Part 2
Making a Statement
IN THIS PART …
Learn the balance sheet to comprehend what a company is really worth.
Use the income statement to understand a corporation's income and costs.
Utilize the statement of cash flows to see how different activities earn or spend money.
Perform the vital basic calculations to make decisions based on the information in corporate financial statements.
Comprehend financial statement calculations that are important to investors and lenders.
Chapter 4
Staying Balanced
IN THIS CHAPTER
For every give, there is a take. For every expenditure or liability, there is an asset of equivalent value. All of business finance must be in balance, and this is reflected nowhere better than on the balance sheet. The balance sheet is a financial report that’s useful to anyone who has even the slightest interest in a business, including management, investors, lenders, business students, union representatives, and all other stakeholders. In short, the balance sheet includes important stuff, so pay attention to this chapter!
Introducing the Balance Sheet
The Securities and Exchange Commission (SEC) requires that all corporations maintain a balance sheet and highly recommends that any business keep one (the distinction being that corporations are publicly-owned companies that are legally required to fulfill these reporting obligations to its shareholders and other regulators).
After all, the SEC’s main purpose is to illustrate the exact value of a company in the very moment that the data are collected. Unlike other financial reports, the balance sheet doesn’t compile data over a period of time. Instead, it reports the value of all the assets the company currently has, divided into relevant categories, and then also includes the value of the company’s liabilities and owners’ equity, each divided in a manner similar to assets.
Here’s the basic formula for the balance sheet:
Assets = Liabilities + Owners’ equity
So the total value of all assets equals the total value of all liabilities plus all owners’ equity. If the two sides of the equation don’t balance, then someone did something wrong, and it’s time for some no-holds-barred combat accounting! Hooah!
Evaluating the Weights on the Balance Scale
Everything of value in a company falls into three primary categories. Each of these categories represents a portion of the balance sheet:
Assets: Assets include anything of value that currently belongs to the company or is currently owed to the company. Remember that the company purchases all assets by using capital acquired by incurring debt and selling ownership, so the total assets must balance with the cumulative totals of the other two portions of the balance sheet (see the next two bullets).
Liabilities: Liabilities include the value of all the company’s debt that must be repaid.
Owners’ equity: Owners’ equity includes all the value that the company holds for its stockholders.
Each portion of the balance sheet begins with the things that are the most liquid at the top. In other words, the top of each portion includes the things that either must be or otherwise can be converted to cash the quickest. As you make your way down each portion, the items included gradually become either decreasingly liquid or require repayment for longer periods of time.
Understanding Assets
Assets include the value of everything the company owns and everything the company is owed. Assets fall into two main categories:
Current assets: Current assets are those assets that a company expects to turn into cash within one year or, for inventories that take more than a year to turn into cash (such as buildings, vehicles, and other things that are usually expensive items), those assets a company expects to sell within one year.
Long-term assets: Long-term assets are those assets that will take more than one year to turn into cash or that are otherwise not intended to be sold yet (but can be sold, if necessary).
Note that a few assets don’t fall into either of these categories. That’s where the last two sections of the assets portion come into play — intangible assets and other assets. I discuss both later in this section.
Current assets
This section outlines the subsections of the current assets portion of the balance sheet from the most liquid to least liquid.
Cash and cash equivalents
Cash and cash equivalents are the most liquid assets a company has available. In other words, they’re the assets that the company can most easily turn into cash because, well, they’re already cash. Cash refers to the money a company has on hand, while cash equivalents refer to savings accounts and such, from which the company can withdrawal cash quite easily, although at times the bank can temporarily restrict access.
Marketable securities
The second most liquid asset that a company has available is everything that falls into the category of marketable securities, including banker’s acceptances, certificates of deposit (CDs), Treasury bills, and other types of financial products that have maturity dates but that companies can withdraw from or sell very easily if necessary.
Accounts receivable
The accounts receivable category includes the value of all money owed to a company within the next year. Note the important distinction between money that’s owed in the next year and money that’s likely to be paid. Unfortunately, sometimes people refuse to pay what they owe. In these cases, the receivable remains receivable until either the money is paid or the period in which the money is due passes.
After the period passes, the company subtracts the value of the account owed from accounts receivable and transfers it to a subaccount called allowances. Allowances include the value