, cash is held in low-risk, highly liquid investments such as money market funds. These holdings can be liquidated quickly with little or no price risk. They’re considered cash that can be used for any purpose of the company.

Too little cash does not bode well for a company, bringing into question its ability to maintain daily operations and pay obligations. However, too much cash may be problematic and may reduce the earnings potential of a company. A well-run company should be able to earn more through its normal business than the prevailing interest rate. Vast amounts of cash may also spur management to make poor decisions instead of making prudent investments or returning value to shareholders. Additionally, high growth companies need cash on hand to fund expansion. Conversely, slowing or contracting businesses may temporarily see cash levels rise as expenditures are curtailed at a pace faster than the decline in revenues.

Short-term Investments

This represents money invested in bonds or other securities that have a maturity of less than one year and yield a higher return than cash. The company will earn interest or can sell the investment for cash. These investments may take a little more effort to sell, but in most cases, investors can lump them in with cash to find out how much money a company has available to meet its immediate needs. Example:

• Money market funds
• Short-term bonds
• Short-term debt securities.

Trade and Other Receivables

Accounts Receivable (or Trade Receivables)

Think of accounts receivable as bills that a company sends to its customers for goods delivered or services rendered but for which the customer hasn’t yet paid but is expected to pay within 12 months. In other words, these are sales (recognised in the income statement) that haven’t yet been paid in cash.

Generally, accounts receivable is reported as the net amount of what a company ultimately expects to receive because some customers are unlikely to pay. The amount of accounts receivable a company believes it won’t be able to collect is usually referred to as the allowance for doubtful accounts. Additions to the allowance for doubtful accounts not only reduce the amount of receivables, but also increase a company’s expenses – known as bad debt expense.

Here is a good illustration of Accounts Receivable.

A relatively low accounts receivable figure may mean that a company is efficient in collecting its payments, that credit standards are strict (which can depress sales), or that a company operates in a payment on-demand business (e.g., restaurants). A high accounts receivable figure may mean a company is having difficulty collecting payments or that credit standards are too loose. A better understanding of a company’s accounts receivable figure can come from analysis over several years. Accounts receivables increasing at a substantially faster rate than overall sales is a potential red flag, signaling that the company may be relaxing credit standards to boost sales. It can also mean that customers are having problems paying their bills, a troubling sign for future revenues and profits. In either case, as accounts receivables increase, a larger portion of invoices due will be uncollected, which reduces the value of the balance sheet line item. Companies may maintain a reserve against potentially uncollectable accounts receivables, titled “allowance for doubtful accounts.” This contra-asset account represents management’s estimate of the dollar amount that will be uncollected because of customer defaults.

Other / Nontrade Receivables

Nontrade receivables are amounts due for payment to a company other than its normal customer invoices for merchandise shipped or services performed. Example of other receivables: Interest receivable, income tax receivable, insurance claims receivable, receivables from employees, deposits and prepaid expenses.

Inventories

There are many different types of inventories, including raw materials, partially finished products, and finished products awaiting sale. This item is especially important for manufacturing and retail businesses that need to hold large amounts of inventory. Inventories tie up capital. The cash that was used to create inventories cannot be used for other purposes until it is sold.

Here is a good illustration of Inventories.

A certain inventory level is needed for fi rms to be able to meet demand and not lose sales opportunities. However, companies with very high inventory levels risk being unable to convert their inventory into sales. This balance is especially important in industries with constant product innovation. Over time, inventory can become obsolete or lose value if there is a product glut. For example, in the technology sector, the personal computing industry is very fast-moving. Companies with low inventory levels will lose customers who are buying computers and expect them within days. Companies with high inventory may risk being unable to sell computers at a reasonable profit or being stuck with out-of-date units. It is important to keep an eye on this figure; it should grow at roughly the same rate as sales.

Prepaid Expenses

The company has paid these expenses in cash but hasn’t recorded them as expenses on the Income Statement yet because they haven’t been incurred. For example, the unexpired portion of an insurance premium will show up as a prepaid expense. The asset will be reduced as the goods or services are provided, while an expense will be recorded on the company income statement. The expense reduces net income and thereby reduces retained earnings, a shareholder’s equity line item that keeps the balance sheet in balance.

Here is a good illustration of Prepaid Expenses.

Noncurrent Assets (Long-Term Assets)

Long-term assets are assets that are not intended for use within 12 months or within the current business cycle.

Long Term Investments

This is cash invested either in bonds with a maturity of more than one year or in shares of other companies, such as bonds, common stock, long-term debt securities, and investment properties. These are not as liquid as cash and short-term investments, and prices can fluctuate, so the value shown on the balance sheet may be too high or too low.

Equity investments are also considered as long-term investments where a company invests in other company:

• Effectively that of a partner in a joint venture or consortium; or
• Long term and substantial (ie not less than 20% of the equity voting rights) – associates.

Click here to learn how we treat investments in associates (equity investment) when Organic Food Everyday acquired 30% of Vege Farm ownership, and Vege Farm became associate of Organic Food Everyday.

Plant, Property and Equipment (PPE)

These assets represent the bricks and mortar of a company used for operations and have a useful life of more than one year: Land, buildings, factories, furniture, equipment and so on. The PP&E amount on the balance sheet is usually reported net of accumulated depreciation – the total amount of depreciation recorded on assets over their life. At some point, PP&E will need to be replaced, and depreciation is a company’s best estimate of these “replacement” costs due to wear and tear. Note that PP &E is usually not a very accurate measure of what a company’s bricks and mortar are really worth. Certain fixed assets depreciate faster than others. For instance, computers have a much shorter useful life than buildings. Additionally, even after an asset is fully depreciated and is no longer accounted for on the balance sheet, it may still hold some value.

Intangible Assets and Goodwill

Intangibles, as the name implies, assets that cannot be touched and generally cannot be converted into cash. These assets lack physical substance but provide economic rights and benefits: Patents, copyrights, licenses, secret formulas, franchises, and trademarks. Intangible assets that expire, such as patents and copyrights, lose value over time as they get closer to their expiration date and therefore must be amortized. Amortization is a non-cash expense.

The most common form of intangible assets is goodwill. Goodwill arises when one company buys another and pays more than the target company is worth (premium paid). It reflects the extra value of an ongoing concern (a company’s ability to stay in business), potential market share gains, brands and other intangibles. A premium is often paid when an acquired company owns brands or recipes that have special value. For example, in the unlikely event of a company being able to acquire Coca-Cola Co. (KO), its secret recipe would undoubtedly fetch a significant premium over the historical book value of its assets, which would be reported as goodwill on the acquiring company’s balance sheet.

Companies may overestimate goodwill. An acquiring company will often pay a premium for company, based on expectations of future synergies and market share gains that may or may not be realized. Companies are required to test goodwill for impairment at least annually. If the fair value of the goodwill is less than the reported value, the company must recognize the difference. This means reducing the reported value of goodwill and taking a non-cash charge on the income statement. It is common for analysts to subtract intangible assets from shareholder’s equity to calculate a tangible net worth.

Click here to learn how Intangible Assets and Goodwill come into picture when Organic Food Everyday completely acquired one cafe, and how the company amortizes its Intangible Assets.

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