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Course 107
A Tour through the Balance Sheet

Introduction


The balance sheet is usually the second financial statement you'll encounter in an annual report or SEC filing, though sometimes it comes first. The purpose of a balance sheet is to tell how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity), which represents the part of the company owned by shareholders. The basic equation underlying a balance sheet is:
Assets - Liabilities = Equity This can also be expressed as:
Assets = Liabilities + Equity These three elements are crucial for evaluating a company's financial health. Companies with lots of assets relative to their liabilities are generally more resistant to setbacks than companies with lots of liabilities are. Financial leverage, equal to assets divided by equity, is one of the most common measures of financial health; the higher a company's leverage, the more it relies on debt to finance its operations. Each of these three primary elements is broken down further on the balance sheet, and these breakdowns give lots of useful information. Few balance sheets will contain all of the items listed below, and often the items that do appear will be arranged in different ways. However, below are some of the most common items that are important to know to make sense of the wide variety of balance sheets you'll encounter.

Assets


Current Assets. Current assets are those likely to be used up or converted into cash within one business cycle, usually defined as one year. (For items that take a long time to manufacture, the business cycle may be longer.) This category is usually broken down into subcategories, of which the most common are the following: Cash. This doesn't refer to actual greenbacks sitting around in a vault but to money in low-risk, liquid investments such as money-market funds or government bonds. It is money that can be used for any purpose the company wants. Marketable securities. Money invested in the stock of other companies, ranging from a token amount to a substantial stake. It's not quite as liquid as cash. Current accounts receivable. Bills that the company hasn't yet collected but that are expected to be paid within a year. Inventories. There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, and finished products that have not yet been sold. Inventories are especially important to watch in manufacturing and retail firms. If a company's inventories rise, the company might be making or buying more goods than it can sell, which eventually translates into lower profits. Noncurrent Assets. Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting period. Like current assets, noncurrent assets are usually broken down into subcategories. Here are some of the most common categories used: Property, plant, and equipment (fixed assets). These are long-term assets that form the infrastructure of the company: land, buildings, factories, furniture, equipment, and so forth. These assets are sometimes referred to as fixed assets, because unlike items such as accounts receivable and inventories, they are independent of the volume of business the company is doing. Intangible assets. The most common form of intangible asset is goodwill, which arises when one company acquires another. Goodwill is the difference between the price the acquiring company pays and the equity of the target company. (Recall that equity is equal to assets minus liabilities; this will be discussed in more detail later in the course.) Especially for fast-growing technology companies, this difference can be quite large.

Liabilities


Current Liabilities. These are the flip side of current assets: money the company expects to pay within a year. Among the subcategories of current liabilities are: Short-term borrowings. This refers to money the company has borrowed for a term of less than a year, usually to meet short-term needs. Current accounts payable. These are bills the company owes to somebody else and are due to be paid within a year. Noncurrent Liabilities. Noncurrent liabilities are the flip side of noncurrent assets. They represent money the company owes one year or more in the future. Though you'll sometimes see a variety of line items under this heading, the most important one by far is long-term debt. This represents money the company has borrowed for a period of years, either from a bank or through issuing bonds. A lot of long-term debt is generally risky for a company, because the interest on such debt has to be repaid no matter how business is doing.

Shareholders' Equity


As noted earlier, shareholders' equity is equal to total assets minus total liabilities, and it represents the part of the company owned by its shareholders. It's generally broken down into three main subheadings.
 
Par Value of Stock. Par value is a legal fiction designed to protect the personal property of the company's shareholders from creditors in the event of bankruptcy. Basically, the law says that such property is protected, as long as the company's stock was issued at or above its par value--so companies arbitrarily set the par value very low, generally around $0.01 a share. The total par value of a company's stock is often a negligible amount, but it has to be listed on the balance sheet anyway. Contributed Capital (Above Par Value). Contributed value represents the amount above par value that shareholders have paid the company for their stock. Note that this isn't necessarily the same as the current market value of the stock, since the company itself doesn't get anything when its stock is traded between third parties (which is essentially what goes on in the stock market). Contributed capital only refers to money the company got when it first issued the stock, either in an IPO (initial public offering) or in a secondary offering. Retained Earnings. Retained earnings represent the profits the company has earned, minus whatever has been paid out as dividends. It's cumulative, so each year the company makes a profit and doesn't pay it all out as dividends, retained earnings grow some more. Likewise, if a company has lost money over time, retained earnings can turn negative and are often renamed an "Accumulated Deficit" on the balance sheet. One final thing to keep in mind about balance sheets is that they are merely snapshots of a company's financial health at a given point in time. This is unlike the income statement or the statement of cash flows, which tally a company's activity over a period. Balance sheets always have dates on them, typically listed at the top, and this indicates the time the "snapshot" was taken.   

Quiz 107
There is only one correct answer to each question.

1 Companies with lots of assets relative to liabilities on their balance sheet:
a. Are in danger of going bankrupt.
b. Have very little shareholders' equity.
c. Are healthier and more resistant to setbacks than companies with lots of liabilities.
2 Current assets:
a. Are those likely to be used up or converted to cash within a given period, usually a year.
b. Are those likely to be used up or converted to cash within the next quarter.
c. Are assets that the company does not yet own.
3 If a company's inventories are rising relative to sales:
a. It is a sign that the company is becoming more profitable.
b. It is a sign that the company may be in danger of becoming less profitable.
c. It is a sign that the company is downsizing.
4 Goodwill:
a. Is a type of intangible asset.
b. Is a type of intangible liability.
c. Is a type of current asset.
5 The par value of a stock:
a. Is equal to its market value when the balance sheet is prepared.
b. Is equal to its market value when it was first issued.
c. Is generally much less than its market value.
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