Chapter 2
In this Part
Learn the balance sheet to comprehend what a company is really worth.
Use the income statement to understand a corporation’s income and costs.
Utilize the statement of cash flows to see how different activities earn or spend money.
Perform the vital basic calculations to make decisions based on the information in corporate financial statements.
Comprehend financial statement calculations that are important to investors and lenders.
Introducing what’s what on the balance sheet
Examining assets, liabilities, and owners’ equity
Understanding how you can use the balance sheet
Introducing the Balance Sheet
The Securities and Exchange Commission (SEC) requires that all corporations maintain a balance sheet and highly recommends that any business keep one (the distinction being that corporations are publicly-owned companies that are legally required to fulfill these reporting obligations to its shareholders and other regulators).
After all, the SEC’s main purpose is to illustrate the exact value of a company in the very moment that the data are collected. Unlike other financial reports, the balance sheet doesn’t compile data over a period of time. Instead, it reports the value of all the assets the company currently has, divided into relevant categories, and then also includes the value of the company’s liabilities and owners’ equity, each divided in a manner similar to assets.
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Here’s the basic formula for the balance sheet:
Assets = Liabilities + Owners’ equity
So the total value of all assets equals the total value of all liabilities plus all own- ers’ equity. If the two sides of the equation don’t balance, then someone did something wrong, and it’s time for some no-holds-barred combat accounting! Hooah!
Evaluating the Weights on the Balance Scale
Everything of value in a company falls into three primary categories. Each of these categories represents a portion of the balance sheet:
» Assets: Assets include anything of value that currently belongs to the company or is currently owed to the company. Remember that the company purchases all assets by using capital acquired by incurring debt and selling ownership, so the total assets must balance with the cumulative totals of the other two portions of the balance sheet (see the next two bullets).
» Liabilities: Liabilities include the value of all the company’s debt that must be repaid.
» Owners’ equity: Owners’ equity includes all the value that the company holds for its stockholders.
Each portion of the balance sheet begins with the things that are the most liquid at the top. In other words, the top of each portion includes the things that either must be or otherwise can be converted to cash the quickest. As you make your way down each portion, the items included gradually become either decreasingly liq- uid or require repayment for longer periods of time.
Liquidity refers to the relative ease with which assets are turned into cash. Cash is clearly more liquid than capital assets like machinery, which must be sold to acquire cash, for example. When a company has become unable to turn their assets into cash in a time period necessary to pay their bills and continue opera- tions, the company is said to be insolvent.
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Understanding Assets
Assets include the value of everything the company owns and everything the company is owed. Assets fall into two main categories:
» Current assets: Current assets are those assets that a company expects to turn into cash within one year or, for inventories that take more than a year to turn into cash (such as buildings, vehicles, and other things that are usually expensive items), those assets a company expects to sell within one year.
» Long-term assets: Long-term assets are those assets that will take more than one year to turn into cash or that are otherwise not intended to be sold yet (but can be sold, if necessary).
Note that a few assets don’t fall into either of these categories. That’s where the last two sections of the assets portion come into play — intangible assets and other assets. I discuss both later in this section.
Current assets
This section outlines the subsections of the current assets portion of the balance sheet from the most liquid to least liquid.
Cash and cash equivalents
Cash and cash equivalents are the most liquid assets a company has available. In other words, they’re the assets that the company can most easily turn into cash because, well, they’re already cash. Cash refers to the money a company has on hand, while cash equivalents refer to savings accounts and such, from which the company can withdrawal cash quite easily, although at times the bank can tem- porarily restrict access.
Marketable securities
The second most liquid asset that a company has available is everything that falls into the category of marketable securities, including banker’s acceptances, certifi- cates of deposit (CDs), Treasury bills, and other types of financial products that have maturity dates but that companies can withdraw from or sell very easily if necessary.
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Accounts receivable
The accounts receivable category includes the value of all money owed to a company within the next year. Note the important distinction between money that’s owed in the next year and money that’s likely to be paid. Unfortunately, sometimes people refuse to pay what they owe. In these cases, the receivable remains receiv- able until either the money is paid or the period in which the money is due passes.
After the period passes, the company subtracts the value of the account owed from accounts receivable and transfers it to a subaccount called allowances. Allowances include the value of the money that’s still owed and past due but has yet to be written off as uncollectible (which is considered an expense). Usually, the accounts receivable entry looks something like this:
Receivables net : $XX Allowances : $XX Receivables gross : $XX
Inventories
The inventories category includes the value of all supplies that a company intends to use up during the process of making and selling something. Inventories include the raw materials used in production, the work-in-process products (partially completed products), end products ready for sale, and even basic office supplies and goods consumed in production (such as stationary used in offices, oil carried on delivery trucks for regular maintenance, and so on).
Income tax assets
Income tax assets include two forms of income taxes. The first is one that many people are familiar with: tax returns. When a company is set to receive money back on its taxes, that money becomes a short-term asset until the company receives it, at which point it becomes cash.
The other form of tax asset is the deferred tax, which occurs when a company has met the requirements to receive a tax benefit but has yet to receive it. For example, a company that experiences losses one year can file those losses the next year rather than the current year, so the value of its losses would be a deferred income tax asset that would decrease any income tax owed the next year.
Prepaid accounts
When a company pays for some expense in advance, the value of that prepayment becomes an asset (called a prepaid account) for which the company will receive
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services in the future. Consider insurance as an example. If a company prepays its insurance for a full year, the full dollar amount paid will add to the value of the company’s prepaid accounts. Every month, the company decreases 1 12 of the value of that prepaid account (each month the company uses up one month’s worth of value). In other words, the company uses up its prepaid accounts as the service it paid for is provided.
Other current assets
The other current assets category is a rather common one to find on the balance sheet, but it means different things to different companies. Generally, it’s an all-inclusive category for any assets that are expected to turn into cash within a one-year period but that aren’t listed elsewhere on the balance sheet. Other cur- rent assets may include restricted cash, certain types of investments, collateral, and pretty much anything else you can think of.
Long-term assets
The long-term assets section includes three main categories — investments, property, plant, and equipment (PPE), and depreciation. I describe each of these in more detail in the following sections.
Investments
Long-term investments typically include equities and debt investments held by the company for financial gain, for gaining control over another company, or in funds such as pensions. It can also include facilities or equipment intended for lease or rent. In any case, all the investments in this section are meant to be held for more than one year.
Note: Sometimes a company lists its bond investments as notes receivables, which are reported sort of like accounts receivables, except with the expectations of receiving payments in the long term.
Property, plant, and equipment
The property, plant, and equipment (PPE) category includes nearly every major physical asset a company has that it will use for more than one year. Buildings, machinery, land, major furniture, computer equipment, company vehicles, and even construction-in-progress projects all qualify as PPE. Basically, if you can touch it and plan to use it for more than a single year, it contributes to the value of PPE.
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Depreciation
The long-term physical assets included in PPE don’t last forever. With age and usage, every long-term physical asset is subject to depreciation, or a decrease in value. Different companies measure depreciation in different ways (some of which I discuss later in this section), but regardless of the manner in which a company measures depreciation, the total shows up on the balance sheet as a subtraction from the total value of PPE. It looks something like this:
PPE net : $XX Depreciation : $XX PPE gross : $XX
A company may choose to leave out the gross PPE line because it doesn’t contrib- ute anything to the value of the total assets (and because you can calculate it eas- ily, given the other information listed).
What follows are two of the most common methods for calculating depreciation.
Straight-line and unit-of-production depreciation
The easiest type of depreciation to use is called straight-line depreciation. Straight- line depreciation is cumulative, meaning that if you report a value in depreciation for a piece of equipment one year, that same amount gets added to the next year’s depreciation, and so on, until you get rid of the equipment or its value drops to 0.For example, if you buy a piece of equipment for $100 and each year it has a depreciation of $25, then you’d report $25 of accumulated depreciation the first year and $50 of accumulated depreciation the next year, while PPE value would go from $100 the first year to $50 the next.
To calculate straight-line depreciation, all you do is start with the original pur- chase price of the equipment, subtract the amount you think you can sell it for as scrap, and then divide that number by the total number of years that you estimate the equipment will be functional. The answer you get is the amount of deprecia- tion you need to apply each year. So a piece of equipment bought for $110 that lasts four years and can be sold as scrap for $10 has a depreciation of $25 each year.
A similar type of depreciation, called unit-of-production depreciation, replaces years of usage with an estimated total number of units that the equipment can produce over its lifetime. You calculate the depreciation each year by using the number of units produced that year.
SUM OF YEARS DEPRECIATION
The sum of years method for calculating depreciation applies a greater value loss at the start of the equipment’s life and slowly decreases the value loss each year.
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This method allows companies to take into account the marginally decreasing loss of value that most purchases go through.
To see what I mean, imagine that you’re buying a new car. Unless you get into an accident or otherwise damage the vehicle, the car itself will never lose as much value during its lifetime as it does in the first year. By the time the car is 10 years old, it will have lost most of its value, but it won’t be losing its value as quickly each year.
To calculate the depreciation each year by using the sum of years method, you divide the remaining number of years of life the equipment has left, n, by the sum of the integers 1 through n, and then multiply the answer by the cost of the equip- ment minus salvage cost. Here’s what that looks like in equation form:
(n [ i1 through n]) Cost Salvage value Sum of years depreciation
So if you purchase a piece of equipment for $100,000 and it’s supposed to last for five years with a salvage value of $10,000, then the first year’s depreciation would look like this:
5 5 4 3 2 1 $100,000 $10,000 $30,000
The first year represents 5 15 of the total depreciation that the equipment will go
through. The next year is 4 15 (in this case, $24,000), the next year is 3 15, and so on. Intangible assets
Intangible assets are things that add value to a company but that don’t actually exist in physical form. Intangible assets primarily include the legal rights to some idea, image, or form. Here are just a few examples:
» The big yellow M that McDonald’s uses as its logo is worth quite a bit because people recognize it worldwide. Imagine if McDonald’s simply gave that M, which it calls the “Golden Arches,” away to another restaurant. How much business would it attract?
» The curved style of the Coca-Cola bottles, as well as the font of the words Coca-Cola, are worth a lot of money because, like the Golden Arches, they’re easy to recognize across the globe.
» For pharmaceutical companies, owning the patent to some new form of medication can be worth quite a lot even if they’re not producing the medicine yet simply because the patent gives them the right to produce that medicine while simultaneously restricting other businesses from producing the same thing.
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None of these examples can be physically touched, but they contribute to the value of the company and are certainly considered long-term assets.
Other assets
Any assets that a company hasn’t otherwise listed in the assets portion of the bal- ance sheet go into an all-inclusive portion called other assets. The exact items included can vary quite a bit depending on the industry in which the company operates.
Learning about Liabilities
Liabilities include those accounts and debts that a company must pay back. Like assets, liabilities usually fall into two main categories:
» Current liabilities: Liabilities that must be paid back, fully or in part, in less than one year
» Long-term liabilities: Liabilities that must be paid back in a time period of one year or more
Current liabilities
This section lists the current liabilities you find on the balance sheet in order from those that must be paid in the shortest period from when they were incurred to those that can be paid off in the longest period from when they were incurred.
Accounts payables
Accounts payables include any money that’s owed for the purchase of goods or ser- vices that the company intends to pay within a year. Say, for instance, that a company purchases $500 in paper clips and plans to pay that amount off in six months. The company adds $500 to the value of its accounts payables. But after the company pays an invoice for the money it owes, it removes the value of that invoice from the accounts payables.
Unearned income
When a company receives payment for a product or service but has yet to provide the goods or services it was paid for, the value of what the company owes the cus- tomer contributes to its unearned income. Imagine, for example, that you own a
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dog polishing business that charges $10 per session. One of your customers pays $120 for monthly sessions, so your unearned income for that customer is $120 at the start. That value decreases by $10 every month as you provide the services that the customer paid for in advance.
Accrued compensation and accrued expenses
As a company utilizes resources such as labor, utilities, and the like, it must even- tually pay for these resources. However, most companies make such payments once every week, two weeks, three weeks, month, and so on, not upon receipt of the resource.
» Accrued compensation refers to the amount of money that employees have earned by working for the company but haven’t been paid yet. Not that the company is refusing to pay, necessarily, just that people tend to get paid once every one to four weeks. So until these people receive their paychecks, the amount that the company owes them is considered a liability.
» Accrued expenses work in a similar way and are applied to such things as rent, electricity, water, and any other expenses that a company incurs and pays at regular intervals.
Deferred income tax
For tax purposes, sometimes a company chooses to report its income in a different period than when it actually earned the income. Although deferred income tax, as it’s called, can be quite useful for businesses in their attempt to reduce tax expenses in any given year, it does provide an additional concern for analysts. To clarify just how much a company owes in deferred income taxes, the company reports this amount in the liabilities portion of the balance sheet.
Current portion of long-term debt
Often companies pay long-term debt in small portions over the course of several years. The current portion of long-term debt that a company has to pay in the next year is subtracted from long-term liabilities (see the next section) and added as a part of the short-term liabilities. Not all companies include this category on their balance sheets, but it’s extremely common.
Other current liabilities
Companies include any liabilities that they have to pay within the next year and that they don’t specify elsewhere on the balance sheet in the liability category creatively called other current liabilities. This category can include a wide variety of things from royalties to interest to rebates and everything in between.
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Long-term liabilities
This section outlines the categories you see in the long-term liabilities section of the balance sheet.
Notes payable
When a company owes money that it expects to pay in a time period that’s longer than one year, the value of that money goes into a category called notes payable. Often this category includes all loans and debt that the company is expected to pay over the long run. However, some companies choose to include any payments on bonds held for more than one year in a separate category called bonds payable.
Capital lease obligations
When a company leases a piece of capital, the total amount owed on that lease adds to the value of the capital lease obligations category of liabilities. As the com- pany gradually pays the lease, each payment causes a deduction from this liability.
Eyeing Owners’ Equity
The owners’ equity portion of the balance sheet breaks down exactly what value the company has to its owners and how that value is allocated to them. The amount of value that investors have in a corporation is equivalent to the amount of total assets the company has minus its total liabilities.
In all cases, regardless of any other variables, debtors always get their cut in a company’s assets before investors. Just as you must take into consideration all the money you owe when calculating your personal net worth, so must every com- pany. Owners don’t get anything until lenders get their money back.
This section goes over the subsections that fall under the owners’ equity portion of the balance sheet. The first three cover different types of stock, while the last three go over other types of earnings and income.
Preferred shares
Company ownership is measured in shares of stock, but the types of stock vary. The first one listed on the balance sheet is called preferred shares. Preferred shares take precedence over all other types of stock in several different ways. First of all, preferred stockholders are guaranteed dividends, which means they always get
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their payments before common shareholders get theirs (see the next section). If the preferred holders don’t get their guaranteed dividends one year, those divi- dends accumulate into the next year. Holders of preferred shares also get their full value in the liquidation of the company should it go out of business before holders of common shares get anything. Some types of preferred shares can be converted into common shares.
On the balance sheet, stock is treated a little differently than on the income state- ment because you need more details than just the type and amount of stock for the owners’ equity portion to be useful. In addition to the exact type of stock (in terms of preferred shares, standard preferred or convertible preferred), the balance sheet must also list the percentage dividends guaranteed on preferred stock, the number of shares authorized, and the par value guaranteed to preferred shares in case of liquidation (see the section “Additional paid-in capital” for details on par value).
Common shares
Like preferred shares, common shares give their holders the right to receive divi- dends and obtain company information upon request, but unlike preferred shares, common shares also come with voting rights that can influence company policy. The balance sheet treats common shares similarly to how it treats preferred shares in that the common shares section must list the number of shares outstanding, the number of shares authorized, and their par value.
Treasury shares
Treasury shares are shares of common stock that the issuing company has repur- chased (a common behavior when a company believes the share price of the stock will increase with decreased shares available to investors). Companies often hold on to treasury shares in an attempt to drive up their own share price with the goal of reselling the shares at a profit. Companies aren’t required to list as much infor- mation about these shares on the balance sheet, but they do have to include total value of shares.
Additional paid-in capital
The par value of a stock is originally set by corporations with contributions by their investment bankers at the initial public offering (the first time a specific stock is sold to investors as a company raises money) — often just called the IPO. The investment bankers determine the value of the company, which is used to estab- lish the amount to be raised, and then divide that amount by the total number of shares to get the par value. During the IPO, shares are sold at no less than the par value, but investors often pay more as they try to outbid other investors. Any
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amount that the company raises over par value contributes to the additional paid- in capital and shows up on the balance sheet as such.
Retained earnings
When a company earns income, that is to say when it makes money, that money either goes to the owner(s) of the company or is reinvested in the company. In either case, the money belongs to the company’s owner(s) and must contribute to the value of their ownership in the company. For corporations, any money that doesn’t go to the stockholders in the form of dividends (which are reported on the income statement; see Chapter 5) is reinvested in the value of the company as retained earnings. Retained earnings consist of the money that a company makes after all expenses that it reinvests instead of giving to the stockholders.
Sometimes actions occur that impact the reported value of a company or some portion of the balance sheet. If these actions need more explanation to be fully understood, the company can include them in the supplemental notes portion of the balance sheet at the very bottom.
Finding Financial Zen
The information included in the balance sheet allows you to determine the very value of a company, as well as to whom that value is allocated as the company either thrives or fails in its pursuits. Everything that contributes to the value of a single corporation is either provided by the owners (the shareholders) or the lenders (who the corporation is obligated to repay). It is for this reason that those in corporate finance must work hard to find the appropriate balance between the two (discussed in more detail in Chapter 17).
By applying this information, you can determine a company’s ability to pay back loans, the value of the company’s stock, and the expected return for investors. Plus, you can use the values you get from these metrics to evaluate whether the company is worth any loans issued, how efficiently management is allocating resources, how efficient the company’s production is working, how effective a company is at managing inventory, how efficiently it sells its products, how effec- tive it is at collecting debt, and so much more.
By itself, the balance sheet shows only metrics related to value. But when you use it with information from the income statement and the statement of cash flows, you can determine how effectively a company is using its assets to generate income, as well as how well a company may use income to pay its debts.