Assets – Investing Class

In any balance sheet, Assets are mostly shown in the order of their liquidity i.e. the time it takes to convert the asset into cash.

Current assets indicate the assets which can be liquidated within a year. These typically contain cash, cash equivalents (liquid securities like government bonds), receivables, inventory, and other miscellaneous items that can be converted to cash within one year.

Cash: Without any doubt, this is the most liquid item on the balance sheet.
Cash equivalents: These are investments in liquid securities such as government bonds or treasury bills.

To understand the receivables and inventory, we should spend some time on the cash cycle for a business. For simplicity, putting it in a picture below:

Financial analysis, Current assets, Cash conversion, value investing, accounting frauds

A business starts with cash, uses the cash to produce goods (captured as inventory on balance sheet), then sells these goods to the customer, for which the customer pays cash. When the customer does not pay cash instantly, it can be said that the company sold goods on an agreement to receive cash later. These payments are captured as receivables on a balance sheet.

An investor should always keep an eye on the inventory and receivables. There have been instances in the past where the companies reported these numbers higher than they were. Typical ways to inflate/misreport these numbers are:

Company might assign a high value to the inventory. So say the hot dog business owner has 1,000 readymade hot dogs in refrigerator on the reporting day. While valuing his inventory, he assigns a value of $20 to each hot dog which takes his inventory value to $20,000. If he is able to sell the hot dogs for only $15 per piece, that is clear misrepresentation of inventory.
Other times, we should be careful of increasing value of inventory if the firm is just ramping up production whilst the corresponding demand is not increasing. So, an investor is advised to compare if the increase in inventory is actually corresponding to increasing revenues.
Most of the businesses can not expect to get cash payment upfront, it is reasonable to expect receivables on the balance sheet. But we should keep an eye on the receivables as a proportion of revenues. If this number changes materially, it could mean that customers are consuming the product but aren’t paying for it. Sounds very fishy, no?

To keep the above factors in mind, it is advised to check the following ratio over the years:

(Inventory + Receivables)/ Revenues

If this ratio changes materially in any given year, it is a red flag and should be investigated more.

Chapter 11 – Non-current assets

Chapter 9 – Balance Sheet basics

The balance sheet shows the state of company’s Assets and Liabilities:

Assets: We can consider this category of items as the investment made by the company to grow the business.
Liabilities: We can consider this category as the items indicating the obligations of the company.

Effectively, Liabilities primarily show the sources of cash for the business (please note that expenses like salaries to be paid to the employees are also included in liabilities as they also represent obligations of the company). Assets most likely show the uses of cash.

In case of Hot dog example, the owner uses his savings along with the money he borrowed from the bank to setup the company. These become the sources of cash for the company and hence, the liabilities, i.e. the company owes this money back to the bank and the owner himself.

When the company uses the cash to buy the Stalls and ingredients to make hot dogs, it is creating assets that can be used to generate more income. Please see below a sample balance sheet indicating the state of hot dog business:

HOT DOG BUSINESS
BALANCE SHEET
ASSETS		LIABILITIES
INGREDIENTS	$1,000	BANK LOAN	$5,000
STALLS	$11,000	OWNER’S EQUITY	$7,000

	$12,000		$12,000

As mentioned in Benjamin Graham and David Dodd’s Security Analysis, an investor can derive the following by carefully going through the Balance Sheet:

“

It reveals how much capital is invested in the business.
It reveals the easy or stringency of the company’s financial condition, i.e. the working capital position.
It contains the details of the capitalization structure.
It provides an important check upon the validity of reported earnings.
It supplies the basis for analysing the sources of income.

“

A typical balance sheet looks as below:

TYPICAL BALANCE SHEET
ASSETS			LIABILITIES

CURRENT ASSETS:			CURRENT LIABILITIES:
CASH & EQUIVALENTS			PAYABLES
INVENTORY			ACCRUED EXPENSES
RECEIVABLES			SHORT TERM DEBT
OTHER CURRENT ASSETS			OTHER CURRENT LIABILITIES

NON-CURRENT ASSETS:			LONG TERM DEBT
PLANT & PROPERTY			OTHER LIABILITIES
GOODWILL
INTANGIBLES			SHAREHOLDERS’ EQUITY
LONG TERM INVESTMENTS			PREFERRED STOCK
OTHER ASSETS			COMMON STOCK
			RETAINED EARNINGS
			TREASURY STOCK
			OTHER ITEMS (INCL. RESERVES)

I will touch upon the specific items in chapters ahead. We need to understand that studying the balance sheet is also a requisite for being a value investor. Sometimes, the opportunities arise in the stock market when the market punishes a company’s stock based on poor earnings announcements, while a careful look at balance sheet may suggest that the price of the share is better than the value indicated by the balance sheet.

Chapter 10 – Current assets

Chapter 8 – Income before tax, Tax expense and Net Profit