Assets: Balance Sheet Components Part 1
This is part 1 of a 3 part article. To learn more, check the links below:
Liabilities: Balance Sheet Components Part 2
Owner’s Equity: Balance Sheet Components Part 3
Asset is a terms used to refer to what a company possesses, properties that can lead to future benefit. They include cash, short term investments, inventory, accounts receivable, equipment, and fixed assets (buildings and lands). Assets are the properties of a business that enable it to operate and make a profit. The purpose of attracting investors or borrowing money from others is to obtain them.
Cash
Cash includes the money we have at our disposal and the amount we have in the bank. Cash is crucial to business processes since it is used to make regular business transactions. Cash deficit can occur when the money needed for these financial activities has not been foreseen. Too much cash is also a sign of poor financial management. Excess cash can be invested for higher returns. Budget forecast enables businesses to foresee the cash flow and plan for cash deficits as well as excess cash beforehand. Liquidity ratios help assess whether a company has enough easily accessible funds to cover short-term obligations.
Short term investments
In cases where the business has more cash than it needs, but also needs to keep it liquidable, it makes short term investments. These investments are made for a return in less than a year.
Accounts receivable (customers receivable)
Since purchases and sales occur regularly and frequently in businesses, the records are kept in corresponding accounts. When an order has been made, the amount of the sales is recorded in the accounts receivable, because sometimes the purchase is not paid in cash. Usually an advance payment is made at the beginning of the purchase, and the rest is paid upon product delivery or other conditions mentioned in the contract or invoice.
Accounts receivable indicated the amount of money that is going to be received in the future (less than a year). Usually there is a procedure that determines how the collection has to be made. The procedure may include sales staff, accounting staff, or in cases where collection seems unlikely, lawyers. In the case that the collection period has been too long and the money is unlikely to be received, the amount is moved from accounts receivable to expenses. It is as if you paid money and did not get anything in return.
Advance and L/C
Advance payments and letters of credit are two common financial instruments used in business transactions. Advance payments refer to payments received from individuals or businesses before the delivery of goods or services. If a business requires customers to make an advance payment, it falls under this category. These payments are deposited directly into the seller’s bank account.
In contrast, a letter of credit serves as a financial guarantee, often acting as a substitute term for documentary credit. Documentary credit is a payment method in which a bank plays a central role in the payment process. The bank acts as an intermediary, underwriting the transaction to significantly reduce the risk of nonpayment by the buyer.
Documentary credit differs from documentary collection in terms of oversight and risk mitigation. While documentary credit involves a rigorous process carefully managed by the bank, documentary collection is more straightforward. In the latter, banks serve solely as intermediaries, facilitating payment upon presentation of documents but without offering a payment guarantee.
Inventory
The second asset is the inventory. Inventory refers to the products in storage. In manufacturing and production businesses, raw materials are processed and turned into products. Products can be easily sold and turned into cash, therefore, they are considered current assets. The number or amount of product in storage is recorded as inventory. While it may sound good, too many stored products is not a good sign. The reason is because we have limited resources. Resources are allocated to equipment, raw materials, and hire the workforce to produce the goods. At this point, money has been spent, and goods have to be sold so that the money can get back into the system and allow the cycle to go on. Too many goods in storage means less money in the system.
Fixed Assets
Every business needs equipment to perform its business activities. Since the equipment help produce goods and therefore earn possible profit, they are considered assets. Machinery are one type of equipment. Based on the type of business, the equipment could vary. Assets such as buildings and lands are also considered fixed assets. Fixed assets are purchased for long-term use. Thus, they are highly unlikely to be sold for cash. A business, especially one that needs to establish itself physically, needs lands and buildings.
Both lands and building have intrinsic value, and last for a long time. Therefore, they are considered assets. However, they are much less liquidable than the goods in storage or the accounts receivable. Besides, no business person in their right minds would consider selling the place where they run their business. Therefore, that business person always makes sure that they have enough cash for their cash flow, reasonable inventory turnover, rational accounts receivable period, and an amount of debt they can clear without having to valuate their fixed assets.
Long term investments
Businesses make long-term investments with the hope to earn more in the future. These investments are highly illiquid. Stocks and bonds are another way for a business to earn more money. Real estate may also be considered one. It is important to keep in mind that money earned from these investments are different from the earnings made from the operational activities of the business. These earnings do not reflect the efficiency and the return of the business. They are solely ways to make use of excess funds instead of leaving them in the current assets. Investments can also be directed to the business itself. Further business developments can be funded by the business itself.
As mentioned earlier, assets are obtained in order to generate future benefit. For that to happen, business has to make sales. The amount of sales to the amount of assets is a ratio that indicated the asset turnover. It shows how much money is being produced using the assets. In a comparison between two companies having the same amount of assets, the one that has more sales shows it is making better use of the investments made on the company.
