The balance sheet is used to summarize
the net worth of a company. It indicates the financial
position and current financial health as of a particular date. It
is an aid in determining whether a
company is capable of generating value for shareholders.
A balance sheet is a representation of the accounting formula: assets =
liabilities + owners' equity. The
objective of being in business is to build ownership. Equity =
unencumbered ownership. Assets are a store of equity (value).
Assets are sources of value that can benefit a company down the road.
There are two major categories of assets: current and non-current.
Current assets are relatively liquid, meaning they can easily be
converted into cash. Current assets are expected to be converted into
cash or used up within one year. Non-current assets, conversely, are not
easily converted into cash. These can include property, equipment,
goodwill, and deferred charges.
Current Assets
Assets that will be used up within the next year or easily converted
into cash within one operating cycle are considered current. An
operating cycle is the time it takes to sell a product or service and
collect cash from that sale. It can last anywhere from 60 to 180 days or
more.
Current assets can also be viewed as operating assets because they fund
the day-to-day operation of its business. Running low on current assets
will force a company to seek other sources of fuel for its operations,
usually leading to debt interest or dilution of shareholder value.
Current assets are listed on a balance sheet from top to bottom with the
most liquid at the top.
Let's review the terms you'll see under Current Assets.
Cash and Equivalents consist of cold, hard cash or very liquid
equivalents, such as money market funds or bearer bonds. This is cash or
insta-cash that is at the company's disposal for operations, growth,
dividends, and share repurchases.
Short-term Investments are just below cash and equivalents in
liquidity. When a company has cash over and above that needed for
operations, it can afford to sink some into short-term bonds that will
earn interest. While not as readily available as cash and equivalents,
short-term investments can be converted into cash without too much
difficulty.
Accounts Receivable (A/R) is what is owed to a company by its
customers. Products or services have been rendered on credit and the
company is now sitting next to its mailbox waiting for a check. Usually,
A/R will be converted into cash in a relatively short time. However, if
a customer cannot or will not pay and sending cousin Louie after 'em
doesn't prove beneficial, the company will be forced to take a write-off
for bad debt. The Allowance for Bad Debt you see next to A/R in
parentheses is money set aside to cover potential delinquent customers.
Look at the rate of growth or decline in A/R and compare it to that of
revenue. Although an asset, A/R is not something you want to see
growing, much less outpacing revenues. A good portion of assets, such as
A/R, are paradoxical in nature -- we'll get more into that another day.
Inventories are the goods a company has for sale and the
materials used to produce those goods. It's idle money, like a
caterpillar in a cocoon, waiting to blossom merrily into flight and
provide cash. Sitting in that cocoon too long, however, is not only
claustrophobic, it can be costly. Companies need to turn inventory into
cash as quickly as possible to put that money back to work for them.
Like A/R, inventories outpacing revenue growth is a sign of trouble
ahead.
Non-Trade Receivables is money due from sources other than
customer purchases. These can include tax refunds, interest income, or
the sale of property or equipment.
Restricted Cash is money set aside for a specific purpose,
generally spelled out in a contract. A company may not use restricted
cash for business operations, therefore it is listed separately from
Cash and Equivalents on a balance sheet.
Prepaid Assets, to finish off current assets, are assets for
which the company has paid the bill in advance for products or services
rendered. Although not a liquid asset, prepaid assets are a bonus
because these bills will not have to be paid in the future, leaving
greater future revenues at your disposal.
We've worked our way down the balance sheet over the last several
weeks, covering assets and liabilities, both current and non-current.
Finishing up tonight, we'll look at the final few items that you'll
encounter in this section of a quarterly report. There's a light at the
end of the tunnel, as they say. Let's hope it's not a train.
Owners' Equity is the owners' stake in the company. If you look
at a company from a balance sheet perspective, it belongs to two
parties: its owners and its creditors. Therefore, when you subtract the
creditors' equity (liabilities) from total assets, what's left over is
owners' equity. Owners' equity includes preferred stock, common stock,
additional paid-in capital, treasury stock, retained earnings,
appropriated retained earnings, and foreign currency translation
adjustment.
Preferred Stock represents ownership in a corporation and gives
the holder a claim prior to the claim of common stockholders on
earnings. In the event of liquidation, preferred stockholders are paid
off before common stockholders, so they get first dibs after liability
holders are taken care of.
Preferred stock generally pays a fixed dividend, which usually must be
paid before dividends are paid on common stock. These dividends are also
cumulative -- any missed dividends must be made up prior to paying
dividends to common stockholders.
These securities, which carry no voting rights, are priced on dividend
yield and trade much like long-term corporate bonds. Some agreements
carry an option that allows preferred stock to be exchanged for a set
number of common shares. Companies will issue preferred stock to
increase their equity and reduce financial leverage.
Common Stock represents shares that have no preference to
dividends or any distribution of assets. Common stock normally carries
voting rights and its holders are the residual owners of a corporation
in that they have a claim to what remains after every other party has
been paid. Common stock of mature companies often pays quarterly
dividends.
Additional Paid-In Capital is what occurs when proceeds from
issuing common stock exceed par value. Par value is an arbitrary amount
assigned to stock, which has little meaning in the present day where
securities regulations are much different from bygone years.
Treasury Stock are shares that have been issued and then
repurchased. Treasury stock is not considered in paying dividends,
voting, or calculating earnings per share. It may be reissued at some
point or retired completely.
Treasury stock is not an asset. Companies cannot create an asset by
holding stock in itself. The amount of treasury stock held is recorded
as a reduction in shareholders' equity.
Retained Earnings is the income that has been retained for
reinvestment in the business rather than being paid in dividends to
shareholders. Income that is retained can be used to acquire additional
income-earning assets, resulting in greater future profits. Retained
earnings represent the maximum amount that could be distributed to
shareholders if the company wished to do so.
Appropriated Retained Earnings are earnings that have been
earmarked by the company as not available for dividend payment. Let's
say a company decides to take on a major project and wants to reserve a
portion of earnings for that project. It can limit the dividend by
appropriating some of its retained earnings for other uses.
Companies will sometimes appropriate retained earnings in order to
decrease the perceivable earnings available for dividends, wages,
benefits, etc. Appropriated retained earnings may be un-appropriated at
any time.
Here is an example excel balance sheet that can be downloaded.
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