An Introduction to the Balance Sheet MG Academy

An Introduction to the Balance Sheet: Current Assets

schoolbusThis article is the second week’s lesson in the ModernGraham Academy beginner’s course, An Introduction the the Balance Sheet.  The ModernGraham Academy is a place to learn about the basics of investing, with an emphasis on the ModernGraham approach.

This course will be a detailed look at the balance sheet, starting with a basic overview, then a look at each part of the statement individually, and finishing up with a review and some final comments.

An assignment is given each week; if the assignment is completed before the next week’s lesson and emailed to ben AT moderngraham.com (replace the “AT” with @), feedback will be provided.

What are Current Assets?

Current Assets are the assets of a company that can be considered to have short-term liquidity.  That is to say, the assets that the company could potentially sell in the very near future and turn into cash.   Current assets are very important to consider when evaluating a company.  Having a good amount of current assets can help a company handle day to day operations.

Here are some of the main types of current assets, and some things to consider about each type.

  • Cash – Cash is the most important and easiest to understand type of current asset.  Cash is made up of all funds in the company’s bank accounts.  Cash is the most liquid asset in the world.  A company with a lot of cash has versatility to make large purchases on short notice.  As a result, if a company suddenly raises a large amount of cash, intelligent investors will be prepared for the company to make a purchase of some sort.
  • Short-term investments (cash equivalents) – In addition to cash, a company often has short-term investments including  small equity positions.  Assets fall into this category when they are considered very liquid but take at least a little bit of effort in order to fully translate them into cash.
  • Receivables – Most companies use the accrual-basis for accounting.  As a result, income is recorded as a receivable in the period it is received.  These receivables are considered a current asset, because it is likely they will be received and turned into cash in the near future.  One consideration for this area is the possibility of bad debts and many companies account for this by reducing the receivables figure by a provision for doubtful accounts.
  • Inventory – possibly the most scrutinized of all the current assets, inventory is considered to be current because it is much more liquid than the non-current assets.  The problem is that it cannot always be transferred into cash very easily.  It is possible that a company would not be able to sell all inventory in a short period of time, or (more likely) would have to sell the inventory at a steep discount to speed the sale, resulting in an actual value lower than what is report on the balance sheet.
  • Prepaid expenses – Similar to receivables, prepaid expenses are not an actual asset but rather an asset based on the accrual method of accounting.  However, they are considered to be a current asset for the balance sheet because they could potentially be exchanged for cash in the form of a refund of the good or service that was pre-paid.

Homework

Last week, the assignment was to find a balance sheet.  All of the people who participated received full credit.

This week, please discuss the following question with a one paragraph response in a comment to this post:  How can a large amount of current assets, relative to debt, be good or bad for a company?

An Introduction to the Balance Sheet Course Overview

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7 thoughts on “An Introduction to the Balance Sheet: Current Assets

  1. A large amount of current assets relative to debt can be good for several reasons. Foremost, a large amount of current assets gives a company the flexibility to be opportunistic. That is, able to take advantage of other assets that are available at a discounted rate. As for disadvantages, the only possible one I can think of off hand is more tax liability.

    1. Very good answer! I’m not sure if there would be a greater tax liability when a company has higher current assets though. Tax liability is based on income rather than how much a company holds in cash.

  2. A large amount of current assets, relative to debt is good for a company because it allows the company to (1) make acquisitions, (2) Increase dividends or (3) pay down its debt. On the other hand, it could be bad for a company because it is not fully utilizing its excess cash to obtain the best Rate of Return.

  3. Large amount of assets relative to debt means that you may be flexible to use opportunities to either make acquisitions or reduce your debt to a ratio that makes your balance sheet, ahhh, more balanced. It also gives you strength to weather a storm or fend off hostile competitors or takeover attempts.
    The downside is that too much assets based on inventory may imply ageing goods that may not be competitive in a fast developing product landscape. Debt needs to be protected by assets without jeopardising the flexibility of the future operations and strategic investments. So its the right ratio that counts, in my humble opinion.

  4. Academy Assignments Week 2
    “How can a large amount of current assets, relative to debt, be good or bad for a company?”

    A large amount of current assets relative to debt allows a company to be fluid in its daily operations. It allows for reduction of debt, expansion and growth; the acquisition of equipment and the ability to increase inventory. In times of slow growth it can be used to reward shareholders in the form of dividends. Companies will hold onto large amounts of cash in times of political/economic uncertainties. I am not sure what actually would be the down side to having a large amount of current assets.

  5. A large amount of current assets compared to debt can be bad for the company because it could attract a big name activist investor. They could demand that the large shareholder’s equitity be paid out through an unplanned dividend. They could not be able to act on oppurtunistic M&A ventures; for instance, if this company is in the energer sector and oil were to drop, they might not be able to buy out a competitor. If they ignored the activist, the shareholders might get concerned with the probablility of future buybacks or dividend increases. Maybe the company could make plans for the assets once the numerator gets to big and write them down as restricted assets; I am just learning so I don’t know if that’s possible.

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