Assets are easy to understand; they are nothing but things and stuff.
Things and stuff are needed to make a business happen. The things include hard objects such as buildings, machines, trucks, forklifts, cars, computers, and tools. Things have a “life,” and businesses tend to keep things for some time. The stuff is what the business sells—inventory, cash, and the money owed to the company, receivables.
There are three classes of assets:
Current assets are stuff that the business is currently using.
Cash is a primary current asset. It gets its own line on the balance sheet. This is the most liquid asset a business can have. Cash is the money in the operating bank accounts, the savings accounts and in the float between different internal bank accounts. Sometimes quickly converted short-term savings (think CDs and money market/commercial papers accounts) called cash equivalents are included in the cash line of the balance sheet.
Accounts Receivable (a.k.a. Receivables) is the money owed to the company by its customers. In retail companies most customers pay cash (or with credit cards) for goods at the point of purchase, but there are still a few retail companies that have house credit accounts. In the world of wholesale or business to business (B2B), the payment for the goods or services often follows or trails the delivery of the goods or services. Payment Terms or Credit Terms, negotiated between the seller and the buyer prior to the close of any B2B transaction, determine the time it takes for a customer to pay an invoice. If receivables are the largest current asset a wholesale distributor has, that distributor may be close to financial failure. A distributor with receivables greater than inventory is acting as a bank to its customers.
Inventory is the last of the current assets. For manufacturers, wholesale distributors, and retailers, inventory will be one of the largest current asset accounts. Manufacturers have three different kinds of inventory: raw materials, work in process, and finished goods. Most manufacturers tie up money in the work-in-process, excess inventory in parts usually made to keep production people busy. Scrap is a major drain in the work-in-progress bucket.
All of the current assets represent working capital, the capital needed for the company to operate.
A building is a fixed asset. The equipment that goes into the building is a fixed asset. An investment in a mine is an investment in a fixed asset. However, the ore removed from the ground becomes inventory at the point of removal.
Fixed assets can have short or long lives. Computers are short-life assets, replaceable within three years. A forklift truck for a machining center may have a life of ten years. Conveyors and storage fixtures have fifteen years of life. Buildings are long-term assets, typically lasting more than twenty years. Land has an endless life.
Sometimes companies are asset light or asset heavy. A manufacturing operation that has investment in a large plant and equipment is an asset-heavy operation. A warehousing operation or trucking operation that does not actually invest in the trucks themselves or in the warehouses (typical of any freight broker or third-party logistics provider) is an example of an asset-light operation.
Long-term assets can be a positive or negative influence on the capabilities of the business enterprise. Companies that own vast assets—including land, buildings, and equipment—can borrow money using the assets as collateral.
Companies may also choose to lease assets, which is in effect a loan against the asset for a portion of the life of the asset. Leases are either operating leases or capital leases. In an operating lease, the term of the “rental” is less than the life of the asset. The lessee is able to deduct the expense from income taxes, and the lessor takes the depreciation credit on their income taxes. The terms of capital leases are typically the standard taxable life of the asset, and the lessee receives the benefit of the depreciation.
Intangible assets are things and stuff that you can't lay your hands on. An example of an intangible asset is the customer list that a company owns. It costs money to create a customer list, and the customer list could be of some value if a competitor buys the company. Another example of an intangible asset is intellectual property (IP). Most often IP is a patent, a trademark, or proprietary intellectual property protected by law to be an asset.
Goodwill is another form of intangible asset. Goodwill shows up on the asset list when a company purchases another company for more cash value than the book value of the target. Goodwill is actually fictitious, funny money. Smart business leaders, like Warren Buffett, write off goodwill as quickly as they can.
You can learn about the asset value of any company by looking at the top half of the balance sheet. The balance sheet presents the assets owned by a company, the liabilities owed to others, and the accumulated investment of the owners of the company.
The purpose of an asset is to help the business entity that owns it to create revenue.
Let's look at an example. You own a distribution house, distributing housewares to different retail stores. You rent your warehouse. You don't own your warehouse, so it really is not an asset. Inside the warehouse you have fixtures that you purchased with cash. The fixtures are long-term assets. You painted the offices and made improvements to the warehouse. Even though it is a rental, those tenant improvements you spent cash on are also long-term assets. You have a forklift, some tables, desks, a computer system, and some other business equipment. These are long-term assets.
Then there is the inventory of housewares. The inventory is a current asset. The money your customers owe you is an asset, as is the cash in the bank.
Your salesmen call on the retail stores to create new customers, and your current customers issue purchase orders for the housewares you distribute. The customers pay you on terms, typically fifteen to thirty days. You send an invoice and they send a check to pay for the goods. You recognize the revenue when you ship the goods to the customer, but sometimes you don’t see the cash for as long as forty-five days. That long? Yes, because although they agreed to pay you within thirty days, some customers pay late.
Part of the service you provide is special packaging of the products. You may contract to have the packaging done by somebody else, or you could invest in equipment that allows you to do the packaging in-house.
Now, assume you’ve invested in a packaging machine with the expectation that you would do a lot of this packaging. If your customers do not want the special packaging, your investment becomes an unused asset, a wasted asset. You bought the machine with the expectation that it would cost less to do the packaging in-house than to outsource. But the packaging business is low volume, and you run the machine only once a quarter. That machine is not creating any additional revenue. Perhaps you should sell the machine and use the cash generated by the sale for something that will create more revenue.
You have a delivery fleet. The drivers are making deliveries every day, and you want your customers to be impressed that you have the best equipment. The drivers like the new trucks that your operations manager ordered for long-haul deliveries. You make those deliveries once a week right now, and then park the truck for the rest of the week in the parking lot. It looks so cool in the lot when it is not out on the road.
Your office overlooks the warehouse. You are proud of how you managed the budget in the warehouse, buying the racks and the lift equipment used. You found a great installer and got everything installed without going over budget.
You saved a boatload of cash on the warehouse, and used that extra dough on your office. That looks nice, right? You own the place anyway, so you deserve a good place to work. Now, if the guys in the warehouse were just a little bit more productive. They sometimes complain about the lift truck not reaching the top beam of the racks, and that they are running out of space.
Any time a business invests in an asset that does not help create revenue, the company is pimping its assets. The stories of Wall Street firms investing in expensive paintings and furniture for the executive offices are examples of pimping assets. Expensive and fancy furniture in the office is pimping the asset. Chrome wheels and fancy lights on the truck? Pimping the asset.
Is our imaginary owner pimping his assets? Look around where you work. Do you see examples of pimped assets?