Yesterday, we talked about the income statement and how to get useful information out of it. We also talked about how to understand the relationship of revenue and expenses.
Today is all about the balance sheet, and we’ll zero in on assets specifically.
The balance sheet is a running total of everything a company owns and owes. It’s a snapshot of the company at any given point in time. There are assets, liabilities, and equity sections; we’ll look at each in detail over the next couple days, starting with assets.
Assets are what a company owns. They’re used to generate sales in one way or another. Common assets on a balance sheet are cash (bank accounts), accounts receivable (amounts owed to you by customers), prepaid expenses, and capital assets.
Cash, from an accounting perspective, includes the physical cash you have, as well as the amounts in your bank accounts. The latter is considered cash because it’s easily accessible and can be quickly turned into physical cash (i.e., you can withdraw cash from the bank).
Accounts receivable is the amount your customers owe you—sales you have yet to collect cash for. Accounts receivable can be used to track how fast (or slow) your customers pay you. If it routinely takes a long time, it might be worth it to revisit your payment terms. You don’t want to be financing your customers… unless you’re in the banking industry.
Prepaid expenses are exactly what the name suggests, expenses that have been prepaid. This account usually has annual insurance amounts or annual membership dues in it. These amounts get allocated to the appropriate expense account as time goes by, to represent the resource being used up. We can’t expense the entire payment all at once because the amount relates to a future benefit.
Capital assets are large purchases that will be used to generate revenue for longer than a year and are not part of the normal course of business. Usually, these are things like buildings, vehicles, and big equipment. Note that just because something’s expensive doesn’t make it a capital asset. If you’re in the business of selling cars and you bought a car to sell, it wouldn’t be a capital asset because you intend to sell it in your normal course of business. It would be inventory. If, however, you bought the car to go to people’s houses to sell cars, it would be a capital asset because you intend to use it to generate revenue.
Understanding your assets can give you great information on where your cash is tied up. If you have a large amount of inventory, you’re in a capital-intensive industry (like brewing or manufacturing, for example) or your clients aren’t paying you on time, which will reduce your cash. Maybe you have many sales, but no cash. It might be tied up in less liquid assets.
Have a look at your assets: Are they highly liquid? Or are they locked in? Understanding the makeup of your assets will provide a clear picture of how easy it would be to pay for unexpected costs.
Task: Create a balance sheet in your accounting software, and note where your assets are. Is there a business reason for each of them and for the level they’re at? For example, do you have duplicate equipment or equipment that’s not really used in the business? This is called a redundant asset and is tying up cash that could be re-invested in the business.
Tomorrow, we’ll look at the other side of assets: liabilities. These are what your company owes.
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