The balance sheet is classified into major groups of assets and liabilities in order to facilitate analysis of the entity’s financial health.
For example, a company’s liquidity (its short-term ability to meet current debts with current assets) can be evaluated by looking at the current ratio, which is current assets divided by current liabilities. Another useful ratio which can be derived is total liabilities to capital; the greater the ratio, the more debt there is in the business, and hence the more risk. Surely, an owner would rather have less of liabilities and more of his or her own capital in a business.
A classified balance sheet generally breaks down assets into five categories:
- Current assets
- Long-term investments
- Property, plant, and equipment (fixed assets)
- Intangible assets
- Deferred charges.
Current Assets group
Current assets are those assets which are expected to be converted into cash or used up within one year or the normal operating cycle of the business, whichever is greater. The operating cycle is the time period between
the purchase of inventory to transfer of inventory through sales, listed as accounts receivable, and receipt of cash. In effect, the firm is going from paying cash to receiving cash.
In most cases, the current asset classification is based upon a life of one year or less. Examples of current assets are ( cash, accounts receivable, inventory, and prepaid expenses). Prepaid expenses refer to expenditures made which
will expire within one year from the balance sheet date; they represent a prepayment for an expense which has not yet been incurred. For instance, if there was the entry Prepaid Insurance of $1,000 as of December 31, 19XX on a policy which had eight months to run, the account would be listed under current assets.