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:
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.