3.05 – Sizing Up Your Assets & Liabilities
Analyzing the Balance Sheet
When analyzing a balance sheet, it’s essential to consider the size of the company’s assets, liabilities, and owners’ equity in relation to its sales revenue. The amount of assets needed to conduct profit-making activities primarily depends on the size of its annual revenue, which, in turn, influences the size of its liabilities and owners’ equity.
In our example, the company has $71.064 million in annual sales revenue, with realistic proportions for other numbers in its income statement and balance sheet. The company earns a 62 percent gross margin, meaning its cost of goods sold is 38 percent of sales revenue. The sizes of particular assets and liabilities can vary significantly from industry to industry and even within the same industry.
Managers can estimate the appropriate size for each asset and liability based on the company’s history and operating policies. These estimates serve as useful control benchmarks to compare actual balances of assets and liabilities. Significant deviations from these benchmarks can indicate potential issues that managers should address.
For instance, based on customer credit terms and the company’s collection policies, a manager can determine a proper balance for accounts receivable. If the actual balance is close to this benchmark, accounts receivable is under control. If not, it requires further investigation.
Sales Revenue and Accounts Receivable
In our example, the annual sales revenue for 2020 is $71.064 million, with year-end accounts receivable of $8.883 million, roughly one-eighth of the sales revenue. This implies an average customer credit period of about 45 days. If the business offers a 30-day credit period, the 45-day average is slightly higher but generally acceptable. However, if the accounts receivable were $12.900 million, indicating a 66-day average credit period, it would raise concerns and necessitate investigation.
Cost of Goods Sold and Inventory
The cost of goods sold for 2020 is $26.891 million, with a year-end inventory of $1.733 million, representing about 16.7 percent of the cost of goods sold. This equates to an average inventory holding period of 61 days. The “correct” inventory holding period varies by industry, but managers should know the control benchmark for their business. Significant deviations from this benchmark should prompt actions to adjust inventory levels.
Fixed Assets and Depreciation Expense
Depreciation spreads the cost of a fixed asset over its useful life. In our example, the company has invested $8.67 million in fixed assets and recorded $4.32 million in depreciation up to the end of 2020, with $1.239 million in depreciation expense for the year. The balance sheet reports both the original cost and accumulated depreciation, giving an idea of the assets’ age and cost.
Operating Expenses and Balance Sheet Accounts
Sales, general, and administrative (SG&A) expenses connect with the prepaid expenses asset account, accounts payable liability account, and accrued expenses payable liability account. Expenses should match sales revenue for the year to accurately measure profit. Many expenses are recorded when paid, but some, like insurance and office supplies, are prepaid and expensed over time.
Intangible Assets and Amortization Expense
Intangible assets, unlike tangible assets, lack physical presence but hold value, such as customer lists, software development costs, patent rights, and goodwill. The cost of intangible assets is recorded in an asset account and allocated to expense over time through amortization. Testing for impairment of intangible assets is complex and requires regular evaluation.
Maintaining a Cash Balance
A business’s cash balance consists of money in checking accounts and on hand. Maintaining a working cash balance is crucial to buffer against daily cash flow fluctuations. Excess cash is unproductive, while insufficient cash can cause missed opportunities. Businesses need to determine an appropriate cash safety reserve based on their specific needs.
Debt and Interest Expense
The company’s debt at year-end 2020 totals $7.25 million, with $350,000 in interest expense for the year, resulting in an approximate annual interest rate of 4.8 percent. Accrued interest is recorded in the accrued expenses payable liability account. Large unpaid interest amounts should be reported separately if significant.
Income Tax Expense and Income Tax Payable
The 2020 income statement shows $6.895 million in earnings before income tax. With a 35 percent tax rate, the income tax expense is $2.413 million. A portion of this tax is paid before year-end, with the unpaid part recorded in the income tax payable liability account.
Net Income and Cash Dividends
The business earned $4.482 million in net income for 2020, increasing the retained earnings account by the same amount. During the year, $400,000 in cash distributions from profit were paid out to owners. Distributions and dividends are not expenses and are reported in the statement of cash flows or changes in stockholders’ equity.
