Investment Basics - Course 302 - The Balance Sheet

By: Steve Bauer | Wed, Dec 22, 2010
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This is the seventeenth Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.


 

Course 302 - The Balance Sheet

Introduction

Now that you have a good idea of how profits are recorded on the income statement, let's adjust those green eyeshades, insert that pocket protector, and move on to the balance sheet. As mentioned in Course 107, the balance sheet -- also known as the "statement of financial condition" -- tells investors how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity) at a specific point in time. Thus, you can think of the balance sheet as a snapshot of what a company is worth -- according to accounting rules -- on a given day.

Although we're going to keep it fairly simple, this Course will provide more details on the key sections of a company's balance sheet and may get a little technical at times.

Prof's. Guidance: It will be well worth the time and effort needed to plow through it even if you get a bit frustrated. So take a deep breath and let's dig in.


Assets, Liabilities, and Equity -- It All Equals Out

One of the most important things to understand about the balance sheet is that it must always balance. Total assets will always equal total liabilities plus total equity. Thus, if a company's assets increase from one period to the next, you know for sure that the company's liabilities and equity increased by the same amount.

Let's now take a deeper look at the various sections of the balance sheet. Although there are potentially many more specific line items that we could cover, we're going to stick with the most common, and in my opinion, the most important sections that investors should be aware of.


Current Assets

Assets are generally defined as things a company owns, which are expected to provide future benefits. There are two main types of assets: current assets and non-current assets. Within these two categories, there are numerous subcategories, or line items.

Current assets are things a business owns that are likely to be used up or converted into cash within one business cycle -- usually defined as one year. The most common line items in this category are cash and cash equivalents, short-term investments, accounts receivable, inventories, and other various current assets.

Cash and Cash Equivalents. This line item doesn't necessarily refer to actual bills sitting in a cash register or vault. Generally, cash is held in low-risk, highly liquid investments such as money market funds. These holdings can be liquidated quickly with little or no price risk. This is considered money that can be used for any purpose the company wants.

Short-Term Investments. This represents money invested in bonds or other securities that have less than one year to maturity and earn a higher rate of return than cash. These investments may take a little more effort to sell, but in most cases, investors can lump them with cash to figure out how much money a firm has on hand to meet its immediate needs.

Accounts Receivable. Think of receivables as bills that a company sends its customers for goods or services it has provided but for which the customer has not yet paid but is expected to pay within the next year. In other words, these are sales (recorded on the income statement) that haven't been paid for yet with cash. Generally, accounts receivable are shown as a net amount of what a company expects to ultimately collect, because some customers are likely not to pay. The amount of receivables a company thinks it won't collect is typically known as an allowance for doubtful accounts. Not only do additions to the allowance for doubtful accounts decrease the amount of accounts receivable, but they also increase a company's expenses -- known as bad debt expense.

Keep an eye on accounts receivable in relation to a company's sales. If accounts receivable are growing much faster than sales, it generally means a company isn't doing an ideal job collecting the money it is owed. This could potentially be a sign of trouble because the company may be offering looser credit terms to increase its sales, but it may have difficulty ultimately collecting the cash it's owed. Conversely, if accounts receivable are growing much slower than sales, the firm's credit terms may be too stringent, at the expense of sales.

Inventories. There are many different types of inventories, including raw materials, partially finished products, and finished products that are waiting to be sold. This line item is especially important to watch in manufacturing and retail firms, which are saddled with large amounts of physical inventory.

The value of inventories shown on a company's balance sheet should be taken with a grain of salt because of the way inventories are accounted for. Similar to accounts receivable, changes in inventories are generally related to a company's sales, or more specifically, the gross profit -- sales price minus the cost of the inventory sold -- it makes from each sale. If inventory levels are growing much faster than a company's sales, it may be making or buying more goods than it can sell. That may force the company to lower its prices, which results in lower profits for each item sold and lower profitability for the company. In some cases, it may have to reduce prices to levels below the value of the inventory itself, resulting in losses.

Additionally, inventories tie up capital. The cash that was used to create inventory can't be used for anything else until it's sold. Thus, another important thing for investors to monitor is how fast a company is able to sell its inventory.

Other Current Assets. While there are too many to list here, this category includes any other assets the firm may have that are expected to turn into cash within the next year. However, some current assets will not turn into cash, the most common of which are known as prepaid expenses (yes, even though it's called prepaid expenses, it's actually an asset). For example, say Harley-Davidson (HOG) buys and pays up-front for an insurance policy for the coming year. Accounting rules say the company should record the entire payment as a prepaid expense (asset) as opposed to a normal expense on the income statement because it represents something of future worth to the company -- a full year's worth of insurance coverage. As the year goes on, the value of the asset will decrease--less time remaining on the policy -- and the amount of the decrease is recorded as an expense, a process known as amortization. Keep in mind that a company's prepaid expenses -- which belong to a broader category known as capitalized costs -- represent cash that was paid up-front and will turn into expenses instead of cash within the next year.


Non-current Assets

Non-current assets are cleverly defined as anything not classified as a current asset. The main line items in this section are long-term investments; property, plant, and equipment (PP&E); and goodwill and other intangible assets.

Long-Term Investments. This is money invested in either bonds with longer terms than one year or the stock of other companies. These aren't as liquid as cash and short-term investments, and prices may fluctuate, so it's possible that the value shown on the balance sheet may be too high or too low. If it's a big enough balance, you may want to dig into the details to make sure you're comfortable with the kinds of risks the firm is taking with shareholders' money.

Property, Plant, and Equipment (PP&E). These assets represent the bricks and mortar of a company: land, buildings, factories, furniture, equipment, and so forth. The PP&E amount on the balance sheet is typically reported net of accumulated depreciation -- the total amount of depreciation recorded against the assets over their life. Eventually, PP&E has to be replaced, and depreciation is a company's best estimate of these "replacement" costs from wear and tear. Keep in mind that PP&E is usually not a very accurate measure of what a firm's bricks and mortar are really worth. Many times, buildings worth millions of dollars are reported at next to nothing in PP&E because of accumulated depreciation. Likewise, the actual value of a company's land -- which is recorded in PP&E at its acquisition price -- may be worth exponentially more than what is recorded.

Goodwill and Other Intangible Assets. Intangibles are, just as the name describes, assets that can't be touched and are generally not going to turn into cash. The most common form of intangible assets is goodwill. Goodwill is formed when one company buys another and pays more than the target company is worth (as defined by the net worth, or equity on the target's balance sheet).

You should view this line item with high levels of skepticism because most companies tend to pay too much when making acquisitions. Therefore, the value of goodwill that shows up on the balance sheet is often higher than what the intangible assets are really worth. Accounting rules require companies to value goodwill every year, and if a company lowers the value of the goodwill it records -- a phenomenon known as impairment -- it's a tacit admission that the company paid too much for an acquisition it made in the past.


Current Liabilities

Now that we're more familiar with what a company owns, let's move to the other side of the balance sheet, what it owes. Similar to assets, there are two main categories of liabilities: current liabilities and non-current liabilities.

Obligations the firm must pay within a year are known as current liabilities. The main line items you should be concerned with in this category are short-term debt and accounts payable.

Short-Term Debt. This refers to money the company has borrowed for a term of less than one year. It's often in the form of a line of credit that may be drawn down at the company's discretion. Typically, the proceeds are used for short-term needs. Often, the amount of long-term debt that must be paid back within one year is also lumped into this line item. The amount of short-term borrowings is an important figure, especially if a company is in financial distress or pays a high dividend, because the entire amount must be paid back relatively quickly, leaving little wiggle room.

Accounts Payable. Accounts payable represents bills the company owes for goods or services it hasn't paid for yet. It is the opposite of accounts receivable, and generally speaking, investors like to see the opposite trends for the two line items. For example, with receivables, we'd prefer a company to collect what it's owed as soon as possible. However, if a company can postpone paying what it owes for a longer period of time -- without getting in trouble -- it will hold on to its cash for a longer period of time, a plus for cash flow.


Non-current Liabilities

Non-current liabilities are the flip side of non-current assets. These liabilities represent money the company owes one year or more in the future. Although you'll see a variety of line items in this category, the most important one by far is long-term debt.

Long-Term Debt. This represents money the company has borrowed, typically by issuing bonds, that doesn't need to be paid back for several years. Too much long-term debt is generally risky for a company, because the interest on debt must be repaid no matter how the business is doing. Determining how much debt is too much is very firm-specific and depends on many things including the interest rate a company pays on its debt, and the stability of the firm's earnings and cash flows. One good way to determine if a company can afford the interest payments on its debt is to see how many times the firm's operating income--otherwise known as income before interest and taxes (EBIT )-- will cover its interest expenses (interest coverage ratio).


Equity

As we mentioned earlier in this Course, equity is equal to total assets minus total liabilities. It represents the part of the company that is owned by shareholders; thus, it's commonly referred to as shareholders' equity. It is also referred to as net assets, or net worth. Although there are several line items within equity, the two main categories investors should focus on are retained earnings and treasury stock.

Retained Earnings. This line item represents the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated deficit."

Treasury Stock. This line item shows how much of its own stock a company has repurchased. Because repurchasing stock is analogous to paying dividends to investors -- and in some cases can be even more desirable -- investors should take note of changes in this account to see how much stock a company is repurchasing from one period to the next.


The Bottom Line

You can exhale because you've made it through my tour of the balance sheet. Although we've admittedly left out plenty of specifics, you should know enough now about the income statement and balance sheet to be dangerous.

In the next Course we'll move forward to what's arguably the most important financial statement of all, the statement of cash flows.

Quiz 302
There is only one correct answer to each question.

  1. Prepaid expenses:
    1. Are found on the income statement.
    2. Are likely to be converted to cash within the next quarter.
    3. Are found on the balance sheet because they represent an asset (money paid up-front for future benefits).
  1. If a company's inventories are rising relative to sales:
    1. It's a sign that the company is becoming more profitable.
    2. It's a sign that the company may be in danger of becoming less profitable.
    3. It's a sign that the company is downsizing.
  1. Goodwill:
    1. Is a type of intangible asset.
    2. Is a type of intangible liability.
    3. Is a type of current asset.
  1. You would especially want to pay attention to short-term borrowing if:
    1. A company is in distress.
    2. A company generates decent cash flow.
    3. A company pays no dividend.
  1. Retained earnings represent:
    1. The amount of money shareholders have paid for the company's stock.
    2. The total profits a firm has earned over time, minus whatever has been paid as dividends.
    3. The amount of its own stock that a company has repurchased.

Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.

 


Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer

Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.

Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.

Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.

Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.

Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.

 


 

Author: Steve Bauer

Steven H. Bauer, Ph.D.

Steve Bauer

Steve has several degrees, i.e. post graduate degrees and doctorate and a great deal of (too much) continued education. For seven years, he did a stent as a University Professor of Finance and Economics.

He owned a privately held asset management firm and managed individual investor and corporate accounts as a Registered Investment Advisor - for over 40 years.

Professionally he is a financial analyst and private asset manager / consultant / mentor.

Steve can be reach at senorstevedrmx@yahoo.com

Copyright © 2010-2011 Steven H. Bauer, Ph.D.

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