What it means
A business is a collection of resources put to work to earn a return. The balance sheet lists those resources as assets and the sources that paid for them as liabilities and equity.
Each asset is recorded because the business expects it to produce cash, directly or indirectly: cash is already cash, receivables will be collected, inventory will be sold, equipment will make products that are sold, a patent will protect sales, and so on. Something that cannot be expected to produce a benefit, however much it cost, is not an asset and is written off.
The classification tells a reader how the business works. Current assets (cash, receivables, inventory, prepayments) cycle through the business within a year and are the resources available to meet short-term obligations; their relationship with current liabilities is the standard test of liquidity.
Non-current assets (property, plant and equipment; intangibles; long-term investments) are the productive base and the source of depreciation and amortization charges. A capital-intensive manufacturer's balance sheet is dominated by non-current assets; a distributor's by inventory and receivables; a software company's by cash and, if it has made acquisitions, goodwill.
Most assets are recorded at historical cost and then reduced by depreciation, amortization or impairment. Some, such as investment property and many financial instruments, are carried at fair value and revalued each period.
Internally generated intangibles, such as a company's own brand, customer relationships and skilled workforce, are generally not recorded at all, because their cost cannot be reliably separated from ordinary spending. This is why book value understates the worth of many businesses and why acquirers record goodwill when they buy them.
Reading the asset side of a balance sheet means asking three questions: what does the business own, is it worth what the books say, and how is it funded? A large asset total is only a strength if the assets are productive, fairly valued and financed on terms the business can sustain.
In practice
Real-world examples.
Example
A dental practice's assets are its equipment and fit-out, a small stock of materials, receivables from insurers and cash; its most valuable asset, the patient list, appears nowhere.
Example
A property investment company's assets are almost entirely investment properties carried at fair value, revalued annually.
Example
A start-up's balance sheet shows $4 million of cash from its last funding round and little else, because its product and team are not recorded as assets.
Think of it
“Think of assets like the tools in a toolbox. Just as tools help a handyman fix things and build new projects, assets help a business operate and grow.
Formula
Calculation
Total Assets = Current Assets + Non-Current Assets
Assets = Liabilities + Equity (the accounting equation)
Return on Assets = Net Profit / Average Total Assets x 100%
Worked example. A regional food manufacturer's balance sheet at year end:
- Cash: $1,200,000
- Accounts receivable: $3,400,000
- Inventory (raw materials, work in progress, finished goods): $2,900,000
- Prepayments: $300,000
- Total current assets: $7,800,000
- Land and buildings (net): $6,500,000
- Plant and equipment (net): $4,200,000
- Software and licences (net): $600,000
- Goodwill from a prior acquisition: $1,900,000
- Total non-current assets: $13,200,000
- Total assets: $21,000,000
Liabilities total $12,600,000, so equity is $8,400,000. With net profit of $1,680,000 and average total assets of $20,000,000, return on assets is 8.4%.
Quality check: of the $21,000,000, $1,900,000 is goodwill that has value only while the acquired business performs; $2,900,000 of inventory includes $400,000 of a discontinued line that will sell at cost; and land and buildings, bought fifteen years ago, were recently valued at $9,500,000. Tangible assets at book are $19,100,000; adjusted for the inventory write-down and the property valuation, an analyst's view of tangible asset value is $21,700,000. The book figure is neither the floor nor the ceiling; it is a starting point.Case study
Seen in the real world.
A haulage company's owner was proud of a balance sheet showing $14 million of assets and offered it to a prospective buyer as evidence of value. The buyer's advisers went through it line by line. The fleet of 80 trucks was on the books at $7 million but included 25 vehicles over ten years old that were worth scrap value; a realistic figure was $4.5 million.
Receivables of $3 million included $600,000 more than 120 days old from a customer in dispute. The depot was carried at its 1998 cost of $1.5 million and was worth $4 million. Goodwill of $800,000 related to a business that had been absorbed and whose customers had largely left.
Adjusted, the tangible assets were about $13 million and the funding behind them, $11 million of hire purchase and overdraft, left little equity. The buyer's offer, based on cash flow rather than assets, was well below the owner's expectation. Both sides had read the same balance sheet; only one had asked what each asset was actually worth.
Watch out
Common mistakes.
- Reading total assets as a measure of what a business is worth. Book values are historical and many valuable resources are unrecorded.
- Treating all assets as equally solid. Goodwill, old inventory and doubtful receivables can evaporate.
- Admiring a large asset base without asking how it is funded. Assets financed by short-term debt are a liquidity risk.
Questions
People also ask.
What is the difference between assets and equity?
Assets are everything the business owns. Equity is what remains for the owners after liabilities are deducted from assets.
Are people assets?
Not in accounting. Employees are not controlled in the way the definition requires and their value cannot be reliably measured, so they are not recorded despite often being the business's most important resource.
How are assets valued on the balance sheet?
Mostly at historical cost less depreciation, amortization and impairment. Some categories, such as investment property and traded financial instruments, are carried at fair value.
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