In my last post I introduced the balance sheet, emphasizing its “static” nature (as of one date in time) but also noted the classification of assets and liabilities as “current” and “non-current”. There are two other behavioral elements to the balance sheet as seen here. The items in the upper half are considered “operating” while those in the lower part are “non-operating”. The important context of these terms is the degree to which they are driven or influenced by the primary function of the business. In dealing with its customers, in the buying and selling of goods obviously the inventory comes from vendors, usually creating an account payable among the current liabilities. Sales will both reduce the inventory and create a receivable under normal commercial trade terms.
Conversely, the customers and vendors have almost no influence (or care for that matter) upon items in the non-operating section of the balance sheet. They rarely will be aware of whether the company owns (an asset) or leases its facilities. They will certainly have no involvement with or input to the capital structure of the business, or its decisions related to long-term debt. It is in this sense that the assets and liabilities in the lower section are “non-operating.
The third and final behavioral attribute of the balance sheet has to do with the degree to which management has influence or discretion over the various assets and liabilities. The top half is considered “Non-Discretionary” and the lower half is “Discretionary”. Changes in value of most of the items in the top section occur whether management wants them to change or not. They happen within the daily framework of the business … the coming and going of customers, delivery of inbound and outbound inventory, collection of receivables, etc. Management can influence them through general shaping of the business structure, policy and practices, but in the short-term day-to-day affairs … they just happen.
On the other hand, decisions regarding and influencing changes in the long-term, non-operating items are almost exclusively the prerogative of management and the owners. These are the type of decisions management makes in private, usually well after normal business hours. Should we own real estate or lease? Is it time to take on additional capital, long-term debt, pay a dividend? Neither customers nor vendors have anything to do with such decisions. Thus to sum up what we have learned about the balance sheet: the top section is Current, Operating and Non-Discretionary. The lower half is Long-Term, No-Operating and Discretionary.
Douglas K. Steele (with Annie)