This lesson is part of the five-day Decode Your Financial Statements training. If you were referred here by a friend, you can join in to receive all the lessons by email.
Sign up for five days of short, easy to read email lessons to help you better understand your financial statements, and begin to use them as tools to enable strategic decisions.
The balance sheet is a running total of everything the company owns and owes – it’s like a snap shot of the company at any given moment. Where the income statement is periodic (it resets to zero every year) the balance sheet is all activities over the life of the company. It’s the balance at a single point in time. Over the next couple days we’re going to talk about each section of the balance sheet and what you should know – starting with assets.
Assets are owned by the company and are used to generate income in one way or another. These are things like cash (bank accounts), accounts receivable (amounts owed to you by other people and due within a year), inventory, prepaid expenses and capital assets (like buildings, vehicles or equipment). Let’s go through each of the common assets in some detail so you understand what you’re looking at when you look at your company’s balance sheet.
Cash, from an accounting perspective, includes the physical cash you have as well as the amounts in your bank accounts. The amount in your bank account is considered cash because it’s easily accessible and can be quickly turned into physical cash (i.e. you can withdraw cash from the bank).
Accounts receivable is the amount owed to you by your customers. These are basically short-term IOUs. Accounts receivable is considered a fairly liquid (close to cash) asset and is looked at as one of the assets that can cover the short-term debts of a company. Liquid assets are important when you’re looking at your company as a whole and thinking about short term management. Will you be able to pay your short term debts as they come due?
By calculating the average number of days your receivables are outstanding, you can get a good idea of how fast your customers pay you [(average accounts receivable/total credit sales) x 365]. If your customers are consistently taking a long time to pay, you may want to revisit your invoice terms. Maybe the they need to be shortened, or you could offer a discount for paying early. A common term is 2/10, net 30, which is 2% off if the invoice is paid within 10 days or the whole balance is due within 30 days.
You don’t want to be financing your customers for too long because it will have negative impacts on your cash flow. You’ll have expenses to pay out for completing the sales contract, so you want your cash from your customer as soon as possible. There’s a balance between to restrictive (customers won’t want to do business with you) and too loose, You’ll have to figure out what works for you and your customers. For help with this balance, you can look at industry benchmarks to get an idea of how long it usually takes customers to pay invoices in your industry.
Inventory is raw materials used for producing goods for sale, goods in the process of becoming ready for sale, and goods available for sale. Sometimes these are three different sub-accounts of inventory, Raw Materials, Work in Process, and Finished Goods, but sometimes it’s only useful to see inventory as one account. It’s up to you what’s useful. Valuing inventory can be very tricky, and is beyond the scope of this course, but if you want to know more about it don’t hesitate to hit reply. I’m always up for talking about inventory valuation.
Inventory is an important number for a product-based business because it represents the main resource required to generate sales. When inventory is sold, the cost to create the product is classified to Cost of Goods Sold (sometimes called Cost of Sales) on the income statement. It’s an important expense and should be compared to revenue regularly to track it as a percentage of income. We talked about the income statement in lesson 1, so that’s all I’ll say about it here.
Prepaid expenses are exactly that, expenses that have been prepaid. These are usually things like insurance that’s paid annually, or last month’s rent paid upfront. Before you use up the benefit of what you’ve paid for (i.e. you’re insured for the month or you have a month of office space), you’ve really just traded one asset (cash) for another one (a future benefit). When you use the asset (the month goes by and you’re insured) then you can expense the amount you paid for it (one month’s insurance premium). This keeps the resources required for benefits received, in the same period. It also gives a more accurate picture of the resources required to generate revenue on the income statement (you need to be insured to be in business).
Capital assets are expensive items purchased to generate sales over a long period of time (longer than a year) and are not sold in the usual course of business. So, if you’re in the business of selling tractors, buying a tractor to sell, while expensive, isn’t a capital asset, it’s considered inventory. Capital assets are considered long-term assets on the balance sheet. All the other categories we talked about are considered current assets.
Because these items generate sales over a period longer than a year, their cost needs to spread out over that time. This is called depreciating a capital asset. You’ll see this expense on the income statement as depreciation expense or amortization expense. (While technically not the same thing, depreciation and amortization are normally used interchangeably). By spreading out the cost, you’re matching up revenue to the resources required to generate that revenue.
Assets are a very important part of your business, without them you wouldn’t be able to carry on operations. The current assets (cash, accounts receivable, inventory, prepaid expenses, etc.) are assets that are fairly liquid and will be used up over the course of the year. These assets are useful in determining how agile your company is. If there was a big change in your environment, like a new law was passed that made operations difficult, or a new technology that disrupted your unique offer, would your company be able to adjust? If your money is tied up in assets that aren’t very liquid, like capital assets, the answer is probably not very quickly. Sometimes that’s just the nature of the industry. Companies that have capital intensive operations, like breweries or manufacturing companies, will have a lot of money in their long-term assets, but they require that structure to operate. Striking the balance will depend on the specifics of your company, but you can look at industry benchmarks to see what’s normal for your industry.
If you have questions about your specific situation, then let’s chat!
Kaitlin Kirk is a Chartered Professional Accountant who helps small business owners learn about their financial situation, work less, and get paid more. She used to do financial process improvement for a $5 billion company and now brings those big business skills and insights to small business owners. She spends a lot of time on the volleyball court and on-stage doing improv comedy when she’s not teaching small business owners how to decode their financial statements.