7. Current Assets
The short-term financial health of the company should start with a look at the balance sheet, particularly current assets - which we will do in this lesson.
- Current assets are cash or assets that can be turned into cash within 1 year
- Examples of current assets include:
--- Cash and cash equivalents - currency, coins, bank account balances and short-term highly liquid investments
--- Accounts receivable - money owed to the company by its debtors for goods or services that have been rendered
--- Inventory - raw materials, work-in-progress products and finished goods
--- Prepaid expenses - future expenses that have been paid in advance
In this lesson, we're going from the Income Statement, to the Balance Sheet, which details the assets and liabilities of a company, on a set date. Unlike the Income Statement, or the statement of cash flows, a Balance Sheet, snapshots a company on a specific date, not over a time period, such as a quarter or a year. The Balance Sheet has three components. Assets, which are at the top, are the resources controlled by the company, such as cash, property and inventory. As I scroll down, you'll see the next section, which is liabilities. Which are the obligations of the company, such as debt or loans. The last section, is equity. Commonly known as shareholders' equity, or owner's equity, which is calculated by subtracting liabilities from assets. In this lesson, we're going to focus on current assets. Which are the assets, that are cash or that can be converted into cash within a year. As a rule, current assets are listed in the Balance Sheet in order of their liquidity, or how quickly they can be turned into cash. If the economics of a business changed for the worse, having a lot of liquid current assets, that can be converted into cash, can really help weather the downturn. The first current asset in our list, is cash and cash equivalents, which are typically, short term investments. This number increases, the more profits we generate. Inventory, is the raw materials or products that we sell to our customers. When we sell inventory to our customers, we create an accounts receivable. Trade, or accounts receivable, is the amount of money owed to us, by customers. When we eventually receive the cash from customers, the accounts receivable is transferred, into cash and cash equivalents. With this additional cash, we can then buy more inventory, to sell to our customers. And so, the cycle continues. This connection, between cash, inventory, and accounts receivable, is known as the operating cycle, or cash conversion cycle. The ability of a company, to generate additional cash quickly, is a great sign of the company's health. However, it's important to distinguish, between the different sources of cash when analyzing the Balance Sheet. If the company grows its cash balance by raising money from investors, or obtaining a loan, this does not necessarily mean that the company is doing well. However, if the business is generating cash from operations, and has very little debt on the Balance Sheet, the company would appear to be in a very strong position. Inventory can tell us a lot about a company's performance. If over time, inventory begins to build up on the Balance Sheet, without a corresponding increase in sales, it may mean that the company is struggling to sell its products, or that some inventory has become obsolete. The amount of inventory you hold on the Balance Sheet, varies depending on the type of business that you're in. For MarkerCo's hardware business, quite a lot of inventory would be held on the Balance Sheet, because the company is selling a physical product to customers, that must be bought beforehand and stored. Service businesses on the other hand, do not hold any inventory, because the product or service that they provide is intangible. As a result, when comparing the Balance Sheet of companies, make sure they have a similar business model, so as not to draw incorrect conclusions, on relative performance, based on inventory. As I mentioned earlier in this lesson, receivables are monies owed to the company by their customers. And some industries, the company gets paid immediately. For example, Amazon. However, in other sectors, particular in professional services, a company can often wait months to get paid. The ability of a company to turn receivables into cash, is critically important. As receivables grow, it gets harder and harder to recover the full amount invoiced. If a company has a lower percentage of receivables, compared to gross sales, it usually means that a competitive advantage exists in the business, due to the company's ability to get paid faster than competitors. Although not included in this example, there are often some other items, listed in current assets. Pre-paid expenses, are expenses which have been paid for, but we have not yet received the service or product. Other current assets, are non-cash assets, that are due within a year, but not yet in the company's hands, such as deferred tax assets. Currents assets, are often compared to current liabilities, when assessing the health of the company. We'll perform this comparison, in the next lesson.