Michael

In the previous episodes of the Learning Finance series, I’ve learned the Basics of Balance Sheet, have learned the different types of assets, and how to use Balance Sheet to understand how companies work.

Every asset item is followed by a number, and that number is the value of that asset. How can I determine the value of an asset?

Historical Cost vs. Fair Value

I’m facing two choices:

1. I can use the sum of money that I spent when I bought the asset at the time, i.e. the purchasing cost of the asset.
2. I can use the current fair value, i.e. market price of the asset.

At first, I’m tempted to use the fair value of the asset because it reflects the real value of the asset. This may work for me personally, but if I want to one day sell the company, this method could potentially be challenged. After all, it is impossible for me to find a selling price for every single asset in the market. For example, if I have a set of equipment in the past five years, I won’t be able to find a fair value for the equipment right away. 

I thought about using the price of a new set of equipment with the same model, and I could then apply a discount to the price. However, even this seemingly feasible method contains flaws.

What discount percentage should I use?

10% of the original price?

Or 90% of the original price?

Both are “discounts” applied against the fair value of the equipment, but the gap between them is simply too large, thus rendering the method NOT objective.

Accountant is a profession of prudent and conservative nature. Accountants dislike uncertainty, and when they face them, unwillingly, they’d rather err on the side of conservativeness, i.e. they would rather underestimate revenues and overestimate costs than vice versa.

After eleminating the second option of determination of an asset’s price, I’m left with the first and only option, which is to use the original purchasing price as value of an asset. Because this transaction happened in the past, there is less room for dispute. 

However, even though doing so offers me peace of mind, it also creates a new set of challenges. Because the value of many assets have fluctuated over the years, the original price doesn’t reflect the current reality. For instance, if I bought a piece of land 10 years ago for 500,000 USD, the current value of the land can easily go above 50 million USD in certain countries. Yet on the balance sheet, the land is still recorded as 500,000 USD – its original purchase price.

Even though this imperfect dilemma exists, using the original purchasing price to document the value of an asset is still my best option. Most countries on this planet have adopted this method, and in accounting terms, it is called historical cost of an asset. In fact, accountants, with their conservative and prudent nature, will even go further than using historical costs of assets; that is, if there was a value increase of the asset, they would “pretend” the increase never happens, but if there was a value decrease of the asset, they would document this decrease with a deduction (what an a**hole!). So if I want to be specific, the asset pricing system is a historical cost system with deduction on devalued assets.

The goal of a Balance Sheet is to reflect the real value of assets. Because often there lacks a common, objective standard in valuing the market value of an asset, we have to use the historical cost in the asset pricing mechanism as our second-best choice.

Now we have established that in pricing assets, the historical cost system is the way to go. Is there a type of asset with a relatively objective fair value, a price that everyone is likely to agree on at any given time? 

There actually is.

Financial Asset – An Exception to Historical Cost

If you think about it, one such type of asset will be public stocks. On any given day, the stock price of any public company is set by the stock market. People all over the world can see and trade on stocks, and there is little argument in the objectiveness of public stocks. 

This asset category is called financial asset, among which stocks are part of. Because there exist an active market for most financial assets, people can reach consensus on their fair values. Therefore, there is no need for us (and the accountants!) to use historical costs for financial assets, since we have a better option to value them. We can simply use fair value for financial assets on our balance sheet.

Real Estate – Another Exception (with Caveat)

Other than financial assets, is there any other asset with this character? Well, you guessed it – real estate, but not any type of real estate, only real estate intended for investments. 

Next to financial assets, the real estate market is also active, thus its price objective and transparent. However, our intended usage does make a difference here; ONLY if our goal is to lease the property to tenants, or hold and sell at a later stage, etc., i.e. treating the real estate as investment, then we can use the fair value in documenting the value for the real estate. If we intend to use the property as office building or manufacturing plant, we will have to resort to using the purchasing price as its value on the balance sheet. 

Understanding Economic Activities

In a nutshell, financial assets and real estate intended for investments are recorded with their fair values on the balance sheet. Other than those, most asset items are measured at historical costs with deduction when they devalue. 

Understanding how asset values are measured can help explain why companies conduct transactions that may appear difficult to understand. For example, a company sells out one of its assets, but buys it back a week later. The asset changes very little during this week; so why does the company even bother to do all of these? 

The reason that this company risks all the trouble is related to the concept of historical cost. Because of this rule, the value of this asset on the balance sheet is always equal to the purchasing price, as long as it’s not sold. To increase the value of this asset, the only way is to make a new deal, i.e. selling and buying it back. 

By now, we’ve learned the meaning of each asset items, the structure of assets, and how assets are valued. We have already gained a comprehensive understanding to assets – the left side of Balance Sheet. All definition of terminologies such as cash, fair value, etc. can be found from here. Next we will liabilities and shareholder’s equity – the right side of Balance Sheet.

Why do we need to read a Balance Sheet? It’s not fun.

The goal is to understand how a company actually works. 

Although we understand the asset items now, they are isolated from one another. How can I “see” a real company when all the pieces of asset items are put together?

This is truly about how to “read between the lines”. Let’s look at the same Balance Sheet again.

Manufacturing Companies

Can you identify the biggest asset of this company? 

If you check carefully, you may discover that fixed asset is the largest item of asset. For this company, the total asset is around 5.4 billion USD.

What about the second largest asset item?

Accounts Receivable – it’s worth about 1.2 billion USD.

If a company’s largest asset is fixed asset, and the second largest one is accounts receivable, what business do you think the company is in?

This is pretty easy to guess. And yes, you might have guessed it – it is a manufacturing company. What’s more, it is a capital-intensive manufacturer requiring upfront asset investment. 

What about competition? 

Considering that its second largest asset is accounts receivable, and accounts receivables allow our customers to pay later, making our goods more competitive in the market, it’s safe to say that this company is facing serious competitions in the market.

As a matter of fact, high fixed assets, high accounts receivables are two traits commonly found in most competitive manufacturing companies.

Service Companies

In our daily lives, we might face more companies in the service industry, and for most of us interested in entrepreneurship, manufacturing is not something we look forward to starting a company in. So what does the balance sheet of a service company look at?

Let’s use a design company as an example.

A design company is essentially just a bunch of people working on their computers in an office. You may guess intangible assets are what the design company has, such as brands, technology or even goodwill. But what if this is a newly formed company, with neither brand power nor goodwill, and it solely relies on brains and has no patent?

For this infant company, the most valuable asset of is people – the employees. This is easy to understand. But how can “people” be reflected on the balance sheet?

Maybe under intangible asset?

Or fixed asset?

The answer is actually neither. Even for companies whose most valuable resources are people, such as a design company, they won’t put people under the asset.

Employees are hired, not owned by the company. They are not assets that can be sold or disposed.

Pro Sports Clubs and Pro Athletes

But is there any scenario where people actually become assets?

Well, there actually is. 

Professional athletes in Europe or North America get paid huge salaries for performing at the highest level on earth. We often hear that pro players get multi-million contract extensions. Within the contract period, the athletes play for their own franchises, but the franchises can also trade players with other counterparts. In this case, professional athletes are more like assets, which can be bought or traded among multiple parties (clubs). For example, if a club signs a $150 million, 5-year contract with a star player, that money should be put in the deferred expense item, since the player contract is creating some future benefit to the club. 

Agricultural Companies

Now we have looked at people, what about animals? There are many companies in the agriculture industry.

For these companies, animals such as chicken or pigs are referred to as biological assets. Animals and plants all belong to this category.

Let’s say I have a farm cultivating chicken. Where should I put my chicken on my balance sheet? Well one thing for sure is that there won’t be an item called chicken.

I’m tempted to treat my chicken as goods; so I should treat them as inventory. However, that might only work in half the situation. 

Since my farm cultivates both roosters and hens, I will need to treat them differently. Well roosters are cultivated mainly for the meat, hens are actually for the eggs. From this perspective, roosters should be treated as inventory, because they can turn into cash in a single cycle, while hens should be treated as fixed asset since they last longer than a single cycle and can generate future value.

As we learn deeper and deeper in this topic, you may find out that except for financial sector, almost all industries use the same format of financial statements. However, behind the same format are vastly different companies operating in different industries with different business structures. The same asset item may have completely different meaning in different industries too. When all these assets are organized, they paint a picture of a real, lively company.

To clearly describe the economic activities of a company, a company first needs a Balance Sheet. The reason is to understand what the initial investment has become, and whether its value is maintained. 

This is what Balance Sheet looks like.

A Balance Sheet is mainly divided into two columns, one on the left and one on the right.

On the left, I got my Assets. On the right there are 2 things listed. The one on the top is called “Liabilities“, the one on the bottom is “Shareholders’ Equity“. 

There is a very important equation called Assets = Liabilities + Equity, but we don’t have to worry about it now. First, let’s tackle each item one by one.

Let’s look at Assets first.

There are two types of assets, Current Assets and Non-current Assets. I will dive into their differences later on, but for now just know that in general, Non-current Assets are more durable and more valuable than Current Assets, and they are less likely to turn into cash. We will dive into Current Assets first.

Current Assets

Cash

The first item we can see is cash and cash equivalents – the good old money. Whether it’s parked in a bank or retained as actual cash in the company, it’s all cash or cash equivalents. 

Accounts Receivables

Why do we have Accounts Receivables? When I sell products, the buyer may not pay me right away. This is actually quite common in the business world. Though I may not like it, but because I don’t want to lose this client, I’d rather let him pay later than never, and sometimes I will even bear the risk of not receiving the money at all. A lot of times, I’m doing this out of necessity because of similar terms extended to customers by competitors.

In this case, say I sign a contract stipulating the payment in two months, I have earned the right to receive payment at a later time (two months later). This right is called Accounts Receivable.

Other Receivables

After that there is a special item called Other Receivables. A common type of other receivables is money advanced to employees for specific purposes such as business trips. In normal business operations, a company shouldn’t have a large amount of other receivables.

Prepaid Accounts

The next item of asset is Prepaid Accounts. Unlike Account Receivables, which are money owed to me by customers, prepaid accounts are money prepaid to my suppliers in the form of deposits. For example, if a supplier has products that are very scarce to get, I’d rather pay him in advance so as to secure the materials. 

Prepaid accounts give me the right to receive products/services from the supplier at a later time, making them part of the asset items.

Inventory

Inventory is pretty straightforward. It can be raw materials, half-finished products, or finished goods. For example, I might be producing metal cups and steel is the raw material that I will need to purchase. After that, I will cut them into smaller pieces (half-finished products), before I finish them into products ready for shipping (finished goods).

Deferred Expenses

The next item of asset is relatively hard to understand, which is called Deferred Expenses.

Let’s use an example. Considering that my metal cup business is booming, I’ve hired more staff to handle not only production, but also order fulfillment. These staff members will need to use stationary such as pens, pencils, and paper etc. Every time I buy office stationary, I will buy everything for about six months usage. 

Now suppose I spent $60,000 on a large batch of office stationary, and then stored them in a warehouse for people to use in the next 6 months. Now the question is this: are the office stationary stored in the warehouse assets or expenses?

For the $60,000 office stationary stored in the warehouse, obviously they can be used in the next six months. Therefore, it’s serving some future purpose, so they should be considered as asset. 

Now let’s consider this: let’s say in a month, my team will use around $10,000 worth of office stationary. By the end of the first month, I will have $50,000 worth of stationary; by the end of the second month, $40,000, etc. In this case, I’d say each month, $10,000 worth of stationary is expended, and the rest in the warehouse are deferred expenses. After six months, all $60,000 of stationary will be expended, and I should delete it from my assets.

Other than office stationary, what else could be considered as deferred expenses? 

Well, my cup selling business might be doing extremely well, and I may decide to enter the retail business myself. I will pay a sum of money, say three months rent, for a retail space to display and sell my line of products to consumers. Since I pay the rent at the beginning of the first month, it should be considered deferred expenses. I may engage an advertising agency to help me promote my brand, and I might pay a six-month advertising budget in advance. If you follow this logic, you may find other expenses such as annual software subscriptions, company gym memberships… You get the idea. 

Current Assets vs. Non-current Assets

For all of the asset types that we have mentioned so far, there is one thing in common: they are all liquid assets. In accounting liquid assets are called Current Assets. 

There is another group of assets called Non-current Assets. What’s the difference then? Let’s pick an example from each of the 2 groups of assets to compare.

From Current Assets, let’s use Inventory as an example. As mentioned, inventory includes raw materials, half-finished products, and finished goods. Let’s take a look at raw materials. Now let’s also pick something from Non-current Assets, say fixed asset. Fixed assets include property, plant, and equipment. Now let’s pick Equipment as an example.

What is the main difference between inventory and equipment that makes the former liquid, or current, and the latter illiquid, or non-current? 

Raw materials are turned into finished goods soon after they are received. These finished goods are then sold to bring back cash. In other words, raw materials, which are bought with cash, become cash again within one cycle. Equipment, on the other hand, is not expended immediately, and can take years to deplete its entire value. 

If you pay closer attention to Current Assets, you may find out that all items on the current asset list are ranked by their order of liquidity, i.e. how fast they can be turned into cash. For example, why are cash and cash equivalents ranked in the first place?

Well cash is cash, and no conversion is needed. So it obviously is the first. Accounts Receivables will become cash once they are collected, so they are ranked in the second place. Inventory needs to be sold, converted into Accounts Receivables, before it can be converted into cash. So it is ranked after Accounts Receivable. This is how we rank the assets.

Non-current Assets

Now let us take a look at the non-current assets.

Fixed Assets

Fixed assets are a type of non-current assets, among which are properties, cars, computers, and so on. To be considered a fixed asset, the asset must be durable, and must have relatively high value.

Should my five-year old cup be considered a fixed asset?
Say I’m extremely frugal and I use the same cup for the past five years. Is it a fixed asset? 
The answer is NO. Even though the time frame is long, the value of a cup is simply too small. A fixed asset must qualify for both standards.

Intangible Assets

Next, let’s look at Intangible Assets. 

Intangible Assets include patents, proprietary technologies, copy rights, franchise license, trademark, goodwill, etc., things that are crucial to a company but do not exist in physical forms. In certain countries, it can include land usage rights, mining rights and other types of commercial rights. 

Long-term Investments

Last but not least, Long-term Investments also belong to the Non-current Assets family.

For instance, the company may own shares of another company, or it may have bought government bonds. As long as I plan to hold the investment for the long term, they can be called long-term investments. 

Learning about accounting is hard, but necessary, as it’s the language of business entities. Next time, let’s look at how assets are valued. 

The foundation for any financial analysis is financial statements.

You might have heard about the three financial statements, which are Balance Sheet, Income Statement, and Cash Flow Statement.

However, do you know why most countries require companies to prepare these three particular financial statements, not something else?

To answer this question, let’s think about why we need financial statements at all. 

We prepare financial statements to describe the economic activities of a company. A company may carry out many economic activities. Depending on the industries, companies could look very different from the outside. 

How can we describe these economic activities in a clear fashion, regardless of their size, industry, or even country of residence?

First, let’s think about this: what kind of economic activities take place in a company?

Economic Activities in a Company

From the perspective of accounting, there are only three kinds of economic activities, which are operating activities, investment activities, and financing activities.

The first type is operating activity. 

What are operating activities? In short, operating activities describe how a manufacturer produces products, sell the products, and collect receivables every day, i.e. the core of why the business exists.

The second type is investment activity.

What are investment activities? Well, a firm may open a new office, enter a new area of business, or develop a new product line. These activities are currently outside of the business’s core economic activities, and would normally require new capital injections.

During the process of operation and investment, if the firm lacks capital, it may choose to borrow from banks,

or raise money from external investment firms such as venture capitals. These are financing activities.

There might be thousands of transactions happening every year, all of them will find a place in any of the three economic activities. 

Next, let’s look at how these activities take place in a company.

Let’s say that I want to start a company. The first thing I need to do is to establish a business entity, i.e. register the new company as a standalone business entity. Once the business entity is registered, my new company is formed.

At this moment, all my company has is a pile of money – the initial capital injected from my personal bank account to the company’s bank account.

Therefore we could say that the starting point of all companies is a sum of invested funds.

However, I’m not simply moving funds just for the sake of depositing it into a bank; I want the company to make a profit.

Suppose I want to set up a factory. Obviously the first thing I have to do is to build the factory plant and purchase the equipment. After having all the infrastructures established, I will need to purchase raw materials and hire staff. Now that I have secured the plant, equipment, technology, workers, and raw materials, I can start making products.

And I must be able sell my products to earn revenues – my ultimate goal.

When I sell products, more often than not, I will not able to receive cash right away. All I got is a bunch of account receivable – the right to receive cash from the buyer at a later time.

When I do receive the sales proceeds in cash, I can then use it to pay down bank loans, or pay dividends to shareholders.

The Repeating Cycle

Every company’s economic activities can be abstracted into this constantly repeating cycle, regardless of industry, specific business, and developmental stage. This cycle starts with invested funds in cash and ends with received sales proceeds in cash. Now let’s examine if the above three economic activities have happened during the cycle.

When I start the company, I may not be able to provide all the initial investment by myself. Instead, I may need to borrow money from the bank. 

This is obviously a financing activity.

Then I take the invested funds to build factory plant, purchase equipment, and may subsequently invest into other companies, or establish a joint venture with someone else.

All of the above are investment activities.

Once I have all the infrastructures set up, I will purchase raw materials, produce goods, market products, and receive cash from sales. This process repeats over and over.

These are operating activities.

Why We Need Financial Statements

My goal for starting a company is to make money, or generating cash, and I want to receive more cash than my invested cash. A company that achieves this goal is making a profit. 

However, only answering this question is not enough. An even more fundamental question is: what happened to the principal of my investment? Though I don’t want to see my company losing money from operating activities, I definitely don’t want to lose my initial investment.

If you can recall, my company’s initial form is just a pile of cash, lying in the company’s bank account. However, after investing in all kinds of infrastructure, the pile of cash – or the principle of investment – is transformed into varies kinds of stuff such as fixed assets. In this process, it’s important that I understand what my initial investment has become, and how much it is still worth.

That is what Balance Sheet will tell me.

Income Statement and Cash Flow Statement serve other purposes in similar fashion. By examining all three statements and their interrelations, I can draw insights for my company that I wouldn’t be able to otherwise.