Like Luke vs. Darth, offense vs. defense, and "Tastes Great" vs. "Less Filling," a balance sheet consists of two opposing forces: assets vs. liabilities. We'll tackle them one at a time.
Assets are sources of value that can benefit a company down the road. There are two major categories of assets: current and noncurrent. Current assets are relatively liquid, meaning they can easily be converted into cash. Current assets are expected to be converted into cash or used up within one year. Noncurrent assets, conversely, are not easily converted into cash. These can include property, equipment, goodwill, and deferred charges.
Assets that will be used up within the next year or easily converted into cash within one operating cycle are considered current. An operating cycle is the time it takes to sell a product or service and collect cash from that sale. It can last anywhere from 60 to 180 days or more.
Current assets can also be viewed as operating assets because they fund the day-to-day operation of its business. Running low on current assets will force a company to seek other sources of fuel for its operations, usually leading to debt interest or dilution of shareholder value. Current assets are listed on a balance sheet from top to bottom with the most liquid at the top.
Let's review the terms you'll see under Current Assets.
Cash and Equivalents consist of cold, hard cash or very liquid equivalents, such as money market funds or bearer bonds. This is cash or insta-cash that is at the company's disposal for operations, growth, dividends, and share repurchases.
Short-term Investments are just below cash and equivalents in liquidity. When a company has cash over and above that needed for operations, it can afford to sink some into short-term bonds that will earn interest. While not as readily available as cash and equivalents, short-term investments can be converted into cash without too much difficulty.
Accounts Receivable (A/R) is what is owed to a company by its customers. Products or services have been rendered on credit and the company is now siting next to its mailbox waiting for a check. Usually, A/R will be converted into cash in a relatively short time. However, if a customer cannot or will not pay and sending cousin Louie after 'em doesn't prove beneficial, the company will be forced to take a write-off for bad debt. The Allowance for Bad Debt you see next to A/R in parentheses is money set aside to cover potential delinquent customers.
Look at the rate of growth or decline in A/R and compare it to that of revenue. Although an asset, A/R is not something you want to see growing, much less outpacing revenues. A good portion of assets, such as A/R, are paradoxical in nature -- we'll get more into that another day.
Inventories are the goods a company has for sale and the materials used to produce those goods. It's idle money, like a caterpillar in a cocoon, waiting to blossom merrily into flight and provide cash. Sitting in that cocoon too long, however, is not only claustrophobic, it can be costly. Companies need to turn inventory into cash as quickly as possible to put that money back to work for them. Like A/R, inventories outpacing revenue growth is a sign of trouble ahead.
Non-Trade Receivables is money due from sources other than customer purchases. These can include tax refunds, interest income, or the sale of property or equipment.
Restricted Cash is money set aside for a specific purpose, generally spelled out in a contract. A company may not use restricted cash for business operations, therefore it is listed separately from Cash and Equivalents on a balance sheet.
Prepaid Assets, to finish off current assets, are assets for which the company has paid the bill in advance for products or services rendered. Although not a liquid asset, prepaid assets are a bonus because these bills will not have to be paid in the future, leaving greater future revenues at your disposal.
We'll close here for tonight. Next week, we'll look at the power of liquidity (and I don't mean Supersoakers) and finish up the asset side of things with noncurrent assets.
Drip on, Fools!