Financials Demystified: Understanding Current Assets for Beginners

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2:07All right, folks. Welcome to Investing for Beginners podcast. Today, we're going to do another edition of Financials Demystified. And today, we're going to talk about current assets. So this is an accounting section. We are going to talk about some accounting stuff, but we are going to make it as fun as we possibly can. This is all essential learning. And if you want to invest in stocks, as Warren Buffett says, you need to understand the language of accounting and current assets is an important aspect to understand. So to maybe weigh the groundwork, what would be a good overview of what are current assets?

2:45And we can kind of go from there. Great explanation. So you have a balance sheet. The balance sheet is what a company owns versus what they owe. So you got assets, what you own, liabilities, what you owe. Now the assets and liabilities are both split up. So you have short-term and long-term. Short-term being anything within the first 12 months. So if I'm a business and I'm expecting a payment from another business in 90 days or 10 months. That all falls within the up to 12-month time frame. So that would be a short-term asset or what they're called as current assets. And that's in contrast to long-term assets, which are things like buildings, equipment, things that have a longer life.

3:41Cash is always considered a short-term asset because it's cash. So that's kind of the big difference. That's how I see them. For me, it helps to think of a balance sheet with assets, liabilities, and then within those two sections have subsections, short-term, long-term. Yeah. So when I'm thinking about the balance sheet, one thing that I learned later, which I think is important to understand, is the balance sheet is organized in an order of liquidity. So things that are the most liquid are at the top of the balance sheet. And as you work down the balance sheet, things become less liquid. So something like a current asset is far more liquid than something like a current liability.

4:26And what I mean by that is that it can easily be turned into cash if the company needs to do something drastic. Let's say that we were in the pandemic and it went longer. a company like Carnival, which has a lot of assets on their balance sheet, i.e. their ships, if they had to liquidate those, it would take them longer to sell a ship than it would to access the cash in their bank account, for example. So that's one way you can kind of think about how assets are assembled on the balance sheet. And if you kind of keep that general principle in mind, it helps you understand, okay, why am I seeing this here?

5:10What does that mean? And so when Andrew and I are going to talk about these different types of current assets, it'll help you understand the liquidity of them and how important that is in what the company does and the decisions they make to do different things. And so I guess always try to keep that in the back of your mind when you're thinking about the balance sheet and when you're trying to analyze it. So hopefully that could be helpful. Yes, that's a great one. So So why is looking at current assets even important? What part of a business does this tell us about? This tells us more about the day-to-day operations of the business than anything else.

5:49When you're looking at something like inventory, for example, that is an important ingredient if you're looking at a company like Walmart or Amazon. They sell inventory. A grocery store sells inventory. Costco sells inventory. And so when you look at the balance sheet, that is important to understand because they have to buy and sell that inventory. And so this is, in essence, money moving in and out of the business. And so by looking at current assets versus something like PP &E or capital expenditures or any of those kinds of things, those are longer-term cash outlays that have an impact on the business.

6:26but when you want to see how the business is operating day to day, you want to look at something like current asset because that to me has a bigger impact on what happens and how, how well are they doing? Are they, are they turning their inventory or not? For example. Yeah. Maybe we can pull on that thread a little bit. If I wanted to look at Walmart and I wanted to look at short term assets, what would you analyze and what would you look for? Well, I think the first thing you'd want to look for with Walmart would be their inventory. There's probably two main categories I guess I would look at.

6:59One would be the cash and the short-term investments on the balance sheet. That would tell you how much money they're building up or how much money they're holding in reserve in case they want to make an acquisition or in case they maybe need to make a bigger inventory purchase that they may not be able to do with short-term cash flow at the particular time. And so that would be a place that I would look first. The second place I would look would be the inventory. And you want to see how the inventory levels are being managed. And you want to look at the long-term trend of that. And you want to see if the company is gradually building up inventory or if they're burning through inventory or maybe they're running lower at different parts of the year.

7:46I would admit this is not a company I've looked at closely, but I would imagine if you looked at the fourth quarter or into the fourth quarter of the company, i.e. Christmas time, you would probably see a bit of a buildup in inventory as they get into that season because that's going to be the busiest season for them with everybody and their brother buying Christmas presents during that time. And then you might see a lower inventory. You would expect to see a lower inventory number in the first quarter of the next year because they would have sold through that and to be trying to normalize that.

8:19I think your company Target, that was one of the things they ran into a problem with, right? Was they had run up their inventory and then they were unable to sell it. And so that caused them a lot of problems. Yeah, it definitely did. How that played out in the case of Target, if anybody's curious, they had, you could see in the cashflow statement, how they were really, really aggressively adding a lot of inventory. And when that did not sell, They had to basically sell inventory. You have to discount inventory in retail when you're not able to sell it like you expect. And so that really hurts your margins.

9:00And so you might be growing revenue when you sell discounted inventory, but it doesn't necessarily happen where it goes to profits, which is what shareholders care about. So yeah, that was a red flag that I had missed. that I was so drink the Kool-Aid on the company. I thought, okay, management sees all this demand, so they're loading up on inventory. So I think this is a hot business. And it turned out management had also drank the Kool-Aid. So they made a pretty big mistake, overestimated demand. And then the stock suffered afterwards, as did profits suffered in the months and years to follow.

9:41So something about looking at the numbers and then also having a healthy skepticism, not believing everything you see, I think can help you avoid situations like that. Yeah, for sure. I was looking at Texas Instruments a few days ago, and I noticed I was reading through their latest earnings call. And one of the things that the management said that I noticed was that they were talking about how they were running a little bit lower of an inventory. so I actually looked and they were so if you looked at the previous the last two years they've been running a little bit of lower inventory but if you look prior to that it looked like they were kind of ramping it up and so for those that are unfamiliar Texas Instruments is one of the leaders in analog chips that you find in just about everything and anything and they have you know hundreds of thousands of devices and SKUs that they sell or products that they sell.

10:38Anyway, they had been building up their inventory and then the cycle, the semiconductor cycle kind of took a turn and it hasn't been performing as well over the last two or three years. And so the company was, I think, caught a little off guard by the turn. and now that they have accepted that there has been a downturn in their business, they have stopped producing as much of their products. And so they're gradually kind of burning down through their inventory as people still need the products, but they're just not buying as much of it. So they're depleting their inventories and the cycle is taking a little longer than I think company and us investors would have liked or would have hoped for.

11:24But that is one thing that you can kind of keep an eye on when you're analyzing a company is looking at the inventory of a company, especially a company like the ones we're referring to. And you'll be able to see how well the company manages the inventory in and out of cycles if those companies have any sort of cyclicality. And it can be very helpful to kind of notice that. Yeah. Can we stick on inventory? I mean, might as well since we're on topic, right? Um, one of the things about inventory, like we said, and this is all risk stuff, so nobody likes to hear it, but too bad I have you captive.

12:05Looking at short-term assets can tell you how liquid a company is. So there's two kind of risk factors when you talk about the longevity of a business. One is their liquidity and one is their solvency. So solvency means like, do you have a ton of debt that's going to be coming due? More like a long-term thing. Liquidity is any, you know, if you just don't have that savings, that emergency fund kind of thing, we have seen weird things happen in markets where you run out of liquidity and then also nobody wants to give liquidity. That's what happens during financial panics and things like that. So in those rare edge case black swan moments, that come out of nowhere, it always gives you better peace of mind if you know the companies you're investing in are liquid.

12:54And so one, I may be overshooting, so maybe let's step back and let's talk about current ratio as a common measure of liquidity. So the current ratio is a great measure or metric that you can use to measure how liquid a company is. And so what you would be doing is it's a very simple calculation. You compare the current assets on the balance sheet to the current liabilities on the balance sheet. And you basically just, most companies will total those up for you. And so you simply divide current assets by current liabilities, and that will give you a number. And if you're looking for a good, bad, or ugly, it can depend.

13:45It's like everything in finance, it depends. Generally, anything above a one is considered good. So that tells you that the company has more current assets than more current liabilities, which in essence means that if the company runs into a problem, they can liquidate all their current assets and pay off all their short-term bills. That's, in essence, what that tells you. So if you want a bad number, it's probably anything under 0.5, 0.5. That's not great. I've seen Amazon at like 0.8, 0.87, those kinds of numbers. That's not maybe ideal, but Amazon's always a bit of a different beast. I think read some studies that have shown that anything above like a three is actually not great either because that means that they have too much cash on the balance sheet or they have too much assets that they're not utilizing to their benefit.

14:46And so that can be, you know, sometimes a really high number is not the best. And in this case, that's another one. So I know you got other things you could add to my little explanation. Yeah, that's a great study to kind of turn up. One of those things that, you know, You talk about cash and assets, and it's like, yeah, that makes sense. Why are you teaching me this? It all makes sense. But then on the flip side, what you're saying, when current ratio is too high, this might be a shocker if you're new to this, but there are management teams out there who care more about keeping their salaries cushiony than actually creating shareholder value.

15:26And I know creating shareholder value has become a meme where it's looked on as this negative thing but as investors we want shareholder value and there are i mean i'm not going to list the companies or speak them out loud but i i can visualize them in my head where if you look at they are overly liquid they are not they're just storing up all this cash and it makes their job safe but it doesn't make for a great stewardship of investor capital so So yeah, I like that you brought that up because it is a good example of too much of a good thing. And as investors, we need to consider both sides. Companies that are too risky, but also companies maybe that are too comfortable.

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18:14Terms apply. Cash App is a financial services platform, not a bank. Banking services provided by Cash App's bank partners. Bitcoin services provided by Block Inc. brand. For additional information, see the Bitcoin disclosures at cash.app.legal.podcast. What's the best way to get started in the market? Download my ebook for free at stockmarketpdf.com. So maybe we could touch on the quick ratio and talk about maybe how that's a little bit different. And the company that I always kind of think of, and this is not a knock on the business, but Apple, I think it's different now. But if you look back 10 years ago, they had a lot of cash on the balance sheet.

18:53And so if you looked at the current ratio just standalone, it maybe was not as flattering of how it didn't illustrate how well Apple was actually operating on a day-to-day basis. And so it could kind of cover up the effectiveness of the company. So maybe you could touch on the quick ratio and maybe how it's normally calculated. and I think you did you have a special way you like to look at it as well yeah I mean I like to look at like revolvers and everything like that but we can get to that if we have time quick ratio is something that was best illustrated by circuit city I've talked about them many times on the show but we're gonna assume that you haven't heard the story yet circuit city was for those of you who can remember a place where you could go go buy a laptop go buy computers go buy speakers for your computers and mouse you remember the mouse that had like a ball on it oh yeah oh yeah they were fun i love circuit city that was like when i needed tech stuff that's where i went oh yeah they had that interesting entrance right where you kind of you felt like you're going somewhere different yeah if you look at the numbers for circuit city despite you know in addition to like our fond memories of the place they actually had really good numbers if you were investor at the time, I imagine you would look and say, this is a great business.

20:18They had revenues going higher. They had earnings going higher. They had number of stores going higher. So this was not some big lots kind of story where everything was collapsing. This was a healthy, growing and happy place for customers and for the people who own shares. The problem was they had not enough liquidity for in case bad things happened. So what you can do, and it all comes back to the inventory discussion. So what the quick ratio is, it's the same ratio we just discussed. It's the current ratio where you're looking at the current assets over current liabilities. But what the quick ratio does is it subtracts inventory.

21:04So the reason why we're subtracting inventory is we're assuming that we can't sell any inventory because of an economic recession or something like that. So inventory is in theory liquid, but it depends on what kind of inventory it is. So if your inventory is more discretionary, think about the malls, the apparel companies, these things where sometimes people buy them, sometimes they don't. And definitely at that time, 2007, 2008, 2009, people only bought electronics when the economy was doing very well. So Circuit City was this interesting case where the current ratio was high and you would have thought, oh, this is a liquid company.

21:44But then the quick ratio was low. And so when that happened and we had all this pullback in consumer spending, they were not able to sell a lot of their inventory and that led to a bankruptcy. I'm trying to pull up, I did a blog post on this if you guys are curious, but I can't find where I wrote what a good quick ratio versus bad one is, but I would think of it similar to a current ratio where if you have a quick ratio of 0.3, you don't really have a lot of steady liquid assets to make up for a worst case scenario. But again, because we said it depends, you have to look at the type of inventory too.

22:35If we're talking about a grocery store, do you think in an economic recession they'll be able to sell bananas and apples and oranges and things like that? Yeah. So you would look at inventory for a grocery store a lot differently than a very discretionary kind of retailer. So that's something to keep in mind. But in general, you look at the quick ratio in a similar way. You look at the current ratio. If it gets too low, we might have a business that's being not safe enough, not conservative enough with their liquidity. Yeah, I think those are perfect examples. While you were talking, I was thinking about Dick's Sporting Goods, a company we both own.

23:15Kind of the exact opposite of the grocery store, right? If they double down too much on a shoe or a clothing line and they aren't able to sell that, that could put them in a big world of hurt. And so that's why when you're analyzing these kinds of companies, understanding not only what inventory is, but also understanding what kind of inventory they're holding also has a direct bearing on how well. And it also gives you some good insight and some clues. You kind of mentioned this earlier. It gives you some good insight and clues into how well a company is run. If a company can manage its inventory really, really well through upturns and downturns, then I think that shows that the company really has a good pulse on their business and are doing a good job.

24:05Kind of contrary to what you were talking about earlier about some companies where they just kind of fluff up their balance sheet and their current assets just because it just makes their lives a lot easier and they continue to get their nice, big, fat paychecks and they don't really care about us, the shareholders. So those are good insights to also understand when you're analyzing any business.

24:32100%. So should we talk about maybe some of the other line items on the balance sheet and kind of give a little bit of a synopsis on each of those? You mean you don't want to talk about inventory for two hours? Oh, I'm sure we could. I'm not 100 % convinced our listeners would like to listen to us talk about inventory for two hours. So I'm trying to think of them. So I guess let's just kind of walk down through some of the basic ones. So let's look at cash and equivalents. So I guess what's the 30-second view on cash and equivalents? Yeah, cash, cash in the bank. The company probably has multiple checking accounts and multiple banks.

25:20Cash equivalents can be things like T-bills. Insurance companies can do that a lot. Banks will do that a lot. So yeah, stuff that can be either if it's not in the checking account, they can write a check on it. They are going to get it very soon or could even sell. You could sell bills in the market and get cash pretty soon. So yeah, that would be cash and cash equivalents. Yeah. Important to understand. It is exactly what it sounds like. It's actual money. So easy to visualize. Short-term investments. Oh, yeah. I guess I skipped into that. So yeah, that would be the T-bills and things like that.

26:00Anything that would be due inside of a year would be considered a short-term investment. So think T-bills, bonds, stuff like that. Exactly. So again, it's things that they can fairly quickly turn into cash if they need to. So we've discussed inventory. Accounts receivable. Yeah, this one's kind of fun. And so if you've been exposed to this in your corporate life in one aspect or the other, you have terms like net 30, net 60, net 90. You get services like a B2B kind of thing. Business provides services to another business and then they pay and have 30 days, 60 days, 90 days to pay it. that would be accounts receivable is you've provided the services to your customer and you're going to get that cash in 30 60 or 90 days there is risks to that too there have been i remember reading in risk factors of different companies depending on what kind of business they're in might have what they call a counterpart is it counterparty risk i believe where it's like okay, if this company goes bankrupt before they pay us, as they owe us in 60 days, we might not recover all or any of that money.

27:21So that's definitely a pretty edge case, but it is just another fun thing to think about. Prepaid liabilities or prepaid expenses. So what do those entail? That sounds complicated. So I'm actually going to read from the blog you did. You can search for total current assets and Dave's blog will pop up. But a company's prepaid expenses, which represent payments made in advance for future goods and services, will categorize as current assets. They are payments already made, even though companies can't redeem them for cash. As a result, companies can use the money for other purposes. because payments to contractors or insurance firms are examples of prepaid expenses.

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