Current Assets on the Balance Sheet
Investing Lesson 3 - Analyzing a Balance Sheet
The first thing listed under the asset column on the balance sheet is something called "current assets". What are current assets? Why do they matter so much? Those are important questions I'm going to answer over the next couple of minutes.
First, let's get to the definition. Put simply, the current assets section of a balance sheet is where a company lists not only its cash and cash equivalents but all of the stuff that can be converted into cash in a short period of time, usually a year or less. Because these assets are easily turned into cash, they are sometimes referred to as liquid assets. Some of the specific items found under current assets are important enough they justify their own explanation so let's get started.
Cash and Cash Equivalents as Current Assets on the Balance Sheet
Cash and Cash Equivalents under the current assets section of a balance sheet represents the amount of money the company has parked in the bank, stashed away in savings bonds, invested in certificates of deposit, and working in money market funds. It tells you how much money is available to the business immediately.
Of course, this begs the question as to how much cash a company should keep on its balance sheet. Generally speaking, the more cash on hand the better, though excessive amounts are likely to make investors unhappy as they would rather have the money paid out in the form of a dividend to be reinvested, spent, saved, or given to charity (nobody likes seeing someone else hoard wealth that rightfully belongs to them, especially if isn't doing anything to earn a good return). Not only does a decent cash hoard give management the ability to pay dividends and repurchase shares, but it can provide extra wiggle-room when times get bad.
Typically, a common stock investor is going to be happiest when the stock market falls apart if he or she owns a large, profitable business with enormous cash reserves and little to no debt. Often, these strongly capitalized businesses can swoop in and take advantage of the maelstrom, buying up competitors for a fraction of their true value, or expanding market share as others in the industry are busy playing defense.
A company that has a policy of piling up staggering amounts of cash and cash equivalents as current assets is known to be adhering to a "fortress balance sheet" philosophy. Two famous examples are Berkshire Hathaway, a holding company here in the United States, and Nintendo, a video game company in Japan. The former routinely has $40 to $60 billion in cash on hand. The latter has so much cash parked in its current assets that even if it stopped selling products tomorrow, it could continue to pay its bills and employees for more than 100 years.
The reason Nintendo has such an extremely high level of current assets is due to institutional memory of the video game industry crash during the 1980s when nearly every video game producer was wiped out, bankrupted, and/or liquidated. Management vowed to never allow the terror of such an industry-specific Great Depression event threaten its solvency ever again.
There are some cases where cash on the balance sheet isn't necessarily a good thing. If a company is not able to generate enough profits internally, it may turn to a bank and borrow money. The money sitting on the balance sheet as cash may actually be borrowed money. To find out, you are going to have to look at the amount of debt a company has, which we will be discussed later in this lesson. The moral: You probably won't be able to tell if a company is weak based on cash alone. The amount of cash relative to debt payments, maturities, and cash flow needs is far more important.
Short Term Investments as Current Assets on the Balance Sheet
These are investments that a company plans to sell shortly or can be sold to provide cash. These short-term investments aren't as readily available as money in a checking account but they provide added cushion if some immediate need were to arise. Such securities and assets become important when a company has so much cash sitting around that it has no qualms about tying some of it up in slightly longer-term investment vehicles such as bonds which have maturities of less than one year. This allows the business to earn a higher interest rate than if it stuck the cash in a corporate savings account.
Not All Current Assets Are Equal
As an investor, you need to understand not all current assets on the balance sheet are equal. When I first wrote this lesson many years ago, I warned that many companies were holding things called auction rate securities they were treating as safe cash alternatives but they were nothing of the sort; that they could dry up and it could take weeks, months, or even longer to convert back into greenbacks. The reason? I wouldn't have wanted to be exposed to a firm that had too many of them parked under the current assets section because it indicated a failure of managerial intelligence to me.
Of course, subsequent experience demonstrated this to be the case and the use of auction rate securities as a current asset declined.
There's always something new, though. I can't tell you what the next thing will be but when it arises, you need to be paying attention. Specifically, you need to dig into the 10K or annual report and find out how stable the cash reserves are.