Current Assets
Cash is the most liquid of the assets and is watched carefully by equity and credit analysts. Keep in mind that when we are referring to cash, we are also including marketable securities and other cash-equivalent interest-bearing accounts. Too little cash may make it difficult for a firm to meet its cash obligations, such as the interest payment on a bond. However, too much cash reduces the potential earnings of the firm. Attractive companies should be able to earn more in their normal business lines than the prevailing short-term interest rate.
Accounts receivable is the credit extended to customers to purchase goods. The accounts receivable balance is the total money owed to the company by customers at the end of the reporting period. A low accounts receivable balance may indicate that the firm is efficient in its collections or that credit standards are too restrictive and depressing sales. A large balance may indicate that the company is having difficulty collecting the money it is owed and its credit standards are too lax. Once a company recognizes that an accounts receivable will not be collected, it must reduce the value of the account and write the uncollectable accounts off. The recognition of this charge will ultimately impact the company. Companies maintain a reserve against potentially uncollectable accounts receivables, titled an allowance for doubtful accounts. It represents management's estimate of how much customers will default on their bills. The allowance reduces (is charged against) the accounts receivable account. The higher the allowance for doubtful accounts, the more conservative the company is in its estimates. Acceptable levels vary by industry, so it is important to compare a company against similar firms.
Inventory levels are also crucial. A low level of inventory may make it difficult for the firm to meet demand, thereby losing sales opportunities; an inventory level that is too high reduces the return on assets and may also imply that the inventory may not be easily converted to sales. Acceptable inventory levels vary by industry and are tied to the useful life, cost and replacement pattern of the goods. For example, personal computer manufacturers must balance the risk of not being able to finish goods because of the shortage of a critical component such as a processor, against the possibility of being stuck with out-of-date or devalued inventory due to product enhancements or price declines. Inventory is generally a wasting asset that must be written off once it becomes obsolete. Inventory levels should be checked against sales. The two items should grow at roughly the same rate. Deviations merit further examination.
The overall level of total current assets also becomes important in comparison to the level of current liabilities (explained in Putting the Numbers to Work: Ratio Analysis).
Property, Plant and Equipment
Property, plant and equipment consists of fixed assets used to generate sales over a period of years. Depending upon the business, it may include buildings, computers, office equipment, machinery, etc. With the exception of land, a portion of the original cost of these items is written off as an expense each year over the estimated life of the asset. These expense write-offs are totaled in the accumulated depreciation account. The cost of property, plant and equipment less accumulated depreciation equals net property, plant and equipment.
The importance of the property, plant and equipment account will vary from industry to industry. For a manufacturing enterprise, it should be watched carefully. For a company selling services, or even software enterprise, it takes on less importance.
Goodwill
Other assets can include securities held by the company as long-term investments (important for financial firms) and intangible assets such as goodwill and patents. Goodwill is created when one company acquires another and pays a price above the book or accounting value of the firm. It is termed an intangible asset because it cannot be linked directly to the cost or value of a real, tangible item. Companies are required to test goodwill at least annually for possible impairment: They must estimate the fair value of all components that goodwill is attributed to and compare that value with the carrying amount currently being reported. If the carrying amount exceeds the estimated value, the difference must be realized as an impairment loss. This creates non-cash charge that lowers reported earnings but not cash flow. Some analysts like to subtract the intangibles account from the owner's equity account to calculate a more conservative tangible net worth value. The need to adjust for intangibles varies from company to company. The potential intangible value of a brand name such as Coke, Disney, or McDonald's is high and can justify a rich premium above the book value. For other firms, a purchase premium may not be justifiable.
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