Balance sheet has two headings – Liabilities and Assets. Liabilities are nothing but sources of funds. Where did the business source its money? Money sourced from insiders is called Share Capital and money sourced from outsiders is called loan.
Assets on the other hand are uses of funds. Where did the business use the money it sourced? Most of the times it is used in acquiring fixed assets. We also discussed that sometimes the business borrows in kind and they are called Current Liabilities. Similarly on the assets side there is Current Assets.
Further simplifying the Balance Sheet in four sections: (1) Share capital and Loans as Long-Term Liabilities (This is called Long-term liability as the business is not liable to pay these within one financial year. Anything payable in a period longer than one financial year is called Long-term Liabilities.) (2) Short-term Liabilities (Current liabilities is the money business is supposed to go out of business within one financial year. Hence they are called Short-term liabilities) (3) Long-term Assets (Fixed Assets) and (4) Short-term Assets (Current Assets).
We did not purchase Land, building and equipments which are fixed assets to sell within one financial year. That is the reason they are called Long-term assets. However, if you are in real-estate business or a car retailer then definitely it would not be classified as Fixed Assets. It would be classified as Inventory under Current Assets. Ideally speaking life of equipment should be equal to life of a loan.
For example, you want to start a taxi business. You are buying a car to use it for five years then take a loan for five years. This is because you can pay a part of the money earned from the passengers as interest to the bank. That is what should be done.
Similarly, Long-term Liabilities should be invested in Long-term Assets and Short-term Liabilities should be invested in Short-term Assets. But in case of business 1 + 1 is never equal to 2. The client who tells you that he is going to give you business next week may not even give the proposed business even in a month’s time. Also the client who is supposed to pay on the 21st day may not pay on that day. It might be 22nd, 25th, 30th or even much longer.
What I want to make clear is that there is no ideal situation in Business. In that scenario it is acceptable to invest Long-term liabilities in Short-term assets. Why am I saying acceptable? It is because long-term lenders will ask for their money only after one financial year. If we have invested in short-term assets, we can liquidate (cash) that short-term asset within one financial year. When we have to pay the long-term lenders, we will have the money to pay them.
All assets can be classified into two types:
- Performing Assets (PAs)
- Non-Performing Assets (NPAs)
Performing Assets (PAs): Are the assets that directly help in generating income.
Non-Performing Assets (NPAs): Are assets that indirectly help in generating income.
- Every organization is bound to posses NPAs.
- Non-performing does not necessarily mean non-essential or those that are not required.
- NPAs are those that do not directly generate income.
- Furniture in Café is essential but does not generate income. However, coffee machine is a performing asset.
- Office car given to CEO is a NPA, however if it is used as a taxi then it is a Performing Asset.
- PA v/s NPA ratio
- Let us assume the ratio to be 50:50. – Sometimes it might be 70:30 and sometimes 30:70. It is very subjective and varies from business to business. For this example we will assume it is 50%.
- The mistake can be avoided by generating $163,000 on an investment of $1,000,000.
- However 50% of assets are NPAs, so business has to generate $163,000 from $500,000.
- This now takes the targeted rate of return from 16.3% to 32.6%.
Question: Do PAs perform throughout the year?
No, it does not.
- It has been estimated that PAs effectively perform for two-thirds (2/3rd) of the year. You open your business in the morning and close in the evening. So, definitely business is not happening for 24 hours. Some business will be open on weekends and some stay off. Then you have public holidays and other holidays. Then you have seasonal variations. So it is estimated in general PAs perform only 2/3rd of the year.
- But liabilities perform throughout the year! The banker will not say that since it is a public holiday and you are not making money so do not bother me paying that day’s interest. That would not happen. You still will have to pay the full amount.
- So now assets are supposed to generate 32.6% which has to be achieved over 2/3rds of the year.
- The effective targeted annualized rate of return now goes up to 48.9%.This is because PAs perform 2/3rds of the year. So the Cost of Capital for this business is 48.9%.
Let me explain to you what an Expense is and what is an Asset. When money is spent, it becomes an Expense or it creates an Asset. So when money goes out of business it is either becoming an Expense or creating an Asset. Let us have a look at a few Examples.
- Six month’s salary in advance. Suppose you have paid an employee six months’ salary in advance. Is it an Expense or an Asset?
- Machinery purchased and destroyed in two months. Is it an Expense or an Asset?
Most of you will get confused. Some will say six month’s salary paid in advance is and expense and Machinery purchased and destroyed in two months is an Asset. Whether money spent is an expense or an asset depends actually on the life of the item being considered. Let me explain this in detail. Let us start with a simple example.
Example: (a) Suppose you buy something and it lasts for 10 months. Is it an Expense or an Asset?
(b) How about something you bought and it lasted for 10 days. Is it an Expense or an Asset?
|Item purchased on
||Balance Sheet prepared on
||Expense or Asset
|a) 01 January ‘14
||10 months (31 Oct ’14)
||31 December ‘14
|b) 27 December ‘14
||10 days (05 Jan ’14)
||31 December ‘14
Well in this case (a) is an expense and (b) is an Asset. To keep it simple as I always do, I would like to replace the word life of an item with consumption. If an item that is purchased is consumed before the Balance Sheet is prepared it becomes an expense. If the item which is purchased and not been consumed before the Balance Sheet is prepared, then it becomes an Asset.
Now you might have a question. What if an item is partially consumed? Well whatever is consumed becomes an Expense and the part that is not consumed is an Asset.