Assets are the fuel that owners use to power their businesses, and fixed assets are listed on the balance sheet of every company. Use these tips to understand fixed assets, how assets depreciate, and why you need to plan for asset replacement.
An asset is a resource that you use to produce revenue in your business. A pizza restaurant, for example, has ovens, refrigerators, tables, and other assets that are used to produce and serve pizza to customers.
Assets are a component of the balance sheet formula, and the balance sheet is an important financial statement that every business owner must understand. The formula is:
Assets – liabilities = equity
Liabilities represent amounts owed to other parties, including accounts payable and long-term debt. Equity, on the other hand, is the difference between assets and liabilities, and equity includes common stock, additional paid-in capital, and retained earnings.
The equity balance is the true value of a business, and you need to review and understand your company’s balance sheet at the end of each month.
Current vs. Non-Current Assets
Assets are categorized in the balance sheet as either current or non-current assets:
- Current assets: Cash, and assets that will be converted into cash within 12 months. Accounts receivable is a current asset account because receivables are expected to be collected from clients within 12 months. In the same way, a business expects to sell inventory items within 12 months, which makes the inventory account a current asset.
- Non-current assets: These assets will not be converted into cash within 12 months, and this category includes machinery, equipment, and other fixed assets.
The balance sheet lists current assets first, followed by non-current assets. When you post accounting transactions, make sure that you properly classify company assets.
Assets may be tangible, such as an oven or a table, or intangible, such as a patent or copyright. To understand the differences, keep in mind that a tangible asset is a physical item, and tangible assets depreciate over time. Tangible assets are labeled as fixed assets in the balance sheet.
Here are some common fixed asset types:
- Stores: Retail businesses typically own furniture, fixtures (shelving and lighting), and other expenses related to the physical location. If the company owns the building and land, those assets are also fixed assets.
- Transportation: Cars, trucks, trailers, and tractors are each defined as fixed assets.
- Manufacturing: A production facility lists machinery and equipment in the fixed asset category.
In addition to purchasing fixed assets, your business will need to invest dollars to repair and maintain assets over time, and that cost may be substantial. Make sure that your business plan includes these costs.
Using Up Assets
As fixed assets are used to generate revenue over time, they decline in value. The oven in the pizza restaurant, for example, can only operate for a certain number of years before it must be replaced. Depreciation expense is defined as the decline in value of a tangible (fixed) asset.
Assume, for example, that a pizza oven was purchased for $10,000, and the oven has a useful life of 10 years. Accounting standards require you to depreciate the oven over time, and the amount of depreciation expense each year should relate to how you use the oven to produce revenue.
In most cases, fixed assets are depreciated on a straight-line basis, meaning that $1,000 of the oven’s cost would be depreciated each year for 10 years. If an asset is used heavily in the early years and less in later years, the business will post more depreciation expense in the early years.
The goal is to match the asset’s use with the revenue generated by using the asset. Ask an accountant to help you determine the proper depreciation schedule for each of your fixed assets.
Many business owners don’t plan for the replacement of assets used in the business, and this mistake can have a huge impact on your business. You can’t operate without fixed assets, and you need a plan to replace them over time.
The owner of the pizza restaurant, for example, should review the list of fixed assets, the remaining useful life of each asset, and how much depreciation expense has been recorded. If the $10,000 oven has two years of useful life remaining, the owner must plan to pay cash or take out a loan to replace the asset in two years.
Review your fixed assets each year, and create a plan for asset purchases. That plan may include setting aside annual profits to fund asset purchases, or a plan to borrow funds. Take this important step, so that your business can continue to operate over time.