|Course 302: The Balance Sheet|
Assets are generally defined as things a company owns, which are expected to provide future benefits. There are two main types of assets: current assets and noncurrent assets. Within these two categories, there are numerous subcategories, or line items.
Cash and Cash Equivalents. This line 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. This is considered money that can be used for any purpose the company wants.
Short-Term Investments. This represents money invested in bonds or other securities that have less than one year to maturity and earn a higher rate of return than cash. These investments may take a little more effort to sell, but in most cases, investors can lump them with cash to figure out how much money a firm has on hand to meet its immediate needs.
Accounts Receivable. Think of receivables as bills that a company sends its customers for goods or services it has provided but for which the customer has not yet paid but is expected to pay within the next year. In other words, these are sales (recorded on the income statement) that haven't been paid for yet with cash. Generally, accounts receivable are shown as a net amount of what a company expects to ultimately collect, because some customers are likely not to pay. The amount of receivables a company thinks it won't collect is typically known as an allowance for doubtful accounts. Not only do additions to the allowance for doubtful accounts decrease the amount of accounts receivable, but they also increase a company's expenses--known as bad debt expense.
Keep an eye on accounts receivable in relation to a company's sales. If accounts receivable are growing much faster than sales, it generally means a company isn't doing an ideal job collecting the money it is owed. This could potentially be a sign of trouble because the company may be offering looser credit terms to increase its sales, but it may have difficulty ultimately collecting the cash it's owed. Conversely, if accounts receivable are growing much slower than sales, the firm's credit terms may be too stringent, at the expense of sales.
Inventories. There are many different types of inventories, including raw materials, partially finished products, and finished products that are waiting to be sold. This line item is especially important to watch in manufacturing and retail firms, which are saddled with large amounts of physical inventory.
The value of inventories shown on a company's balance sheet should be taken with a grain of salt because of the way inventories are accounted for. Similar to accounts receivable, changes in inventories are generally related to a company's sales, or more specifically, the gross profit--sales price minus the cost of the inventory sold--it makes from each sale. If inventory levels are growing much faster than a company's sales, it may be making or buying more goods than it can sell. That may force the company to lower its prices, which results in lower profits for each item sold and lower profitability for the company. In some cases, it may have to reduce prices to levels below the value of the inventory itself, resulting in losses.
Additionally, inventories tie up capital. The cash that was used to create inventory can't be used for anything else until it's sold. Thus, another important thing for investors to monitor is how fast a company is able to sell its inventory.
Other Current Assets. While there are too many to list here, this category includes any other assets the firm may have that are expected to turn into cash within the next year. However, some current assets will not turn into cash, the most common of which are known as prepaid expenses (yes, even though it's called prepaid expenses, it's actually an asset). For example, say Harley-Davidson HDI buys and pays up-front for an insurance policy for the coming year. Accounting rules say the company should record the entire payment as a prepaid expense (asset) as opposed to a normal expense on the income statement because it represents something of future worth to the company--a full year's worth of insurance coverage. As the year goes on, the value of the asset will decrease--less time remaining on the policy--and the amount of the decrease is recorded as an expense, a process known as amortization. Keep in mind that a company's prepaid expenses--which belong to a broader category known as capitalized costs--represent cash that was paid up-front and will turn into expenses instead of cash within the next year.
Next: Noncurrent Assets >>
|Learn how to invest like a pro with Morningstar’s Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.|
If you have questions or comments please contact Morningstar.