Last updated by
Charles Hall
on
June 10, 2022
All business needs assets to operate, but what exactly are assets and how do the different types of assets affect my business?
All business needs assets to operate, but what exactly are assets and how do the different types of assets affect my business?
Assets are resources with economic value owned by a business that can be used to produce future value. Assets can be categorized into 5 groups:
Within each category, there are many different types of assets as well as different ways to utilize them to maximize growth. Keep reading for an in-depth guide to all things assets.
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Table of contents
As we mentioned above, assets are broken up into five main classifications. This helps to easily identify assets by similar type and purpose. They are intentially arranged on the balance sheet in order of liquidity, with the most liquid assets (such as cash) list at the top.
Current assets are listed first because they are the most liquid, meaning they can be quickly converted to cash in less than a year.
Assets that fall into this category in order of liquidity are:
Cash is obviously what is in your checking or saving account by what are cash equivalents? Cash equivalents are short-term investments or marketable securities which can be easily converted into cash amounts.
Examples of cash equivalents are:
Accounts receivable is any money owed to your business for product or services delivered. Whenever someone purchases something from your business but does not pay for it right away, the money they owe you goes under accounts receivable.
Invoices are typically used to document what someone owes. An invoice documents a specific transaction and details the terms of the deal and payment requirements.
Inventory is saleable product whether purchased or produced. We typically associate inventory with finished goods your business has already produced or purchased but has not sold yet. However, other items fall into this category as well, such as:
When you make an advanced payment for a good or service that you will receive in the future, this is considered a prepaid expense.
Examples of prepaid expenses are:
As a small business, you must be able to pay your debts when they come due. Otherwise, you will end up having to borrow money. Current assets are an indicator of your ability to pay current liabilities. Hence having more current assets than current liabilities positions your company for growth.
Small businesses should have at least a 1:1 ratio of current assets to current liabilities. Many people use the current ratio formula to keep track of this.
The current ratio measures your business's ability to pay off its debts. It is calculated by dividing your business's current assets by current liabilities. Typically, a ratio between 1.5 to 3 is considered healthy for most industries.
Fixed assets, also known as Property, Plant, and Equipment, are physical items with useful lives of more than one year. These items are not intended to be immediately sold, rather they are intended to improve the productivity of the business.
Examples of assets that fall under this category are:
Most fixed assets wear out as they are used and have to be expensed over time. This expensing process is call depreciation.
Depreciation is the associated cost of a fixed asset wearing out. Depreciation tries to match the revenue generated by the fixed asset with the associated “wearing out” cost of the fixed asset. Just like cash is removed from your books when it is spent, the value of fixed assets are removed as they are used through depreciation.
Depreciation calculates the decrease in the value of the asset over its useful life. There are four popular ways to do it:
All fixed assets need to be depreciated throughout their useful life, except land. This is because land is not depleted over time like other fixed assets, land typically appreciates in value over time.
When a company invests in another institution and does not plan to sell the acquired assets within a year, these assets are considered long term investments.
Assets that fall into this category are:
Businesses may wish to make long term investments when their cash is not immediately needed for short term projects. Long-term investments allow an asset to grow while it is not being used in the operations of the business.
Small businesses may consider this option to prove to possible investors that they have enough capital available to invest for a long period of time. This shows that they are performing well and not just trying to survive year to year.
However, small businesses need to be sure that they still have the necessary current assets available to continue paying off their debts when they make these sorts of investments.
An intangible asset is an asset that is not a physical item but helps the company produce value on an ongoing basis. Examples of intangible assets are:
There are two different types of intangible assets. They are:
Small businesses acquire intangible assets to increase the value of their business in the long-term. They have value due to the business's sole legal or intellectual rights over them.
Intangible assets also help to improve the value of your business's tangible assets. For example, brand recognition (an intangible asset) can help sell the business's inventory (a tangible asset).
Intangible assets can be destroyed and/or diminished in value. The main example of how this occurs is through business failures, such as bankruptcy. When a business goes bankrupt, assets such as its trade secrets will be diminished in value or destroyed.
Brand reputation is another asset that can be destroyed rather quickly in a few different ways. For example, if your business responds negatively to a bad review, this can harm your reputation.
As mentioned before, correctly recording your assets on your balance sheet is important. To record intangible assets correctly, you need to allocate their use over their useful life. To do this, we use the process of amortization.
Amortization is like depreciation, but for intangible assets. The main way to calculate it is with the Straight-line method.
If an intangible asset has an unlimited life, it is subject to an impairment test periodically. An impairment is a decline in the asset's value permanently, unlike amortization, which has a defined set of years.
When an asset does not fit into the other main categories, it falls under the "other" asset classification. This category is the last line in the asset section of the balance sheet.
Examples of assets that fall under this category are:
Assets are everything your business owns. They are what help you operate from day-to-day. From the vehicles you drive to the patents you hold, they are everything you use to make money for your business.
Assets are important because they help:
Correctly utilizing your assets can help increase sales and decrease expenses.
The more efficiently you use your assets, the more sales you will be able to generate. To use your assets efficiently, you need to look at how you can cut down on expenses associated with them. For example, you can lease equipment instead of buying it.
A good way to keep track of how well your assets are generating revenue is with the asset turnover ratio. You get this ratio by dividing net sales by average total assets. The higher the ratio, the more efficiently your company is using its assets.
There are multiple ways to determine the value of your business. The asset-based business valuation is one of them. This valuation can be done in one of two ways.
By accurately recording your assets, you can benefit the value of your company by:
Properly caring for your assets can reduce your business's risks. For example, if you do not maintain your production machinery, it could break, resulting in:
Assets are valued for a number of different reasons. The reason for valuing the asset will help determine which way the asset should be valued. Reasons for valuing your assets include:
Assets can be valued in a few different ways, including:
The cost method is the easiest method. The price at which the asset was bought is the current value of the asset. You do not need to use any formulas or do any math for this method.
However, this method is not very accurate because many factors affect an asset's value. Many assets lose value over their lifetime, while some may gain it. Therefore, it is better to use a method that takes these different aspects into account.
The fair market value is used to determine the price the asset would sell for on the open market. It is the most common way that assets are valued.
This process is difficult, though, because there is not just one formula that can be used. You need to take into consideration all the circumstances connected to the property, such as:
Some common valuation types to determine the fair market value are:
The IRS gives a more in-depth explanation about how to find the fair market value for each type of asset.
This method uses expected cost instead of actual costs. You find the difference between expected costs and actual costs from past experiences and use them to determine the asset's expected cost.
Using an appraisal to value your asset involves having a specialist come in and use unbiased methods to determine the asset's value. This specialist is known as an appraiser.
An appraiser will use a valuation method to find the asset's worth, such as the fair market value or the liquidation value. However, since they are not from within the company, they are often trusted more by others to have determined a fair value of your assets.
Appraisals are often done for assets such as:
Liquidation value is only used when a business is being forced to liquidize, normally resulting from bankruptcy. Due to this, assets are normally valued much lower than the fair market value since the business is being forced to sell them.
To better understand how to find the liquidation value of a single asset, check out WallStreetMojo.
Valuing your assets is important for a number of reasons, including:
Knowing the correct value of your assets can help you know the value of your business. Knowing the value of your business can help you to make important decisions about how to grow.
Many small business owners will often ask if assets acquired with cash need to be recorded in their accounts differently from assets acquired with a loan. The answer is no.
Assets are depreciated and valued the same no matter how they are purchased.
You need to use your assets if you plan to deduct or depreciate the cost. You can buy an asset and not use it within the first year, but you cannot deduct or depreciate it in that year. Instead, you have to start the deduction process in the year it becomes usable.
However, if the asset is "placed in service," the trick around this is that you can deduct it, even if you are not using it. This means that the asset needs to be readily available to use but not necessarily used.
For example, if you buy a printer in year one but store it away until year two, it cannot be deducted or depreciated for year one. However, if you install it in year one and make it readily available to use but do not use it until year two, it can still be deducted and depreciated for year one.
We have focused mostly on how assets fit onto a balance sheet for accounting purposes. However, assets are treated differently for tax purposes than they are for accounting ones.
Unlike for accounting purposes, the IRS distinguishes assets by if they can be depreciated or expensed.
Items are expensed when they are current or low-fixed cost assets. To expense an item is to receive the tax deduction in the current tax year. You can then use the money that the expense reduction has freed up from the taxes right away.
Items are depreciated when their useful life is greater than one year. Depreciation for tax purposes is an annual deduction of your business's taxes, similar to depreciation for accounting purposes.
If an item is depreciated, it will take several years before you can receive the full benefit of the tax benefit.
Listed properties are a type of business asset that is used for both business and personal purposes. These assets are closely monitored by the IRS and have specific requirements when it comes to tax deductions.
The IRS requires that you keep a journal that can prove the dates of when and how the asset was used for business purposes. You also need to be able to prove:
Examples of listed properties include:
When you sell certain assets for profit, you have to pay a capital gains tax. Most assets are considered capital assets and are subject to the capital gains tax. Assets that are not considered capital assets include:
A capital gain is when the asset's selling price is higher than the original cost of the asset. If you lose money by selling the asset, you are not taxed because this is considered a capital loss.
The business' income determines the capital gain tax rates. There is a short-term capital gains rate and a long-term rate. If you sold your asset within 12 months, it is subject to a short-term rate.
Understanding how to diversify your assets can help you grow as a business. Also, understanding how to manage your assets as your business grows is important as well.
In other words, assets can help your business grow, but they need to be effectively managed to keep up with the growth; otherwise, they will hinder it.
Managing your assets will help keep your business afloat. To do this, you need to properly forecast your sales. If your actual sales differ greatly from your expected ones, your business will be in trouble.
For example, if you do not sell as much inventory as you forecasted, your revenue will be much lower, and your inventory costs much higher.
If you sell more than you expected, you will not be able to keep up with production demand. This will limit your growth. That is why you need to be constantly evaluating your assets and forecasting your sales properly so that you will not limit your growth.
When you first start your company, you should have mostly current assets that are self-liquidating. Self-liquidating assets are assets that are liquidated by the end of the period. They rise and fall with demand.
You want to focus on the current assets because you want to ensure you can pay off all your debts at the end of the year. You do not want your money tied up in long-term investments or lots of fixed assets that you will not be able to liquidate in time to pay your bills.
As you become successful, you can start to have current assets that are less liquid. For example, you could consider producing more inventory to have on hand for your clients to make their selections.
Essentially, you have a certain level of current assets maintained to support your business's growth that does not fluctuate with demand. As your business grows, so does the more permanent level of current assets.
Once your business has proved its success and started to grow, you can start to think about long-term investments and assets that have a useful life of more than one year.
You must make sure you always maintain a current assets level that allows you to pay off your debts. This is why you should wait until your business has proven its growth before investing in the long-term. You do not want to end up in debt if your capital is tied up in long-term investments and you do not have enough current assets to pay it off.
You will have a certain number of fixed assets at the beginning stages of your business to ensure your business can function properly, such as machinery and buildings. However, as you grow, you will be able to think about your company's long-term growth and success by tying your money up in long-term investments.
Assets are an extremely important aspect of any business. Properly recording and managing them can increase your business's value as it continues to grow.
Knowing how to utilize your assets and grow them with your business properly is a major key to running any successful business. They are so much more than just property the business owns. They are the fuel that drives it.
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