Accounting for Entrepreneurs
Balance Sheet Interpretation Part IV: Current Assets
Written by Bobby Jan for Gaebler Ventures
When running or acquiring a business, it is important to be able to interpret and analyze a balance sheet. This article, the fourth article in our Balance Sheet Interpretation series, will help you interpret the current assets category of the balance sheet.
Every business owner needs to understand the accounting concept of current assets.
What are current assets? Current assets are assets that could be converted quickly into cash. They are liquid assets.
Current assets include cash, short and long-term investments, accounts receivable, marketable securities, inventories, and pre-paid expenses. When analyzing a balance sheet, it is important to understand what these current assets mean for the business.
This is the most liquid of all assets because it is already in liquid form. If a company has a large pile of cash, then it has a nice safety cushion for hard times. A large pile of cash could also mean that management is looking for an acquisition or simply return it to the owners if a profitable acquisition could not be found. Beware of the bladder theory of corporate finance: the more cash there is, the more pressure there is to piss it away.
After cash, short-term investments are the most liquid asset. Short-term investments are investments that are expected to expire within one year. Treasury bills and other highly liquid securities can be considered short-term investments.
Generally speaking, short-term investments are as good as cash since they are easily converted into cash at a minimum cost within a short period of time. However, as the saying goes, liquidity is a coward; it runs away at the first sign of trouble. During times of market turmoil, the value of short-term investments may drop significantly, coinciding exactly with when cash is most needed. Short-term investments may also be inflated during times of market bubbles.
Account receivable entries represent the amounts the business claims against debtors. The due date of these relatively short term debt ranges from a few days to a year. For example, if a customer paid for a purchase from a business with a credit card, then the business's accounts receivable will increase by that amount. Accounts receivable will be reduced when payment is received.
You should not expect to recover 100% of the accounts receivable, especially if you are a retailer who deals with many clients. If this is the case, you will see an entry called "allowance for bad debt" besides the accounts receivable entry. Sometimes, a business will have to write down substantially more than the allowance for bad debt. If the accounts receivable is significant and if the business only has a few major clients, make sure to investigate thoroughly before making a commitment to purchase the business. You do not want to acquire a business only to find out that it's largest client, who is responsible for a large portion of the company's business, is about to go bankrupt and unable to make payment. Also, check if the accounts receivable to revenue ratio is growing over time. If it is, this means that the business is selling more and more on credit, which also warrants a full investigation.
Although, technically speaking, pre-paid expenses are not liquid since they could not be converted quickly to cash, many of the pre-paid expenses are essential for business operations and requires cash payments (such as insurance, advertisement, etc.). Having pre-paid expenses means you do not have to fork out cash in the future.
Learn More About Interpreting a Balance Sheet
To learn how to read a balance sheet and understand what a balance sheet says about how a company is doing, read the other articles in the Balance Sheet Interpretation Series:
- Introduction to the Balance Sheet
- Liquidity Ratios
- Price-to-Book Ratio
- Current Assets
- Current Liabilities
Cheng Ming (Bobby) Jan is an Economics major at the University of Chicago who has a strong interest in entrepreneurship and investing.
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