THE BALANCE SHEET
In Part 1 we described the Accountant's Report, which identifies the level of assurance the accountant is responsible for. After reading the Accountant's Report, it becomes time to actually start looking at the numbers, or as W.C. Fields said, "Take the bull by the tail and face the situation."
The first financial report in a set of financial statements is the balance sheet. The balance sheet summarizes the company's assets, liabilities and owner's equity. By reviewing this report, the reader can determine the financial strength of the company.
Assets consist of the property the company owns, including tangible personal, intangible personal and real property. They are presented in order of liquidity. The following is a list of typical assets:
- Accounts Receivable (net of bad debt allowance)
- Prepaid expenses
- Machinery and equipment (net of depreciation)
- Buildings (net of depreciation)
- Notes Receivable
VALUING THE ASSETS
Generally accepted accounting principles require that assets are stated at the lower of cost or market.
Often, a company will own an asset that is now more valuable than the original cost. Examples of assets that might be more valuable than cost are investments, inventory, building, or goodwill. Accountants are not allowed to revalue these assets up to fair market due to the conservative nature of accounting principles.
On the other hand, if an asset decreases in value below cost, we will be forced to lower the carrying amount to the lower of cost or market value.
DEPRECIATION OF ASSETS
Assets such as machinery, equipment, furniture and buildings are recorded at cost. We then estimate the useful lives of each asset and write off a portion each year. The gradual write-off of these tangible assets is called depreciation expense. The write-off of intangible assets, such as a five year prepaid franchise fee, is called amortization.
Liabilities are what the company owes creditors. They are typically listed in order of the most current to the most long-term, as follows:
- Accounts Payable
- Accrued Expenses (expenses incurred, but not yet payable)
- Taxes Payable
- Line of Credit Payable
- Short Term Notes Payable
- Long Term Notes Payable
Sometimes a company will have a potential to owe money, but it is uncertain if there is actually a liability. An example might be a lawsuit in progress. In this case, the liability is recorded if it is probable to occur.
Often a company will lease equipment or vehicles. Accounting principles require that leases be recorded as a loan payable if the lease is actually financing the purchase of the asset. These liabilities are usually called capitalized lease agreements.
The owner's equity represents the amount left over after subtracting assets from liabilities. For corporations, the owner's equity is divided between capital stock and retained earnings. The capital stock account is the money funded by the owners. Retained earnings consists of all of the net income the company has earned since inception, less distributions to the owners. Other names for owner's equity include: net worth, stockholder's equity, shareholder's equity, and in a partnership, partner's capital.
CLASSIFIED BALANCE SHEET
Most companies use a "classified" balance sheet. A classified balance sheet segregates the current assets and current liabilities, allowing easier analysis. Current assets are assets expected to be realized in cash or used within one year. Current liabilities are obligations expected to be paid within one year. Typical current assets are cash, accounts receivable and inventory. Typical current liabilities are accounts payable, taxes payable, accrued expenses and line of credit payable.
ANALYZING A BALANCE SHEET
Start reading your balance sheet line by line. Compare each account with prior balances for trends or variations. In time, you will become accustomed to the various account balances.
After reading line by line, you will want to make a series of calculations. The first calculation is working capital. This is equal to current assets less current liabilities. Working capital is a measure of ability to pay bills on time (also known as liquidity). The ideal amount of working capital varies based on company size and industry.
Another measure of liquidity is the current ratio. The formula for current ratio is current assets divided by current liabilities. Since it is a ratio, it is less dependent on company size and industry than the calculation of working capital. In general, a current ratio of 2 is considered healthy and less than 1.5 is cause for concern. After stating this, keep in mind that each company has unique demands and that some companies are healthy with a current ratio as low as 1.
As a reference point, here are some recently reported current ratios:
- Microsoft Corp. 5.29
- Motorola 1.29
- Ford Motor Company 1.02
- Intel 2.74
- IBM 1.16
- Chevron .84
- Exxon .83
- Texaco 1.54
- Home Depot, Inc. 1.93
- Pepsico .93
- Walmart 1.58
- K-Mart 1.45
Note that large public companies can get by with current ratios of less than 1.5. Smaller companies with a current ratio lower than 1.5 will often have trouble paying bills on time.
If a company has substantial inventory, analysts of financial statements will calculate the acid-test ratio. The acid-test ratio, also known as the quick ratio, is a more critical test of liquidity than the current ratio. This ratio gives a measure of liquidity without giving value for inventory. It is equal to current assets, without inventory, divided by current liabilities. A quick ratio of one or higher is generally considered healthy.
After reviewing the liquidity of the company by calculating the current and quick ratios, next calculate leverage ratios.
Leverage ratios focus on the relationship between liabilities and equity. They provide a measurement of the company's ability to survive adverse business conditions. Although there are many leverage ratios, the most commonly used is debt to net worth. Debt to net worth is calculated by dividing total liabilities by total owner's equity. A well capitalized company will have a low equity to debt ratio. For most businesses, a debt to net worth of one is very good. Two is average and over four is considered highly leveraged.
When calculating debt to net worth on privately owned businesses, the analyst will often reclassify loans from stockholders out of liabilities, then include the amounts as owner's equity. This helps the company have a better debt to net worth ratio.
Two other leverage ratios are equity to debt and debt to total assets. These ratios are mathematically inter-related. If you know one, the other two can be derived. The most commonly used leverage ratio is debt to net worth.
The balance sheet shows what a company owns and what it owes. By reading this report you can determine the financial strength or weakness of the company. In particular, you can determine the ability to pay bills on time and the ability to survive adverse business conditions. In Part 3, we will discuss everybody's favorite report--the Income Statement.