Almost all businesses need substantial amounts of assets to make sales and to carry on operations. The total assets of most businesses are a third, a half, or more of their annual sales revenue. Assets don’t come cheap. A business has to raise the capital to invest in its assets. Are these statements totally correct? Of course, these are correct when we are talking about common business practice. There are, however certain business practice which asset isn’t dominant.
One of my friends is a good example, used to run a business that was quite unusual. The only assets she owned were a cash register and a little cash in the till. She needed virtually no assets. She sold goods only on consignment, and she rented all the space she needed. It’s very unusual to run a business with no assets.
This post first examines the assets that businesses use in making profit and focuses on the linkages between sales revenue and expenses and their corresponding assets. The size of an asset depends primarily on the size of the revenue or expense that impels the particular asset.
Business Assets: Owned, Leased, Operational, and Non-operational
You’ve probably heard the oft-repeated observation that every business is different. This is certainly true regarding the asset profiles of different businesses. Even businesses in the same industry may have different asset profiles, depending, for instance, on whether they own or lease their assets.
Assets legally owned by a business are reported in its financial statements, of course. But, as you know, almost any asset can be leased, which includes real estate, machines, tools, trucks and autos, and computers. A leased asset is not reported in the financial statements of a business—unless the lease, in substance, is the means to finance (pay for) the acquisition of the asset. This type of lease is called a capital lease.
When a lease extends over the largest part of an asset’s expected useful life and the business (lessee) has a purchase option for a bargain price at the end of the lease, then the business records the lease as a de facto purchase of the asset. The asset is recorded at a cost figure, and the obligation for future lease payments is recorded as a liability on which interest is charged.
The periodic payments under a capital lease are split between interest expense and reductions of the liability balance. The cost of an asset being acquired under a capital lease is recorded to depreciation expense each year over the predicted useful life of the asset.
In contrast, assets being rented under short-term operating leases are not recorded as assets and are not reported in a business’s financial statements. Rents paid under these short-term leases are recorded to expense in the period the asset is used.
So, what kind of assets do you normally see in a business’s financial report? Well, the assets of a bank differ from the assets of an airline, which differ from the assets of an electric or gas utility, which differ from the assets of an auto manufacturer, which differ from the assets of an amusement park, which differ from the assets of a retail supermarket, and so on. You probably get the idea.
Some businesses are asset heavy, or capital intensive. Other businesses are asset light—they make small investments in assets relative to their annual sales revenue.
Coming up with an asset profile for a typical business is complicated by another factor. A business (except a sole proprietorship) is a separate legal entity, that is, a distinct person in the eyes of the law. Types of legal business entities include corporations, limited liability companies, partnerships, and other forms of for-profit organizations that are enabled by law.
As a separate legal entity, a business can own almost any asset that an individual person can. (One exception: Only an individual can own a 401k retirement investment account.) Many businesses invest in assets that are not needed or used in making sales. Wal-Mart, for instance, could invest some of its cash in IBM stock shares.
Generally speaking, assets can be divided into two broad categories:
- Operating Assets, which are those resources actually used in making sales or generating the mainline revenue of a business; and
- Non-operating Assets, which are those resources that a business could do perfectly well without as far as making sales or generating revenue is concerned.
A business may hold substantial investments in non-operating assets; in fact, many do. The range of investments in non-operating assets is beyond the scope of this post. (This post focuses on operating assets used in making sales and carrying on the profit-making activities of a business.)
I should point out, however, that in their external financial reports many businesses do not make a clear distinction between their operating assets—those assets that are absolutely critical for carrying on the profit-making activities of the business—and their non-operating assets.
In any case, the non-operating assets of a business should have a legitimate purpose and should provide a good source of income.
A business should not carry “excess assets” that don’t yield a satisfactory stream of income.
Asset Profile of a Business
This post concentrates on a business that sells products. Furthermore, it is assumed that its customers buy on credit. The purpose of using this type of example is to explain two main business assets:
- Products held for future sale that are purchased or manufactured by the business; and
- Receivables owed to the business from credit sales to its customers.
A typical business has other assets as well, of course. In the financial report of a business that sells products you find the following assets:
1. Cash – Includes checking accounts balances in banks and currency and coins held by a business. (A car wash business keeps a lot of quarters in its change machines, for example, and most retailers keep a fair amount of currency on hand.) Note: It’s permissible to include in the cash account presented in a financial report “near-cash” items, such as temporary investments in short-term marketable securities that can be immediately liquidated into cash.
2. Accounts Receivable – The total of receivables from customers for sales made on credit to them. These receivables should be collected early next period.
3. Inventories – The total cost of products not yet sold to customers. These products are being held for sale, which should occur in the short-term future.
4. Property-Plant-and-Equipment (PP&E) – Includes various economic resources, also called fixed assets—owned by the business that are used in its operations. These assets are recorded at their purchase costs, and their costs are allocated over their predicted useful lives, which is called depreciation. These assets are not held for sale in the normal course of business.
5. Intangible Assets – Things that have no physical existence, in contrast to fixed assets that are tangible (having physical substance that you can touch and see). Intangible assets include legally protected rights, such as patents, copyrights, and trademarks. A principal example of an intangible asset is goodwill, which generally refers to the competitive advantage that a business enjoys, such as a widely recognized and well-respected brand or business name. Goodwill is recorded only when a business actually pays for it. This purchase happens when one business acquires another business and pays more than what the tangible assets of the business acquired are worth by themselves.
6. Other Assets – Assets other than the “hard core” basic types just listed; generally much smaller than the basic assets. For example, a business might loan money to its executives or make advances to employees for travel expenses; these receivables are recorded as assets. Many businesses have to put down deposits for such reasons as guaranteeing future performance on contracts. The deposits will be refunded to the business at a future date; such deposits are recorded as assets. A business could have a tax refund coming to it, which is recorded as an asset. This category of “other assets” is rather open-ended—you never know what you will find in it.
One word of advice: A business owner/manager should know which things are parked in the “other assets” account. Not necessarily every last little thing, but the manager certainly should know the larger items included in this asset account, which can become a dumping ground for too many odds and ends that can get out of control over time.
Asset and Liability Linkage With Revenue and Expenses
The following example sidesteps the last type of assets:
It is assumed that the business does not have any “other” assets. The example includes only mainstream assets—cash, accounts receivable, inventories, fixed assets, and intangible assets. (Well, another asset called prepaid expenses also has to be discussed.) These are the main assets of the great majority of businesses that sell products.
For this new business example, below table illustrates the vital connections between revenue and expenses on the one side and the assets and liabilities that are integral to the profit-making process on the other side.
In the table, cost of goods sold, depreciation, and amortization expenses are shown separately; but all other expenses are grouped together in one amount. The lump sum for other expenses includes operating expenses as well as interest expense and income tax expense.
You probably know that interest and income tax are disclosed separately in internal P&L reports to managers and in income statements presented in the external financial reports of a business.
You wouldn’t see a profit report like on the table inside or outside a business. It highlights the linkages between revenue and expenses and their corresponding assets and liabilities. The assets and liabilities in the table do not comprise all the assets and liabilities of the business.
In other words, the table isn’t a statement of financial condition for the business—commonly called a balance sheet—which discloses all its assets and all its liabilities, as well as the sources of its owners’ equity.
In it, only those assets and liabilities directly connected with revenue and expenses are shown. You probably noticed that the asset “cash” is not included in the table. This omission is explained shortly. The year-end balance sheet of the business is presented later in the post.
Connecting Revenue and Expenses with Asset and Liability
The main message of the previous table is that sales revenue and certain expenses of a business drive particular assets and liabilities of the business and that particular assets drive certain expenses which I describe below:
- The business makes sales on credit; thus it has an asset called “accounts receivable.” These receivables are recorded at sales prices charged to customers.
- The business sells products, so it carries a sizable inventory (stockpile) of products awaiting sale. Inventory is recorded at cost (not at the sales value of the products). There are different accounting methods for determining cost.
- At year-end, the business has not paid for its entire inventory because it buys most items on credit. It has bills for products on hand in its year-end inventory; these bills will be paid next period.
- The business has purchased several different fixed assets (property, plant, and equipment); the costs of these assets are allocated to depreciation expense over their predicted useful lives.
- The business has invested in intangible assets (goodwill); the costs of these assets are allocated to amortization expense over their predicted useful lives.
- Certain expenses (such as insurance premiums) have to be prepaid. The portions of these prepayments that will benefit future periods are held in the asset account called prepaid expenses; these amounts will not be released to expense until next period.
- Certain expenses have not yet been paid at the year-end. The liabilities for these expenses are recorded, so that the full amounts of the expenses are recorded in the correct period. In the table, these liabilities are collapsed into one amount called unpaid expenses. In financial statements, these liabilities are reported as accounts payable, accrued expenses payable, and income tax payable (see the Balance Sheet presentation later in the post for example). You find many variations of these basic account titles in financial reports.
The ratios of the assets’ balances at the year-end compared with their revenue or expense amounts for the year are of the utmost importance.
1. Weeks of Sales in Accounts Receivable: Accounts Receivable Turnover Ratio – Compare the year-end balance of accounts receivable against sales revenue for the year. The business made $52,000,000 in sales during the year, which is an average of $1,000,000 per week. The year-end balance of accounts receivable is $5,000,000, which equals five weeks of annual sales. The flip way of looking at this is as follows: Divide annual sales revenue by accounts receivable to get the accounts receivable turnover ratio: $52,000,000 annual sales / $5,000,000 accounts receivable = 10.4 times. Whether expressed as weeks of sales in accounts receivable or as the accounts receivable turnover ratio, this important measure should be consistent with the credit terms offered to customers. Suppose the business gives four weeks credit to its customers, on average. Some of its customers pay late, and the business tolerates these late payers. Thus, five weeks of uncollected sales (accounts receivable) at year-end is not out of line. If, on the other hand, the business had seven or more weeks sales in accounts receivable, at year-end this would be cause for alarm.
2. Weeks of Sales in Inventory: Inventory Turnover Ratio – The company’s cost of goods sold expense for the year is $33,800,000 (see previous table), which is an average of $650,000 per week. Dividing the company’s $8,450,000 cost of year-end inventory by the weekly average reveals that its year-end inventory equals 13 weeks of annual sales. Put another way, the company’s inventory turnover ratio is 4 (i.e., 52 weeks / 13 weeks inventory = 4, which is also referred to as 4 “turns” per year). A business manager should control inventory, which means keeping it at a proper level relative to sales. Inventory turnover ratios vary quite a bit from industry to industry. Wal-Mart or Costco would not be satisfied with an inventory turnover of four times per year. They move their products in and out the door more frequently. A full-price retail furniture store, in contrast, may be satisfied to hold products for as long as six months on average before sale, which is an inventory turnover of only two times per year. How long products are in the pipeline varies a great deal from industry to industry. The line from the “inventory asset” to the “payables for inventory” liability signals that a good part of the company’s inventory has not been paid at the end of the year. The ending balance of this liability is about 30% of the cost of its inventory. Because inventory equals 13 weeks of its annual cost of goods sold, this liability equals about 4 weeks of annual cost of sales: 30% × 13 weeks of inventory = about 4 weeks. If the business buys inventory on credit terms of about 4 weeks, this ratio seems right.
3. Long-Lived Assets Ratios – The costs of fixed assets, or of the long-lived tangible operating assets, of a business are allocated to annual depreciation expense over their predicted useful lives. Each year is allocated a fraction of the cost, which is recorded as depreciation expense. The most intuitive allocation method is to charge each year an equal fraction of a fixed asset’s total cost, which is called straight-line depreciation. For example, one-tenth of total cost would be recorded as depreciation expense each year for a 10-year fixed asset. Alternatively, accounting rules permit higher depreciation amounts to be recorded in the early years and smaller amounts in the later years of a fixed asset’s lifespan. This “front-end loading” of depreciation expense is called accelerated depreciation. Likewise, the costs of intangible assets, such as goodwill or patents, are allocated over their predicted useful lives (usually by the straight-line method). Each period is charged with a fraction of the cost, which is recorded as amortization expense. The previous table shows the lines of connection from these two operating assets to their two expenses. As just explained, the inventory turnover ratio takes the annual cost of goods expense and divides it by the cost of ending inventory. In like manner an asset turnover ratio can be calculated for the company’s fixed assets and for its intangible assets. The $785,000 depreciation expense for the year could be divided by the $16,500,000 original cost of its fixed assets. This calculation shows that depreciation expense for the year is about 5% of original cost, which indicates a 20-year average depreciation life for its fixed assets. In the same manner, the average amortization life of its intangible assets is 25 years (give or take a little). What these two ratios reveal is that it takes 20 years on average for the business to recover the costs invested in its fixed assets and 25 years on average to recover the costs invested in its intangible assets.
4. Prepaid and Unpaid Expenses Ratios – Most businesses have no choice but to prepay certain expenses, as explained earlier. In the table, see the line of connection from “other expenses” to the “prepaid expenses” asset account. Generally speaking, an “eyeball” review of the prepaid expenses balance relative to total expenses is enough for the manager. In this example, the asset’s year-end balance is about 7% of the other expenses for the year. The manager can judge whether this is about right or perhaps too high for the business; 7% seems like it might be too high. The manager should compare this year’s ratio with that of past years to reach a conclusion. Most businesses have not paid 100% of all their expenses by the year-end. In fact, unpaid expenses at year-end can add up to a much higher amount than you might suspect. A typical business buys many things on credit. In the example, unpaid expenses at year-end equal about 17% of the other expenses for the year. Put another way, unpaid expenses are about nine weeks of other expenses for the year. The manager should ask: Is this ratio consistent with the general credit terms extended to the business by its vendors? This liability also includes certain accruals for expenses that have been incurred but not paid, such as sales commissions earned by the sales staff that will not be paid until next period. The nine weeks of unpaid expenses may be consistent with previous years. The manager will have to make a conclusion whether the business is waiting too long before paying its bills. Perhaps the business is short of cash, or perhaps it just waits as long as possible to pay its bills.
Cash Sources and Usages
In the previous table, cash is the asset missing in action. Now you may be thinking: Don’t revenue and expenses flow through cash?
Of course they do—although these cash flows for the period differ from the accrual-basis accounting revenue and expenses figures for the period. Cash is the universal asset. Virtually all activities of a business flow through cash—not just its revenue and expenses. Cash is the master clearing account for almost all the transactions of a business.
The next table summarizes the diverse sources and uses of cash through a business.
The accounting profession has adopted a threefold classification (as shown in the table) of cash flows for external financial reporting:
- Cash flow from operating activities.
- Cash flow from financing activities.
- Cash flow from investing activities.
Accordingly, the statement of cash flows presented in the external financial reports of a business follows this threefold classification scheme. Operating activities is the term that refers to the profit-making activities of a business—its revenue and expenses.
Any extraordinary, nonrecurring gains and losses that a business records during the period also are included in cash flow from operating activities. Certainly cash is the pivotal asset in the profit-making activities of a business. However, as the table shows, more than just profit-making activities cause cash flows. There are also financing activities and investing activities.
To get the proper perspective, cash has to be put in the context of the overall financial condition of a business, which is reported in its balance sheet.
Balance Sheet for Business Example
The purpose of a balance sheet is to provide a summary of all the assets and liabilities of a business. The assets of a business should be more than its liabilities, of course. (A business in bankruptcy may have more liabilities than assets.) The excess of assets over liabilities equals the owners’ equity of a business. This point is expressed in the following version of the accounting equation:
Assets – Liabilities = Owners’ Equity
Owner’s equity arises from two sources: (1) capital invested in the business by the owners, and (2) profit made by the business that is retained and not distributed to the owners. This second source of owners’ equity is generally called retained earnings.
Most businesses do not distribute their entire annual earnings to their owners. Therefore, businesses accumulate a substantial amount of retained earnings over the years. Indeed, for a mature business, retained earnings can be many times the amount of capital invested by owners.
More properly, a balance sheet is called a statement of financial condition; and, in fact, this title is used in the financial reports of most businesses.
Nevertheless, the informal term balance sheet is very widely used. The term derives from the two-sided nature of this financial statement, which is summarized in the accounting equation:
Assets = Liabilities + Owners’ Equity
(As just mentioned, liabilities can be subtracted from assets to determine owners’ equity, which is another version of the accounting equation.)
A balance sheet is not prepared in a slipshod, arbitrary fashion. The balance sheet is one of the primary financial statements in the external financial reports of a business. External financial reports circulate outside the confines of a business; they are issued to its lenders and outside shareowners, as well as to other interested parties.
In preparing financial statements for its external financial reports, the chief financial and accounting officers of the business are (or should be!) very aware that the statements should conform with generally accepted accounting principles (GAAP). These are the ground rules for the public reporting of financial statements. It would be extremely difficult to justify departures from these financial accounting and reporting standards. Indeed, such departures, if material, constitute prima facie evidence of financial fraud.
Financial accounting reporting standards have been developed over many years. The principal purposes of developing GAAP are to ensure adequate disclosure to the outside stakeholders of a business and to achieve reasonable uniformity in profit accounting methods and in the valuation of assets and liabilities across all businesses. The next presents the balance sheet for the business example introduced earlier in the post, in accordance with GAAP, of course.
The balance sheet format above follows standard practice. Current, or short-term, high-turnover assets are listed first. Longer-term, low-turnover assets are listed second. (In certain specialized industries, such as public utilities, assets are presented in just the reverse order.)
The accumulated amounts of depreciation and amortization are deducted from the original costs of these assets, instead of disclosing only the net balances of the assets.
Current (short-term) liabilities are listed first, followed by the long-term liabilities. Then the stockholders’ (owners’) equity sources are presented for the business, which is organized legally as a corporation.
The first three current liabilities reported in the balance sheet (see the balance example above) are generated by the profit-making activities of the business. These operating liabilities are discussed earlier in the post. The total of these three liabilities is $5,000,000.
Compared with the company’s $35,500,000 year-end assets, there is still $30,500,000 remaining to be accounted for. Where did the $30,500,000 come from? What are the sources of capital that provided this money for the company’s assets?
The business’s sources of capital are shown in the shaded area of the balance sheet (see the balance sheet). In summary, the business borrowed a total of $7,375,000 on short-term and long-term interest- bearing debt. And, it has $23,125,000 total owners’ equity at the end of the year.
Businesses that sell products need certain key assets to make sales and to carry on their operations. They need an adequate working cash balance. Extending credit to their customers means that they have accounts receivable. A product-oriented business carries a stockpile of products awaiting sale, which is called inventory.
In addition, a business needs a diverse array of long-term tangible assets to carry on its operations, which has the generic name of property, plant, and equipment. These ‘fixed assets’, as they are also called, include land and buildings, vehicles, office equipment, machines and tools.
These assets can be leased instead of being bought outright. Long-term-purchase-type leases are recorded and reported as assets. Short-term leases, on the other hand, are not reported as assets in a company’s financial report.
The revenue and expenses levels of a business drive the levels of the operating assets that a business needs. Managers need to understand these vital connections in order to plan for and to exercise control over the assets used in the profit-making activities of their business. In other words, the revenue and profit goals of a business determine in large part the asset needs of the business. The asset requirements of a business, in turn, determine the amount of capital that the business must secure from its debt and equity sources. Capital is not a free good!
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