Table of Contents:
Balance sheet
The balance sheet tells you how much the company owns, and how it is financed. It shows the financial position of a company at a moment in time, like a snap shot (rather than a movie, such as the income statement). The three main financial statements of a firm include the Balance Sheet, the Income statement and the cash flow statement.
What to look for on a Balance Sheet
When studying a balance sheet for the first time, you should look for three things:
1. liquidity - the ease with which assets can be converted to cash. Compare current assets to long term assets. The more liquid the firms assets, the less likely they will have trouble with liquidity or net working capital troubles. The trouble is that more liquid assets also have a lower expected rate of return than fixed assets, so firms try to hold as little net working capital as possible. It is an investment for the firm to keep working capital, because there is an opportunity cost (of not investing in longer term, more productive assets).
2. debt vs. equity - when a firm borrows (rather than raising money from owners), it is essentially giving debt holders the first contractual right to the cash flows of the firm. If the firm does not meet the bond holders obligations, they can sue, and force the company into bankruptcy.
Trouble might arise if instances such as when buyout (PE) firms take debt positions and equity stakes in the same company -- a practice that many critics say they believe will lead to conflicts of interest, and may even be illegal in some cases. One example could be a scenario in which the portfolio company runs into trouble and other creditors seek to renegotiate its loans -- the private-equity firm may be in a position to block the renegotiations to maximize the value of its equity stake
3. value vs. cost - when accountants talk about "book value" of assets, they are actually talking about the historical cost of those assets, which might be significantly different from the actual market value. For example, assets on the balance sheet are recorded by what the owner originally paid for them, and not what they would trade for in the market today. In many cases, the assets are actually much more valuable than the book cost indicates.
Who uses the Balance sheets (for different purposes)
1. Investors use the balance sheet want to know the value of the firm, not its cost. This implies that they must use their judgement when valuing a firm because much of what a firm is valuable for is not included on the balance sheet, such as management skill, or trademarks (such as McDonald's), etc.
Note: book value is what the firm is worth "dead", but investors want to know what the firm is worth alive, and so investors often look at ratios such as Market / Book ratio which compares the market value of the firm vs. the book value of the firm.
2. A banker might look at the balance sheet differently as they are more concerned about liquidity and working capital availability, because they are more concerned about the firms ability to pay back loans.
3. A supplier might look at the balance sheet and key in on the accounts payable ratios, which would tell the average number of days outstanding of accounts payable, or how quickly the firm typically pays is suppliers.
How the Balance sheet looks:
By definition, the balance sheet must balance, with Assets = Liabilities + Owners equity
A = L + CS + sum((R-E) - D)
Assets
Liabilities
The liabilities and stockholders equity side of the equation shows the proportions of financing, and the capital structure of the firm (the mix of debt and equity financing, and the mix of short term and long term debt).
Raise $ from non-owners
Bank = long term
suppliers / employees = short term
obligations to non-owners = liabilities
Definition of Liability: (has to meet all three)
1. there is a "probable" sacrifice of resources in the future
2. Can not avoid
3. Something has already occurred in the past (not just an exchange of promises)
notes:
1. lenders often require certain ratios to be met (debt / equity of 60% max, for example), or they want their money back
2. Reported liabilities under GAAP might be different than actual obligations. Some obligations don't need to be reported on the Balance sheet. Analyst needs to be aware of such items as obligations under operating leases, and guarantees of debts of others, which are not on the B.S., but are obligations of a company.
3. In order to understand long term liabilities, you first need to understand "net present value" (NPV) and the concept of "compound interest".
4. Long term liabilities are valued at their NPV on the books, at the historical interest rates (which have probably changed since then).
5. Because interst rates have changed, then the real market value of the long term debt will surely be different than is reported on the balance sheet. An analyst needs to recalculate the actual debt.
6. If actual market value of debt is higher than is reported on the book value, then the actual shareholders equity will be smaller than reported.
7. Note: not all obligations are liabilities (even though all liabilities are obligations)
Types of Liabilities
Current Liabilities
within one cycle (1 year)
normally value at historical cost, with no discounting (not at NPV)
Accounts Payable to creditors
Because there is no interest, you should delay payment as long as possible.
Try to negotiate longest grace period before due, but then always pay on time
Short term notes and interest payable
note payable = less than one year
payments should pay off interest first, then pay off principle.
Wages, salaries
company pays government on the employees behalf (for the employees, who actually owe)
Deferred liability - advances from customers
advance from a customer is a liability
don't record revenue yet
then, after you earn the revenue, at that time you debit advance from customers, and credit sales revenue
Deferred liability - product warranties
company should be able to estimate the warranty cost
example - 4% of sales revenue
At the time you recognize the revenue (and earnings), you should also recognize the expense (and a liability), even though the actual expenditure might be different than estimated. later, when the money is actually spent, you reduce cash and also reduce the liability (not an expense later on). this way, the expense is recognized at the same time as the revenue (and not when the money is actually spent).
Long - Term Liabilities
Now, you have to deal with interest.
If the loan is long term, then you recognize the interest at regular intervals
But if the loan is short term, then you recognize the interest as one lump sum at the end.
Book Value - NPV of rem
Liability Valuation
Historical cost accounting - should show NPV of liability on books
Use interest rate at time of issue (historical interest rate)
Current liabilities - do not bother to discount to NPV
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