So let’s go down the asset categories one by one. First on the list come cash and cash equivalents. It is the only item anywhere on the balance sheet you can actually spend right now. Everything else on the assets side is either an item of value other than cash – a machine, or else an unsettled promise and agreement, such as a receivable. Next on the list of assets come accounts receivable. That is what people owe the business – that is, what they have promised to pay. Usually, most of the receivables consist of trade receivable, or what the company is owed by customers.
Then comes inventory. Companies in manufacturing industries have raw materials, work-in-process, and finished-goods inventory. Retailers and wholesalers have goods on the shelves waiting for sale. The inventory is valued according to various accounting principles relating to its cost.
Next comes notes receivable. Notes receivable refer to interest-bearing loans the company has made, primarily to customers.
Then the balance sheet lists assets that are relatively liquid – that is, assets that aren’t expected to be converted into cash in that twelve month period.
First in this category is an item we label gross fixed assets. Many balance sheets label it gross property, plant and equipment.
Note a funny thing about that gross fixed assets number. When accountants write down the value of a company’s fixed assets, they use what they call historical cost. In other words, they measure the value of an asset by what the business paid for it, not what it may be worth now.
Next comes an item called accumulated depreciation. Right here, unfortunately, is where some accountants and financial folks begin to confuse their clients. After all, almost everything thing else on the assets side of the balance sheet is something you can see, touch, collect or spend. Accumulated depreciation, by contrast, is just a number. How can businesses “own” accumulated depreciation?
The answer is, it doesn’t. Depreciation is simply a way of spreading the cost of an asset over a certain number of years, with the time span roughly corresponding to the useful life of the asset. Accumulated depreciation is just a way of showing how much of the cost has been allocated to prior years.
An example should clarify this idea. Say you run a pizza franchise and you bought a delivery truck three years ago for $25,000. The entire $25,000 is included in the gross fixed assets line of your balance sheet because that’s what you paid for the truck (its historical cost). But by now, the truck is three years old and its face value has declined. Each year, your accountant has listed a portion of the truck’s price as an expense on your income statement and is said to have depreciated it (more of this later). The accumulated depreciation line on the balance sheet shows the total cumulative depreciation over the three years since you bought the truck.
Typically, a balance sheet will then show net fixed assets or net property, plant, and equipment, which is just the gross number minus accumulated depreciation. The gross shows what the company paid for its fixed assets. The net shows that cost minus accumulated depreciation.
There may be other items on a balance-sheet as well. Other operating assets are a catch-all category that can include items such as a prepaid insurance policy or prepaid rent on a building. (If other assets are short-term, they will appear as gross fixed assets: if they’re long-term, they’ll appear after net fixed assets.) Other investments refer to assets such as long-term CDs or equity in another business. And many companies have a line labeled goodwill.
You’re likely to run into this puzzling term goodwill – it’s usually written as one word – any time a business is sold, and understanding it will help you understand the assets side of the balance sheet. All of the other assets on the balance sheet have a defined value. Cash and accounts receivable have a dollar value. So do fixed assets, with the dollar value determined as described earlier. But someone who buys a company (even in an asset sale) is usually buying much more than just the assets recorded on the seller’s balance sheet. The buyer gets an ongoing business. The company has a customer list, business relationships, a reputation, a place in the community. The price of the business will be determined not just by the value of the seller’s assets but by the company’s market value, which depends on these intangibles and many other factors that do not appear on the seller’s balance sheet. What a buyer pays for a business is often more – sometimes much more –than the dollar value of the assets on the seller’s balance sheet.
That “extra” that the buyer pays is what accountants call goodwill. It appears on the balance sheet just like any other asset, and it will be amortized over time much like any depreciable asset. It’s the most common of what are known as intangible assets -something that has value but can’t be touched, collected or spent.
This is a series of 5 blogs that will be posted this week to help you understand one aspect of running a business that is crucial to be able to make informed business decisions for your business. Check back tomorrow for more content.
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