Understanding assets in accounting can help businesses obtain both short- and long-term financial goals.
The term "asset" is often heard when the financial value of a business is being assessed. An asset can be any resource that an individual or a corporation controls and generates a positive economic benefit for its owner. Personal assets contribute to a person's wealth, while business assets are for corporations and are listed on balance sheets and used against liabilities and equity. Here is a primer on assets, including how they work and how to determine their value.
What are assets in a business?
Assets are resources, owned by an individual or a corporation, that can be converted into cash or generate cash flow in the future. Examples of personal assets include homes, cars, art, property, and investments such as bonds, pensions and retirement plans. A person's net worth is calculated by subtracting their liabilities (everything they owe) from their assets (everything they own).
Business assets include anything the business owns that has positive economic value and could sustain production and growth. A company lists its assets on a balance sheet, which details the business's worth, how it is financed and how well it manages its resources.
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Examples of assets
The most common assets that companies list on their balance sheets are cash, investments, accounts receivable, inventory, prepaid expenses, property, buildings, equipment, furniture, vehicles and company devices. Calculating the total value of assets can help determine a company's net worth. Businesses need to classify assets to determine the business's value and financial health.
"Having this type of real-time information at their disposal – cash, inventory, etc. – is incredibly beneficial to business owners," said Alberto Ortiz, president of ATAX. "Classifying short-term assets such as cash, accounts receivable and inventory provides a snapshot of where a business owner's resources are invested for operations."
Ideally, a company's assets should be balanced to accommodate both short-term and long-term business needs, Ortiz said.
"Think of it as a tripod: Too much allocation in one area can unbalance a business's financial position," he said. "For example, having a high accounts-receivable outstanding balance could indicate a business has less cash available to fund upcoming inventory, reducing sales or forcing a business owner to borrow for upcoming purchases inadequately. The same problem can occur in reverse, when having more inventory than necessary to keep up with demand can deplete cash balances."
How do assets work?
It's essential to keep track of business assets, because they can be necessary in many financial matters for a corporation. When business owners are looking to be insured and protect themselves, for example, they need to identify their assets and their worth to get proper insurance coverage.
Assets also play a role in the loan process, as lenders consider the value of your assets when determining the amount of a loan and whether to approve it. They may also use certain assets as collateral, depending on the amount of the loan.
Every asset has three key properties that help determine its value:
- Ownership: Assets that represent ownership can be converted into cash and cash equivalents.
- Economic value: Assets with economic value can be sold or exchanged.
- Resource: Assets can be used to create future financial benefits.
What are different types of business assets?
Convertibility: Current and fixed assets
Current and fixed assets can easily be converted into cash or cash equivalents.
"Healthy cash flow is critical for any business, and all owners must keep an eye on cash," said Stacy Burrell, director of finance at Fracture. "Because assets are the business, cash obviously sits on top of the list of all assets, which are ordered by how easily they can be converted to cash."
A current asset can be converted into cash within one financial year or operating cycle. These assets are used to facilitate day-to-day operational expenses and investments. They include (but are not limited to) cash, market securities, accounts receivable and inventory.
"Accounts receivable and inventory are current assets, as they can easily be converted to cash," Burrell said. "Inventory refers to assets that are ready to be sold or converted into a finished product to be sold."
Current assets are typically expected to be liquidated within one year or cycle or converted into fixed assets. Fixed assets have a life of more than one year. They typically include property, equipment, vehicles and furniture. Fixed assets cannot be easily converted to cash in or meet short-term operational demands or expenses.
Physical existence: Tangible and intangible assets
When assets are categorized by their physical existence, they are considered either tangible or intangible. Tangible assets exist in a physical form; they can include cash, investments, land, buildings, property, inventory, vehicles and many other valuables. Many current and fixed assets fall into this category.
Intangible assets do not exist in any physical form, and their value is not easily determined. They can include a brand name, a dictation network, patents, processes, corporate methodology and business copyrights.
Usage: Operating and nonoperating
Assets that are categorized by their usage can be considered operating or nonoperating. An organization uses operating assets in its day-to-day operations; these include cash, stock, buildings, inventory, equipment, machines, copyrights and patents.
Nonoperating assets generate revenue but are not required for business operations; they include short-term investments, vacant property and interest income.
How do you determine the value of your assets?
Asset valuation is incredibly important for a corporation's financial success, especially in the event of a company merger, loan application, audit or sale of the asset.
Businesses should start by listing their assets on a balance sheet. [See our reviews of the best accounting software]. From there, they can add up their assets and use the basic accounting formula to determine their net worth. Larger businesses' assets need to be determined by a professional appraiser.
There are four methods of determining the value of an asset: the cost method, the market value method, the base stock method and the standard cost method.
- The cost method appraises an asset based on its original price. Because of the changes in the market and depreciation, however, businesses don't always get the most accurate results.
- The market value method determines the value of an asset based on the price it would sell for on the open market.
- The base stock method has the company keep a certain level of stock, and the value is assessed based on the base stock. Not every type of asset can be determined through this method.
- The standard cost method uses expected costs, as opposed to actual costs, to appraise an asset. The company bases the expected cost on its experience with the asset and estimates what it will be worth in the future. To determine these costs, a business records the differences between expected and actual costs. Because actual costs often differ from expected costs, these differences are known as variances. Favorable variances are when actual costs are less than expected costs; unfavorable, or negative variances, occur when actual costs exceed expected costs. Variances can affect the company's valuation, and large, recurring variances should be investigated.
Understanding how to properly value your business's assets is critical to understanding its overall financial health. Using the methods above will help you ensure a more accurate valuation of your assets.