Anything of value that is owned or due to the business is included under the Assets section of the Balance Sheet. Assets are shown at net book or net realizable value.
Current assets are those which mature in less than one year. The following accounts are included:
Cash pays bills and obligations. Inventory, receivables, land, building, machinery and equipment do not pay obligations even though they can be sold for cash and then used to pay bills. If cash is inadequate or improperly managed the company may become insolvent and be forced into bankruptcy. Include all checking, money market and short term savings accounts here.
Accounts Receivable (A/R)
Accounts receivable are dollars due from customers. They arise as a result of the process of selling inventory or services on terms that allow delivery prior to the collection of cash. Inventory is sold and shipped, an invoice is sent to the customer, and later cash is collected. The receivable exists for the time period between the selling of the inventory and the receipt of cash. Receivables are proportional to sales. As sales rise, the investment you must make in receivables also rises.
Receivables increase for two reasons: 1) Growth in sales, and 2) Change in average collection period. Growth in sales is a healthy reason to increase receivables. Change in the collection period may be unfavorable, particularly if the reason is due to a collection problem with a customer. To analyze the change in the collection period, some measure of the receivable's quality must be used. We do this by comparing the actual collection period to the stated payment terms. The actual collection period is known as Days In Receivables. The collection period and the terms should be about equal. If the calculated collection period is greater than the offered terms, then its time to dig deeper and see if some of your customers are lagging in paying their accounts.
At some point in time you may have customers that are unable to pay for the goods or services they received from you. When you determine that you will be unable to collect these accounts, you will write off the receivable and record a charge off loss. As your business matures, you will be able to estimate the amount of such losses. Many businesses calculate this expense on a monthly basis based on sales or a percentage of past due accounts. The allowance for doubtful accounts is subtracted from gross receivables on the Balance Sheet to show the net receivable balance.
Inventory consists of the goods and materials a company purchases to re-sell at a profit. In the process, sales and receivables are generated. The company purchases raw material inventory that is processed (also known as work-in-process inventory) to be sold as finished goods inventory.
For a company that sells a product, inventory is often the first use of cash. Selling inventory does not bring cash back into the company - it creates a receivable. Only after a time lag equal to the receivable's collection period will cash return to the company. It is very important that the level of inventory be well managed so that the business does not keep too much cash tied up in inventory.
The correct level of inventory is a function of the length of the company's inventory cycle and the company's sales level. A company's inventory cycle consists of three phases:
- The Ordering Phase
- The time it takes the a company to order and receive raw materials.
- The Production Phase
- The time it takes to produce finished goods from raw materials.
- The Finished Goods/Delivery Phase
- The amount of time finished goods remain in stock plus the delivery time to a customer.
The inventory cycle in days is the sum of the days spent in each of the phases. This investment requires the use of cash. We can estimate the dollar ($) amount of inventory as follows:
Minimum Investment in Inventory (in $'s) = Inventory Cycle In Days X Cost of a Day's Sales (in $'s)
The investment in inventory will vary according to both the sales per day and the length of the inventory cycle in days. As sales rise, the amount of inventory sold daily rises and the investment in a day's worth of inventory must increase or stockouts will eventually occur. As the inventory cycle lengthens, more inventory must be kept on hand to produce the same level of sales and the investment in inventory increases.
Just as we measured the quality of accounts receivable, another ratio can be used as an indicator of the quality of inventory. This is done by comparing the actual inventory level to the inventory cycle. Insufficient inventory indicates potential stockouts, Excessive inventory may indicate stale inventory, poor inventory controls, or miscounting. To measure quality, the actual number of days of inventory on hand is measured as follows:
Days In Inventory = (Actual Inventory / Cost of Goods Sold per year) X 360
Ideally, inventory will be at a level slightly greater than the inventory cycle.
Notes Receivable is a receivable due the company, in the form of a promissory note, arising because the company made a loan. Notes receivable is usually a note due from one of three sources:
- Employee, or
- Officer of the company.
Customer notes receivable is when the customer who borrowed from the company probably borrowed because he could not meet the accounts receivable terms. The customer's obligation may have been converted to a promissory note.
Employee notes receivable may be for legitimate reasons, such as a down payment on a home, but the company is neither a charity nor a bank. If the company wants to help the employee, it can co-sign on the loan advanced by a bank.
An officer or owner borrowing from the company is the worst form of note receivable. If an officer takes money from the company, it should be declared as a dividend or withdrawal and reflected as a reduction in net worth. Treating it in any other way leads to possible manipulation of the company's stated net worth, and banks and other lending institutions frown greatly upon it.
Prepaid expenses are amounts you have paid in advance of when they are due. For instance, you may pay your rent annually in order to get a reduced payment. The entire amount paid would be credited to prepaid expenses. Then, one-twelfth of that amount would be transferred each month to rent expense.
Other Current Assets
Other Current Assets consist of other miscellaneous and current assets. Miscellaneous and other current assets generally consist of small deposits or receivables.
Non-current assets are defined as those that will not mature into cash within the next 12 months. The following accounts are included:
Fixed assets represent the use of cash to purchase physical assets whose life exceeds one year. Included are:
- Machinery and Equipment
- Furniture and Fixtures
- Leasehold Improvements
When a fixed asset is purchased for use in operations of the business it is recorded at cost. As the asset wears out, an amount is charged to expense and accumulated annually in a contra-account known as accumulated depreciation. Accumulated depreciation is the cumulative sum of all the years' worth of wearing out that has occurred in the asset. The gross fixed asset (purchase price) less the accumulated depreciation equals the Net Fixed Asset Value (also known as book value).
Gross Fixed Assets (Purchase Price) - Accumulated Depreciation = Net Fixed Assets (Book Value)
Intangibles represent the use of cash to purchase assets with an undetermined life. They may never mature into cash. Intangibles can also include the value of the reputation your business has built during its life span. For most analysis purposes, intangibles are ignored as assets and are deducted from net worth because their value is difficult to determine. However, should you decide to sell the business, intangibles are an important item in the valuation of the business.
Intangibles can consist of assets such as:
- Research and Development
- Market Research
- Organizational Expense
Intangibles are recouped, like fixed assets, through incremental annual charges (amortization) against income. Standard accounting procedures require most intangibles to be expensed as purchased and never capitalized (put on the balance sheet). An exception to this is purchased patents that may be amortized over the life of the patent.
Other assets consist of miscellaneous accounts such as deposits and long-term notes receivable from third parties. They are turned into cash when the asset is sold or when the note is repaid.
Learn more about the other sections of the Balance Sheet: