Deliver Credibility, Accuracy, Practical Value
Building the Business Case
Solution Matrix Ltd®

Asset and Asset Life Cycle Management
Explaining Definitions, Meaning, Categories, Asset Categories, Examples

 

For companies in heavy manufacturing, factory machines and buildings represent the largest component of the firm's asset base.

Expensive assets justify their place on the Balance sheet by earning returns.

What Are Assets?

Businesspeople use the term asset in at least two different ways:

First meaning: Assets in Financial Accounting

To accountants, an asset is an item of value the firm owns, which the firm acquires at a measurable cost and uses in its normal line of business to generate income.

  • Business people rightly view a firm's assets as investments. Firms acquire assets at a cost and they expect assets to produce returns that outweigh their costs.
  • Accountants record and track asset book value withasset category accounts.Familiar examples include Balance sheet accounts such as "Cash on Hand," and "Property, Plant, and Equipment."
  • The methods a firm uses for acquiring, using, and disposing of assets, together, make up the practice known as life cycle management.
  • Analysts measure asset earning performance with financial metrics such as return on assets (ROA) and inventory turns. Assets that are not performing well become candidates for disposal or replacement.

Sections below further develop these points, all assuming the accountant's formal asset definition, above. Before moving to these points, however, it is worth noting briefly that business people sometimes say "assets" when they have in mind a much broader meaning.

Second Meaning: Assets as "Valuable Resource"

Many people use the term asset when they simply mean "valuable resource." In this sense, a firm's assets include physical resources such as office furniture and computer systems, of course, but also non physical resources such as employee skills and a strong brand image.

Business firms sometimes issue public relations statements such as these: "Our employees are our greatest assets." Or, "Loyal customers are this firm's most valuable assets." When businesspeople use the term asset in this second, broader sense, certainly not all the resources in view qualify for the accountant's Balance sheet.

Nevertheless, astute managers fully scope the broadly-defined asset base and try to understand the business value of every important resource. Astute directors and officers expect senior managers to make the best use of all assets, on or off the Balance sheet.

Explaining Assets and Life Cycle Management in Context

This article further defines assetin context with related concepts in asset management, accounting, and finance.


 

Contents

Related Topics

 

Understand the Asset Base
Start With the Balance Sheet

The Balance sheet is a high-level snapshot of a firm's asset structure and the book value of its asset accounts. For this reason, the Balance sheet is an excellent starting point for building an understanding of a firm's asset base.

Assets Should Earn Returns

Owners expect assets to earn returns throughout their lives in service on the Balance sheet. Assets that do not or will not earn returns become candidates for disposal.

  • In construction industries, for instance, heavy equipment that sits idle for long periods of time fits this description.
  • In transportation industries, costly assets such as aircraft and delivery vehicles are normally in service or in maintenance around the clock, so as to maximize asset returns.

Company management and stockholders expect assets to justify their place on the Balance sheet by producing value for the company in excess of their cost. Financial statement metrics such as Inventory Turns, Total Asset Turnover, or Return on Assets (ROA) use Income statement and Balance sheet figures to measure the company's efficiency and productivity in using assets.

The Balance Sheet Always Balances.

The firm's Asset accounts and their end-of-period balances make up one "side" of the Balance sheet, while the entire sheet is simply a detailed instance of the so-called Balance sheet equation:

Assets = Liabilities + Owners Equity
  • Assets are resources the entity uses for earning income.
  • Liabilities are what the entity owes.
  • Equities are what the entity owns outright.

Most firms in private industry practice accrual accounting with a double-entry accounting system. With this approach, the balance between Assets, on the left, andLiabilities + Equities, on the right, always holds. Double-entry rules ensure that a change to an account in any category (Assets, Liabilities, or Equities) brings an equal offsetting change to one or more other accounts, restoring the balance.

  • If the firm buys a production machine with $2,000 cash, accountants credit (decrease) an Asset account "Cash" by $2,000 while debiting (increasing) another Asset account, "Production machinery" by the same $2,000. As a result, the overall Assets total does not change and the Balance sheet balance holds.
  • If instead the firm takes a $2,000 bank loan for the same purchase, accountants credit (increase) a Liabilities account "Bank Loans" by $2, 000. At the same time, they debit (increase) the Asset account "Production Machinery" by $2,000. Adding $2,000 to both sides of Balance sheet equation in this way maintains the balance.

The Balance Sheet Reveals Asset, Capital, and Financial Structures

Exhibit 1, below shows how the Balance sheet reveals three of the firm's structures: Asset Structure, Capital Structure, and Financial Structure. Green, blue, and red borders in Exhibit 1 show that each structure represents a group of Balance sheet accounts.

Grande Corporation                            Figures in $1,000's
Balance Sheet at 31 December 20YY   
ASSETS
Current Assets
LT Investments & Funds
Property, Plant & Equip
Intangible Assets
Other Assets
Total Assets


9,609
1,460
9,716
1,222
   68

Asset






22,075
Structure
   
    LIABILITIES
Current Liabilities

 3,464
 
 
  Long Term Liabilities
Total Liabilities
 5,474
8,938
   
OWNERS EQUITY
Contributed Capital
Retained Earnings
Total Owners Equity

3,464
 5,474

Capital



13,137
Structure
   
Total Liabilities & Equities
               Financial Structure
22,075

 

Exhibit 1. Asset book values and Asset Structure on the Balance sheet. In fact, the components of Asset Structure, Financial Structure, and Capital Structure all appear on the firm's Balance sheet. Asset Structure is defined in terms of the relative magnitudes of asset values in each category.

  • Asset Structure shows how the firm distributes its investments in assets among different asset categories.
  • Capital Structure (Capitalization) shows the funding sources for the firm's asset base. Funds for acquiring assets are taken from either or both of the following:
    1. The Equities base. Funds from this source constitute Equity funding,
    2. Liabilities such as bank loans or bond issues. These funds areDebt funding.
  • Financial Structureis very similar to Capital Structure. The difference is as follows:
    • Financial Structure includes Current Liabilities, Long Term Liabilities, and Equities.
    • Capital Structure includes only Long Term Liabilities and Equities.
  • Analysts regard Financial Structure as a comprehensive snapshot of the firm's overall financial position. Capital Structure, by contrast, shows how the firm capitalizes (acquires) its asset base.

Picturing Asset Structure

Exhibit 1 shows that Grande Corporation's asset base has a book value of $22,075,000. The firm's asset structure shows how the firm distributes this total among 5 asset categories. Grande can picture its Asset structure as a table ( Exhibit 2) or as a chart (Exhibit 3).

Asset Category Total Assets Asset %
Current Assets $9,609 43.5%
Property Plant & Equip. $9,716 44.0%
Intangible Assets $68 0.3%
Long Term Investment $1,460 6.6%
Other Assets $1,222 5.6%
Assets Total $22,075 100.0%

Exhibit 2.Grande Corporation Asset structure in table form. Percentage of the total asset base that appear in each category (third column) define the structure.

 

Exhibit 3. Grande . Corporation Asset Structure in graphical form. The Pie Chart format is appropriate because it shows how the firm distributes 100% of its total asset investment among different asset categories.

The Asset Base as Investment Portfolio

Directors and owners of public companies hold the firm's officers and senior managers responsible—above all—for earning, growing, and maximizing profits. They expect profits, moreover, in the firm's core line of business. To understand exactly how they develop strategies for pursuing profits, it is helpful to cast managers and officers in the role of investment portfolio managers. In this sense,

  • The asset base is a collection of investments.
  • Each asset category is a different class (or kind) of investment.
  • The five asset classes in Grande's asset structure represent the firm's complete asset investment portfolio.

The mandate to deliver maximum profits can now be re-stated as the portfolio manager's mandate to maximize returns from an entire investment portfolio.

Different Asset Structures for Different Industries

In pursuing profits, different portfolio structures (Asset Structures) perform best in different industries.

  • Grande, for instance, has an Asset Structure that performs well for companies in heavy manufacturing. Grande invests heavily in Property Plant and Equipment (44.6% of the asset base) and Current Assets (43.5 % of the base).

    For companies in heavy manufacturing, incidentally, the greatest part of the Current Assets investment normally consists of inventories—Raw Materials, Work in Progress, and Finished Goods inventories.
  • The same asset structure would perform very poorly, however, for firms in certain other industries. Companies in Financial Services, for instance, may invest very lightly in Property Plant and Equipment.

    These firms typically maximize asset portfolio performance by investing heavily in Long Term Securities and certain other Current Assets, such as Marketable Securities and Short Term Investments.

Further resources on Asset, Capital, and Financial structures

What is Asset Life Cycle Management?

The entire practice of acquiring, using, and disposing of assets is known as asset life cycle management. The specific activities and methods that asset managers use differs among different kinds of assets. Generally, however, those responsible for managing assets try to use best-practice methods for pursuing the following objectives:

  • Ensure assets are available where and when the firm needs them.
  • Minimize the risk of asset failure.
  • Maximize the return (gains) from assets.
  • Ensure that the firm uses assets productively throughout their economic lives.
    • This means assets are not wasted or allowed to sit idle.
    • This may involve working with other managers to improve or re-design processes that impact asset utilization and productivity.
  • Sell or otherwise divest assets that are idle or unproductive.
  • Set priorities for acquiring assets, replacing assets, and planning future expansion or reduction of the asset base.

Reaching Asset Base Objectives

Reaching these objectives requires very good knowledge of asset ...

  • Expected gains or returns.
    • This means knowing specifically how each assets class contributes to meeting business objectives for operational performance,
    • This also means knowing asset life cycle total cost of ownership
  • Advancements and the current state of technology. This is obviously true for computing and communications technology, but it is also important for:
    • Any asset class involving constantly improving technologies, such as medical or laboratory equipment.
    • Assets subject to changing requirements for fuel efficiency or emissions.
  • Reliability and availability risks.
  • Available choices in leasing vs. buying, and the implications of each choice for:
    • Upgrade or replacement flexibility.
    • Responsibility for maintenance.
    • Position either on or off the Balance sheet.
    • Potential tax liabilities and tax savings.
  • Asset depreciable life, economic life, and service life.
  • Appropriate depreciation methods for each asset class.
  • Fair market value and replacement cost.
  • Residual value at the end of depreciable life.

Tangible vs. Intangible Assets
Do Both Belong on the Balance Sheet?

Accountants classify assets first as either tangible or intangible assets. The distinction impacts the way they report, track, value, and expense (depreciate or amortize) these assets.

What Are Tangible Assets?

A tangible assetis an item with physical substance, such as land, buildings, computers, or cash. "Tangible" simply means the asset exists as something "touchable.".

Accountants view certain kinds of assets as tangible, even though they may seem at first to have no physical substance. Familiar examples include:

  • Cash funds in bank accounts. Such funds are tangible, even though they exist only as account records in the bank's accounting system.
  • The firm's Accounts receivable funds. These are tangible Current Assets, even through they exist only as recorded debts that customers currently owe to the firm.
  • Purchased software programs. These are tangible Long Term Assets, even when they exist only as information in computer memory.

What Are Intangible Assets?

An intangible asset, like all other assets, is an item of value the entity acquires at measurable cost and uses to generate income in its normal line of business. The intangible kind, however, have no physical substance and are by definition not "touchable." Typical examples include:

  • A purchased right to use a patent, copyright, or trademark owned by another firm.
  • The right to use another firm's logo and brand name. Such rights are normally included when one firm purchases an operating franchise from another.

Even though they have no physical substance, intangible assets can and often do appear on the Balance sheet. However, a given asset's eligibility for the Balance sheet depends on factors such as these:

  • How the firm acquires the intangible asset.
  • Whether the asset is a legal intangible or a competitive intangible.
  • Whether asset ownership has a limited life or indefinite life.

Acquiring assets: Purchased intangibles vs. internally created intangibles

A patent (the intangible), for instance, might result from the company's own internal research and development activities. Alternatively, the a firm might purchase the right to use a patented design from another owner.

By accounting standards (such as GAAP), purchased intangibles are usually easier to value and include in financial reports than are intangibles that firms develop internally. Intangibles bles that firms develop internally are generally not subject to depreciation.

Logos and Brand Names as Intangible Assets

Logos and brand names that firms such as Coca Cola, Georgio Armani, and Apple own are arguably "valuable resources" for the companies that own them. Nevertheless, these specific logos and brands do not qualify as intangible assets for the Balance sheet because their owners create them over time—they do not buy them outright.

By contrast, the purchaser of an operating franchise, such as a franchise holder with Domino's Pizza, or McDonalds, can list the franchise brand name and logo as intangible assets on the franchise owners Balance sheet. This is because the use of these assets was purchased at a measurable cost for use across a specific time period.

Legal Intangibles vs. Competitive Intangibles

Businesspeople sometimes refer to Legal intangibles as intellectual property. These may include such things as trade secrets, proprietary knowledge (for example, a proprietary soft drink formula), patents, trademarks, and copyrights. Intellectual property rights for such things are legally defensible in courts of law.

On the other hand, competitive intangibles are intangibles that enable the company to compete effectively. These may range from such things as human capital—the skill and experience of the company's employees—to company reputation or brand recognition. Competitive intangibles may also include collaborative activities and business partnership agreements. Such competitive intangibles are generally not legally defensible in court.

Limited Life Intangibles vs. Indefinite Life Intangibles

A company's brand recognition (a competitive intangible) is usually , also, an indefinite life intangible. This is because it will probably remain with the company indefinitely. By contrast, where there is a purchased right to use a patent or brand name for a specified period of time, the intangible (right to use the patent) is a limited life intangible.

The Major Asset Categories
Where Do They Appear on the Balance Sheet?

Balance sheets generally do not list individual asset items. This would occur only if a single asset item had an asset account of its own in the accounting system, and then only if that represents more than a few percent of the total asset base. As a result, asset names on the Balance sheet usually do not identify individual asset items, but rather, they represent the following:

  • Individual asset accounts such as "Raw Materials Inventory"
  • Asset account groups, such as "Current Assets.

Balance sheet asset listings, in other words, must represent the firm's own Chart of Accounts. And, because there is no single standard Chart of Accounts, it follows that there is no single standard list of asset categories.

Nevertheless, this section presents some of the more frequently used asset categories. A later section presents an example Balance Sheet with a very large set of asset accounts and account categories (see the Balance Sheet Example, below).

Current vs Long Term Assets

Major asset categories (major asset account categories) for Balance sheet reporting appear below. Most companies begin asset classification with two high level categories;

  • Current assets (or Short Term assets): Assets with an expected life of one year or less.
  • Long term assets: Assets with an indefinite expected life, or an expected life of at least exceed one year.

Generally accepted accounting principles in most places require that long and short term assets list separately. That is, not Long and Short Term assets do not combine in a single Balance sheet item. Beyond this, however, there is some room for flexibility and individuality in the application of asset class names.

  • The categories below, for instance, are not necessarily mutually exclusive: Some assets may qualify for listing under several classes listed below, such as capital assets, property plant and equipment, or fixed assets.
  • Some companies choose to report asset categories by naming the asset, such as "Store Equipment," "Computer Systems," or "Delivery fleet vehicles."

With these considerations in mind, familiar Balance sheet asset categories (account categories) include the following:

Current Assets

Current assets are so-named because they include cash and other items that the firm could convert into cash or use up in the near future, usually within a year. Accounts Receivable and Finished Goods Inventory, for this reason, normally appear under Current Assets. Other kinds of current accounts may include Short Term Notes ReceivablePrepaid Expenses, Prepaid Taxes, and Deferred Taxes

Figures for Balance sheet Current Asset items contribute to asset-focused liquidity metrics. These metrics include acid-test ratio, current ratio, and working capital.

Long Term Assets

Long term assets are assets that will remain on the Balance sheet for a year or more. These assets typically include Capital Assets, Fixed Assets, and Property, Plant and Equipmentassets.

Figures for long term items from the Balance sheet contribute to asset-focused investment and valuation metrics for the company, such as Return on Total Assets ROA, and Total Asset Turnover.

Capital assets

The term Capital Asset is sometimes used interchangeably with Fixed Asset. A capital item is long-lived and usually tangible. These items:

In order to qualify as a capital resource, the item must have an acquisition cost above a specified value, and it must need to have a useful life of more than one year.

In Balance sheet accounting, capital items are reported separately from Current assets. Fixed items are considered less liquid than Current items because capital items would be more difficult to convert into cash in the short term.

Fixed Assets

The term fixed asset is sometimes used interchangeably with capital or non current assets. These are tangible resources owned by the corporation or entity, that are not used up, consumed, or converted into cash during normal business operations.

Factory machinery, buildings, and large computer systems are typical Fixed items. In Balance sheet accounting, firms report capital and/or Fixed items separately from Current items, sometimes in a category called "Property, Plant and Equipment."

Wasting Assets

Wasting assets include items that are "used up" as well as other items that otherwise lose value after a specific time period. Those in the first category include natural resources, such as timber, or oil, which are consumed or used up in the course of business. Assets in the second category include stock options which either expire at a certain date or, due to changing market conditions, become worthless (become "out of the money").

Intangible Assets

An intangible asset, as the section above explains, is an item of value the firm owns or controls, which the firm acquired at a measurable cost. Unlike the physical assets described in this section, however, Intangible assets have no physical substance and are by definition not "touchable." Monetary items such as cash or accounts receivable are generally not included in this category .

Even though they have no physical substance, intangible assets can and often do appear on the Balance sheet. Those eligible for the Balance sheet may include a purchased right to use:

  • Patents, copyrights, trademarks, or proprietary intellectual property.
  • Another company's logo or brand name. This can occur when a business purchases a franchise to operate under another firm's name.

Asset Placement on the Income Statement and Balance Sheet

The acquisition and use of assets impacts both the company's Income statement and Balance sheet reports.

Assets on the Income Statement

An asset's full purchase cost generally does not go onto the Income statement as an expense item, at least not all in one year. Instead, the accounting practice of depreciation provides a way to account for the purchase of long-lasting items over a period of years.

The idea is that these items have a useful life (depreciable life), over which they are used up or worn out, and that the owner receives the tax benefits of paying for these items over those years instead of all at once. Each year of the useful life, owners charge a certain percentage of the purchase price against income as a depreciation expense. Tax authorities provide depreciation schedules that specify depreciation rates and depreciable lives for different asset classes. These lower the company's reported income across a number of years and creates a tax savings for the company.

The example Income statement below (Exhibit 5) shows how depreciation expense can appear on an Income statement. For a more complete coverage of the subject, see the encyclopedia entryDepreciation.

Assets on the Balance sheet

The Balance sheet reports book values of the company's assets. For most items, this is the acquisition cost less its accumulated depreciation through the end of the current year of depreciable life. Each year of depreciable life, asset book value decreases by the amount of depreciation (or amortization) expense, until it reaches its residual value.

The example Balance sheet below (Exhibit 5) shows how Accumulated Depreciation for several asset classes is subtracted from their initial cost, to result in the Balance sheet book value.

Financial Statement Impacts

The financial statement impacts above refer most directly to situations involving capital and fixed items. Note that the other categories of assets may also create Income statement expenses and have their book value decreased annually, but with some differences:

  • For intangibles with a limited life (e.g., the purchased right to use a patent for a certain time), the process of reducing book value and charging an expense against income is called amortization instead of depreciation. Amortization expenses of this kind usually calculate with the straight line method across the amortization life.
  • Indefinite intangible assets may also create an Income statement expense, sometimes, and reducing book value accordingly. In this case, however, owners must validate the reduction in value by probing, or testing the current value.

    Damage to a company's brand recognition (if carried as an indefinite intangible) would represent such an impact, if the firm can prove that damage to the company's ability to compete.
  • Generally, business firms do not depreciate Current Assets (including primarily Cash, Accounts Receivables, and Inventories) .
  • Land and other real estate assets are generally not subject to depreciation.
  • Wasting items may sometimes be depreciated according to a usage-based depreciation schedule rather than a time-based schedule. That is, depreciation expense each year is as a percentage of acquisition, estimated as the percentage used up or depleted during the reporting period.

For a broader discussion of the structure of a company's base in these categories, see the encyclopedia entry asset structure.

Example Income Statement
Asset Depreciation Expenses on the Income Statement

Depreciation expenses appears on the Income statement in positions that depend on where and how the firm uses the specific assets.

  • Product production assets, for instance, contribute depreciation expense to cost of goods sold and thereby impact Gross Profit.
  • Below the gross profit line, assets used in selling (e.g., store equipment) appear under "Selling Expense.
  • Assets used for general administrative purposes (such as computer systems) appear under "General and Administrative Expenses."

Exhibit 4 below shows asset depreciation expenses in three categories, one above the Gross Profit line, and two below the Gross Profit line.

Grande Corporation                                   Figures in $1,000's
Income Statement for Year Ended 31 December 20YY   
Revenues
Gross sales revenues
   Less returns & allowances
      Net sales revenues
Cost of goods sold
   Direct materials
   Direct labor
   Manufacturing Overhead
      Indirect labor
      Depreciation, mfr equipment
      Other mfr overhead
      Net mfr overhead
         Net cost of goods sold
Gross Profit








5,263
360
  4,000


33,329
    346


6,320
  6,100




 9,623



32,983








 22,043
 10,940
Operating Expenses
Selling expenses

   Sales salaries
   Warranty expenses
   Depreciation, Store equip
   Other selling expenses
          Total selling expenses
General & Admin expenses
   Administrative salaries
   Rent expenses
   Depreciation, computers
   Other general & admin expenses
      Total general & admin exp
           Total operating expenses
Operating Income Before Taxes
  

  4,200
  730
  120
   972


1,229
180
179
   200






6,022





  1,788













  7,810
  3,130
  Financial revenue & Expenses
  Revenue from investments
      Less interest expense
      Net financial gain (expense)
  Income before tax & ext items
  Less income tax on operations
    Income before extraordinary items
 



118
  511



  (393)
 2,737
  958
1,779
Extraordinary Items
   Sale of land
   Less initial cost
      Net gain on sale of land
      Less income tax on gain
         Extraord items after tax
 
610
  145



465
  118





  347
Net Income (Profit)       2,126
 

Exhibit 4. Example Income statement showing depreciation expenses in 3 different locations. Depreciation expense location depends on how the assets in view are used.

Example Balance Sheet
Accumulated Depreciation on the Balance Sheet

Balance sheets sometimes list asset groups as general asset categories, (e.g., Current assets). However, they can also identify asset categories in terms of how they use the assets (e.g., Store equipment), and sometimes simply in terms of what the items are (e.g., Computer systems).

Exhibit 5 below shows how Grande Corporation reports assets in a number of different categories.

Grande Corporation                                   Figures in $1,000's
Balance Sheet at 31 December 20YY   
ASSETS
Current Assets
   Cash
   Short term investments
   Accounts Receivable
      Less allowance doubtful accts
      Net accounts receivable
   Notes receivable short term
   Inventories
      Raw materials
      Work in progress
      Finished goods/merchandise
      Operating & office supplies
            Total Inventories
   Prepaid exp, insurance, def taxes
          Total Current Assets




1,969
   137



    611
1,692
3,664
      19


1,369
  137


1,832
     20





5,986
  265
















9,609
Long Term Investments and Funds
   Common stock held
   Preferred stock held
   Bonds Held / Sinking funds
   Other Long Term Investments
          Total Long Term Investments
    
  493
  184
  364
  419





1,460
Property, Plant & Equipment
   Factory Manufacturing Equipment
      Less accumulated depreciation
      Net factory mfr equipment
   Store Equip / Selling Assets
      Less accumulated depreciation
      Net store/selling equipment
   Computer systems
      Less accumulated depreciation
      Net computer systems
           Total Property, Plant & Equip
 
5,983
 2,782

5,456
 1,292

4,721
 2,370




3,201

4,164


  2,351










9,716
Intangible Assets
   Copyrights
   Trademarks and Patents
   Goodwill
          Total Intangible Assets
    
1,014
108
  100




1,222
Other Assets
                    Total Assets
         68
22,075
LIABILITIES
Current Liabilities
   Accounts payable
   Notes payable, short term
   Current portion of long term debt
   Accrued expenses, Interest payable
   Unearned revenues
   Taxes payable Other withholding
          Total Current Liabilities



 1,642
    912
    349
     146
     274
    141








3,464
Long Term Liabilities
   Bank notes payable
   Bonds payable, other LT liabilities
          Total Long Term Liabilities
                    Total Liabilities
     
912
 4,562



 5,474
8938
OWNERS EQUITY
Contributed Capital
   Preferred stock
   Common stock
   Contributed capital excess of par
          Total Contributed Capital

Retained Earnings
          Total Owners Equity


3,798
4,184
 1,457





9,439

 3,698








13,137
          Total Liabilities and Equities
    22,075
 

Exhibit 5. Detailed example Balance sheet, listing a number of different asset categories along with depreciation accumulations for several assets.

Asset Focused Financial Metrics
Business Ratios for Asset Questions

Management and investors will want assurance that the company has the assets it needs to operate and grow. They will also seek assurance that the company is using assets efficiently and productively. 

To address these issues, analysts turn to financial statement metrics that attempt to measure the company's resources and their utilization.

Asset Question 1
Does the Firm Have Assets It Needs?

One way to address his question is through so-called liquidity metrics, which focus on the short term. The three most commonly used liquidity metrics are Working Capital, Current Ratio, and the Quick Ratio(Acid-Test Ratio). All three take their input data from Balance sheet entries (for the example Balance sheet with these entries, see the Sample Balance sheet in Exhibit 5, above).

The Working Capital Metric

Working capital is a figure in currency units (such as dollars, pounds, or euro) showing the difference between current resources and current obligations:

Working capital = Current assets – Current liabilities
                             =  $9,609 – $5986 = $3,623

How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next year as well as the cash inflows they expect for the next year.

Current Ratio

The current ratio metric is built from the same input data as the working capital metric, except that here the metric is the ratio of Current Assets over Current Liabilities:

Current ratio = Current Assets / Current Liabilities
                        = $9,609 / $5986 = 1.61

This company's Current ratio may be cause for concern, because a current ratio value of 2.0 is a generally used "rule of thumb" requirement for healthy liquidity, while a Current Ratio under 1.0 is usually a cause for alarm.

Quick ratio / Acid-Test ratio

The most severe liquidity test of the three appearing here is the Quick Ratio, or Acid-Test Ratio. This ratio is similar to the Current ratio, except that the Inventories figure is subtracted from the "Current" total before performing division. The idea is that inventories are the least liquid of the current components:

Quick ratio = (Current Assets – Inventories) / (Current Liabilities) 
                     = ($9,609 –  $3,464)  /  $5986 = 1.03

Here, too, this company's Acid-Test Ratio might be cause for concern. Analysts generally consider an Acid-Test Ratio of about 1.1 as a minimum healthy level.

Asset Question 2
Does the Firm Use Assets Efficiently?

Activity and efficiency metrics such as Inventory turns and Total Asset Turnover address this question by computing ratios from Income statement and Balance sheet data.

Inventory Turns

Inventories, like other assets are supposed to produce returns and not sit idle or unproductive. The Inventory turns metric uses an Income statement item (Net Sales Revenues) and a Balance sheet item (Inventories) to approximate the number of times per year the company "turns" over its inventories.

A higher number of turns for the year is generally preferred for two reasons:

  • Firstly, inventory storage and care can be costly. Removing items from inventory completely means they have been sold.
  • Secondly, inventories tie up funds that might otherwise be used for some other means of producing revenue.

For this example, assume that Grande Corporation's net sales revenues for the year were $32,983, and that its Balance sheet entry for total inventories was $5,986.

Inventory Turns = (Net Sales Revenues) / (Inventories)
                           = $32,986 / $5,986   =  5.5 turns / year

Management may set specific target turn rates, and the value of reaching these targets can be readily calculated.

Total Asset Turnover

Companies acquire resources for the purpose of generating revenues. Total asset turnover compares directly the revenue "returns" from the company's resources, to the book value of these resources. The higher the turnover rate, the shorter the time it takes for these resources to generate their own value in sales. This example uses the same net sales figure ($32,983) as the previous, along with the sample Balance sheet total assets figure of $22,075.

Total asset turnover = (Net Sales Revenues) / (Total Assets)
                                     = $32,983 / $22,075  = 1.49 turns/year

If the company's turn rate is out of line with industry standards, analysts will want to know why. (Companies in the same industry sometimes do have quite different business models, and this could account for the difference between one company's metric and the rest of the industry.

Asset Question 3
Are Asset Investments Profitable?

Are asset investments profitable? This question, in fact, points to the highest level company performance metric in the DuPont System of Analysis.1 And, obtaining an answer to this question represents the primary objective for those who approach asset management as an exercise in investment portfolio optimization. The primary metric for this purpose is the profitability metric Return on Total Assets, ROA .

Return on Total Assets (ROA)

The most wide ranging asset-focused metric is simply return on total assets (ROA). This is simply the company's net income for the year (bottom line of the Income statement) divided by total assets from the balance sheet.

Assuming that Grande Corporation reported a net income (profit after taxes) of $2,126 for the year, and the Balance sheet total assets were $22,075, ROA is:

                        ROA  = (Net Income) / (Total Assets)
                                  =  $2,126 / $22,075  = 9.6%

Investors and senior management will compare this ROA with other companies in the same industry, with year to year changes in this company's ROA, and with other opportunities for earning returns from the same value resources.

For more on asset-focused financial metrics, including Return on Assets ROA and the DuPont System, see the Excel-based ebook Financial Metrics Pro.