Here in Rule Maker land we believe that it is very important for an investor to have an understanding of financial statements and the terms that appear in them. Some of the most commonly asked questions on our Rule Maker discussion boards revolve around the sometimes-confusing terms found on the balance sheet. "Do marketable securities qualify as cash?" If you've asked this or a similar question about the balance sheet, today's column is for you.
In order to calculate our Foolish Flow Ratio or a cash-to-debt ratio, you need to be able to look at a balance sheet and spot the line items that qualify as cash along with the ones that qualify as debt. Admittedly, this can be a little tricky. Last August, I wrote a column -- The Many Faces of Debt -- in which I reviewed many of the terms commonly used to describe liabilities. Today, we're going to take a similar journey through the current assets. Between this article and the one I wrote last August, you should be prepared to make sense of any balance sheet you come across.
The first and most important current asset is cash. Rule Maker investors just love to find gobs and gobs of cash on the balance sheet. Cash has many advantages for the company, and if the company has lots of it, then chances are good it will be able to fund operations from the cash generated by its business. Cash can also be used to protect the company if business turns south for a period of time. Without enough cash during tough times, the company may have to borrow to make ends meet. Sometimes that's OK. However, if things don't turn around quickly, the result can be a spiral of ever-increasing amounts of debt, more and more money thrown out the door in the form of interest expense. If the ship isn't righted, the company could ultimately crumble under the weight of its debt to the point that it declares bankruptcy or goes out of business.
Did you ever notice that when you look at a balance sheet the current assets appear first and that cash is the first asset listed? (Take a look at Cisco's latest balance sheet, for example.) There's a reason for this, and it's also something that's pretty helpful. You see, the assets on the balance sheet appear in a particular order, which is based upon how readily each of them is convertible into cash. The current assets section of the balance sheet generally represents those assets that are convertible into cash in a year or less. Since cash is cash, there's no time required to convert it into cash. That's why it's the first asset listed on the balance sheet. In my experience, I've found that all assets that appear above accounts receivable on the balance sheet can be treated as cash or equivalent to cash.
For Rule Maker investors there are really only two kinds of current assets found on the balance sheet. The first are the good ones -- cash or cash equivalents. The second are the bad ones -- everything else. When we calculate our financial ratios, we essentially reward a company that has lots of cash and penalize one that doesn't.
If you've made it this far, that's great. Before proceeding you should take a break. If you're at home right now, think about spending some time with your spouse, significant other, or your children before coming back to finish up. If you're reading this at work, well, you probably better pass on the break and finish up because you're already on a break.
Now that I've got your attention again, I'll throw out a list of terms that you can find on the balance sheet. I'll follow the list up with a brief explanation of each.
Cash and Cash Equivalents = GOOD. Examples include:
- Cash equivalents
- Marketable securities
- Short-term marketable securities
- Investment securities
- Other securities
- Short-term investments
- Trading assets
- Accounts receivable
- Trade accounts receivable
- Accounts receivable -- related parties
- Other receivables
- Loan receivable
- Inventories (includes raw materials, work-in-process, semi-finished goods, and finished goods)
- Deferred tax
- Prepaid income tax
- Prepaid assets
- Other prepaid expenses and receivables
- Other current assets
Cash -- Moolah, green stuff, currency. I think you get the drift.
Trading assets -- This one is fairly uncommon. As a matter of fact, Intel (Nasdaq: INTC) is about the only company that I've run across with this account on its balance sheet. According to the accounting policies footnote in Intel's annual report, this asset portfolio is "maintained to generate returns that offset changes in certain liabilities related to deferred compensation arrangements." The fact that these assets consist mainly of marketable equity instruments that are stated at fair market value leads me to classify them as a cash equivalent. If there weren't a ready market for these securities, it would indicate that they are much more difficult to convert to cash, and they would not be cash equivalents.
Cash equivalents -- These consist primarily of investments in interest-bearing demand deposit accounts with financial institutions (your checking account could be an example of this kind of account) and highly liquid debt securities of corporations and the U.S. government. These investments mature within 90 days of the balance sheet date.
Marketable securities / short-term investments / etc. -- This group of assets consists primarily of high-grade fixed-income investments. Generally, such assets are available for sale, which necessitates carrying them on the balance sheet at fair market value. These investments are typically highly liquid, have insignificant interest rate risk, and short-term maturity dates.
In short, what all these cash-like assets have in common is that they are conservative investments that are easy to convert into cash. As a result, when evaluating a company's Rule Maker characteristics, we treat them as part of the company's cash balance.
All right, let's move on to the non-cash (i.e., bad) current assets that you might find on a balance sheet.
Accounts receivable / trade accounts receivable / etc. -- It wouldn't surprise me if the first time many people hear us say that receivables are bad assets, they think we're total fools. If you find yourself in that crowd, then give me a chance to change your mind. The problem with accounts receivable balances is that they represent interest-free loans. They involve giving someone else the use of your money for free. That's just not a good thing. We want our companies to collect their outstanding receivables as quickly as possible, or better yet not even have any of them.
Loan receivable -- While this asset does provide additional income to the lender in the form of interest, which theoretically can make it a little better than the other receivables that I mentioned, it's not easily converted into cash, so it's not viewed as a cash equivalent.
Inventory -- When a company has inventory sitting on its shelves, that inventory represents money that the company doesn't have access to. If it can't sell the inventory quickly enough, then it's possible that it could go bad, become obsolete, spoil, etc. That means excess inventory is potentially money that could be thrown out the window. We do understand that there are reasons for a company to have inventory on hand to meet its customers needs, but we look for companies that manage their inventory levels as efficiently as possible.
(Note: For more on how to measure a company's efficiency at turning over its inventory or collecting its receivables, you can check this article: The Cash Conversion Cycle.)
Deferred taxes -- This is the way accountants account for the difference between the taxes paid using Generally Accepted Accounting Principles (GAAP) vs. the liability computed under the IRS rules. A deferred tax asset generally arises when the amount of the current deduction under GAAP is more than it is for income tax purposes. This creates a temporary difference, as the company essentially has to pay taxes to the IRS, that it will get credit for later when it can claim the benefit of these deductions.
Prepaid taxes -- This could refer to deferred tax, or it could relate to taxes that the company has paid in advance of the actual due date.
Prepaid assets -- This refers to expenses that a company has paid ahead of time. For example, let's say that back in February The Motley Fool signed a deal to advertise on Yahoo! (Nasdaq: YHOO) for the next six months, and Yahoo! required payment at the time the contract was signed. In that case, the Fool's June balance sheet would include two months' worth of prepaid advertising expense. The corresponding amount would be found in the current liability section of Yahoo!'s balance sheet as deferred revenue.
"Other current assets" -- To really know what's in this category you'll have to check the footnotes to the financial statements. The "other" category includes all of the items that aren't large enough to be separately stated. You shouldn't expect to find any cash here.
One final thing to keep in mind is that if you're unfamiliar with what an asset truly represents, it's often helpful to take a look at the company's "Summary of Significant Accounting Policies," which is typically the first or second footnote found in the financial statements.
If you wish to discuss this report further, please feel free to ask your questions on any of the discussion boards linked below. Finally, if you're interested in learning more about Rule Maker investing, there are still a couple more days left to sign up for our Rule Maker Online Investment Seminar.
Phil Weiss (TMFGrape on the boards)