In previous articles, we covered a general overview on how financial ratios could be used to diagnose the financial health of a company, as well as how to interpret and make sense of those ratios. Today, we would be diving deeper into the financial position or balance sheet to shed more light on the concepts of assets and liabilities.
What is an asset?
The International Financial Reporting Standards or in short IFRS’s (i.e. international accounting body) definition of an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. This definition highlights two important concepts of what an asset is:
- Control: An asset must be a resource that the entity can control. Control is generally evident from the ownership of the resource, but would depend upon the terms and conditions of the ownership. For example, a company would have control over a property if the property is leased to them for the entire estimated period of its useful life. On the contrary, employees cannot be defined as an asset by most company in general, as employees are free to tender in their resignation on any given day. This is however different for a football club in which their football players are contracted for a fixed period of tenure.
- Future economic benefits are expected: This means that economic benefits must be reasonably expected to flow into the entity as a result of the control of the resource. Therefore in an event that the economic benefits are not expected to flow into the entity, like in the case of a long overdue amount of receivables or an obsolete product inventory, the assets have to be written off or down to the amount that the entity reasonably expects to receive.
Importance of assets in the evaluation of the financial health
Assets and their value are essential in valuing a business. For example, a rational management would only purchase a machine at a value that is lower than the expected economic benefit that would be derived from the utilisation of the machine. As such, the recognition of the assets of the entire business would be an indication of the expected future economic inflow and hence the value of the business. It is also a good proxy indicator of the business’s ability to generate sufficient resources to pay off all of its current liabilities (i.e. financial sustainability of the business). The timing of the inflow is also something that the company would want to monitor, so as to ensure that the inflow amounts are timely to pay off the amounts when due to creditors (i.e. liquidity of the business).
Another important aspect to assets is that, like all businesses, some are of higher quality than others. For example, PPE (Property, Plant and Equipment) would be of higher quality than trade receivables and cash in evaluating the growth potential of a company. This is because trade receivables and cash are not investments that would generate a greater economic benefit than the amounts already reflected in the balance sheet. As such, it is generally deemed as of lower quality than other assets, which are investments in nature, in evaluating the growth potential.
If sustainability of the business is the evaluation standard, then the reverse is true. More liquid assets, such as trade receivables and cash are preferred to investment natured assets like PPE. This is simply because the materialisation of investments into cash are generally more uncertain and requires a longer period of time. Therefore, non-investment natured assets are of higher quality in the evaluation of this aspect.
Assets are an essential part of the business and is an aspect that should be monitored by business owners. It serves many purposes as an indicator of the business value, the growth potential of the company, the financial sustainability and liquidity of the company.
With that, this concludes the first part of the article. In the next and final part, we would cover the liabilities aspect to the balance sheet; touching on what are liabilities and more importantly what does these mean to business owners.