When we look at a business’ balance sheet as analysts, we like to see that there are significant current assets which, we think, provide the business with liquidity and so make our lending reasonably safe. But do they really mean there is liquidity in the business or are we just fooling ourselves?
The Accounting Equation
As a starting point in evaluating a business’ assets, we should keep in mind the accounting equation;
Assets = Equity plus Liabilities
The reason we should think about this equation is so that we fully understand that all assets have to be funded somehow. That funding could come from the owners/shareholders in the form of equity. Or it could come from funds borrowed from creditors in the form of liabilities.
Either way, it implies that holding assets comes with a cost to the business. So it makes sense that a business should have as few assets as possible while optimising its operations. That enables it to avoid incurring unnecessary costs in funding redundant assets.
There are two major types of business assets; non-current assets and current assets and our approach to their evaluation differs depending on the type. In this article I will focus on the current assets. You can find my discussion about non-current assets here.
The need to minimise assets is especially true when we’re talking about the current assets. These are the working capital of the business and generally they suck-up cash, depriving the business of true liquidity and, when inefficiently managed, result in the business taking on more short-term, risky debt.
What are current assets?
Typically, businesses that hold current assets would have the following in their balance sheets;
- Inventory (also called “stock”)
- Accounts receivable (also called “trade debtors”)
- Cash and cash equivalents
- Other assets such as tax receivable, prepaid expenses and the like. These are irrelevant to us as analysts as they provide no, or uncertain, cash flow so we don’t spend any time thinking about them.
The difference between non-current assets and current assets
The key difference between non-current assets and current assets is the role they play in the business’ operations and the reason the business acquired them initially. Non-current assets tend to be held for the long-term. They’re not expected to be converted to cash within the 12-months following the date of the balance sheet.
On the other hand, current assets are the working capital of the business and will provide cash to enable the business to settle creditors, repay and service debt, pay operating expenses etc. It’s absolutely essential to the business’ future that the working capital is managed effectively and efficiently.
Keep in mind that most businesses that fail do so because they run out of cash, not because they’re not profitable.
How do we evaluate current assets?
The two questions we need to think about when we look at the current assets are;
- “How accurate are the values shown in the balance sheet?”
- “How quickly will these assets be converted into cash?”
The figure you see in a balance sheet for inventory reflects its value at the lower of its cost or its net realisable value (i.e. what the inventory could be sold for in the current market – in theory, at least).
What this implies (and what we should be concerned about as analysts) is that the figure may be inflated through the inclusion of inventory that is no longer saleable because;
- It is damaged. Perhaps it is water-damaged or fire-damaged and can’t be sold to customers or returned to suppliers
- It is obsolete. That could be due to newer technology, later versions or models, or last year’s fashion.
Whatever the reason, inventory like this should be removed from the total valuation but owners are usually reluctant to do that as it reduces the asset value on the balance sheet and makes the business look a little weaker. Plus it reduces the profit on the income statement as the value of the written-off inventory would appear there as an expense.
Equally, watch out for very high values of inventory. That may simply indicate inefficient management or inventory that cannot be sold. To confirm high inventory levels, track the average inventory turnover (in days) over several accounting periods.
In this article I take a deeper dive into the evaluation of inventory.
How to evaluate accounts receivable
The accounts receivable figure you see on a balance sheet is the amount owed to the business by its customers for products or services that have been purchased by them at an earlier date.
Normally, we would ask the business to submit a breakdown of the accounts receivable list showing the names of the customers, how much each one owes and the time that has elapsed since the invoice was issued to the customer for the products or services purchased by them.
A key part of our analysis is to determine whether there are amounts owing that are not likely to be paid to the business by its customer. That might be due to the customer being a known defaulter, having already gone out of business, or where the amount due has been owing for an extended period of time.
These amounts should have been deducted by the business from the total of the accounts receivable but that rarely happens as it reduces the future cash flow that the business wants to show the bank.
Also, any amounts due that have been written-off as bad debts will reduce profit on the income statement as they will appear there as expenses.
In this article I take a closer look at the evaluation of accounts receivable.
How to evaluate cash and cash equivalents
This is pretty much straight-forward. This is the amount of cash, or assets that were as good as cash, at the time the information was collated. What that means is that although the figure may be good, the figure may only be of historical value. You should check to see whether that cash is still held at the time of your analysis.
So, while it’s undoubtedly true that current assets are key to a sustainable business (and therefore a good credit risk), we can’t assume that the figure as it appears in the balance sheet is accurate. Critical questioning of management is always necessary.