2

The balance sheet

This chapter will divide the balance sheet into five major blocks:

• Fixed assets
• Current assets
• Owners’ funds
• Long-term loans
• Current liabilities

Balance sheet structure

Figure 2.1 shows the balance sheet divided into five major blocks or boxes. These five subsections can accommodate practically all the items that make up the total document. Two of these blocks are on the assets side and three go to make up the liabilities side.

Almost every item that can appear on a balance sheet will fit into one of these boxes. Each box can then be totalled and we now have a balance sheet that consists of five numbers only. These five numbers will tell us much about the company’s structure.

We will continually come back to this five-box structure, so it is worthwhile becoming comfortable with it, as we go through each box in turn.

We use this five-box balance sheet for its clarity and simplicity. It will be seen later how powerful a tool it is for cutting through the complexities of corporate finance and explaining what business ratios really mean.

Let us look first at the two asset blocks. These are respectively called:

• fixed assets (FA)
• current assets (CA).

These can also be considered as ‘long-term’ and ‘short-term’ types of assets. We will see that while this distinction is important in the case of assets, it is even more significant in the case of funds.

Current assets (CA)

This box in the bottom left corner contains all the short-term assets in the company. By short-term we mean that they will normally convert back into cash quickly, i.e. in a period of less than 12 months.

The various items that find their home in this box can be gathered together under four headings:

• inventories (stocks)
• accounts receivable (trade debtors)
• cash
• miscellaneous current assets.

These items (see Figure 2.2) are in constant movement. Inventories of raw materials are converted into finished goods. These when sold are transformed into accounts receivable which in due course are paid in cash to the company.

The ‘miscellaneous’ heading covers any short-term assets not included elsewhere and is usually not significant. The amount of cash held is often small also, because it is not the function of a company to hold cash. Indeed, where there are large cash balances, there is usually a very specific reason for this, such as a planned acquisition.

The two significant items in current assets therefore are the inventories and accounts receivable. They are very important assets that often amount to 50% of the total balance sheet of the company.

Fixed assets (FA)

Fixed assets comprise the second major block of assets. They occupy the top left corner of the balance sheet (see Figure 2.3).

We use the term ‘fixed assets’ even though the block contains items that do not strictly fall under this heading. A more accurate description would be ‘long-term investments’, but the term ‘fixed assets’ is more commonly used. Another common description used mainly by large global companies is ‘non--current’ assets.

The items that fall into this block are grouped under three headings:

1 Intangibles

Included under this heading are all assets that do not have a physical presence. The main item is goodwill. This is a component that gives rise to some controversy although it is outside the scope of this book.

2 Net fixed assets

Large, expensive, long-lasting, physical items required in the operations of the business are included here. Land, buildings, machinery, and office and transport equipment are the common entries. The standard method of valuation is to take original cost and deduct accumulated depreciation. In the case of property, adjustments may be made to reflect current values.

3 Investments

‘Investments/other assets’ include long-term holdings of shares in other companies for trading purposes. Not all such investments are shown in this way. Where a holding company has dominant influence, the accounts of the subsidiary company are totally consolidated. This means that the separate assets and liabilities of the subsidiary are aggregated with corresponding items in the parent company’s balance sheet. It is only investments in non-consolidated companies that are shown here.

The question as to whether the balance sheet values should be adjusted to reflect current market values has, for years, been a contentious one. In times of high inflation, property values get out of line – often considerably so – and it is recommended that they be revalued. However, it is important to note that the balance sheet does not attempt to reflect the market value of either the separate assets or the total company. Prospective buyers or sellers of course examine these matters closely.

Liabilities

The liabilities column is subdivided into the following three categories:

• owners’ funds (OF)
• long-term loans (LTL)
• current liabilities (CL).

(There are certain types of funds that do not fit comfortably into any one of the above listed classes. At this stage we will ignore them. Usually the amounts are insignificant.)

Current liabilities (CL)

Current liabilities (see Figure 2.4) have a strong parallel relationship with current assets. For example ‘accounts payable’ counterbalance ‘accounts receivable’. Also ‘cash’ and ‘short-term loans’ reflect the day-to-day operating cash position at different stages. We will return to the relationship between current assets and current liabilities later.

Long-term loans (LTL)

These include mortgages, debentures, term loans, bonds, and any form of debt that has repayment terms longer than one year.

Another common description for long-term loans used mainly by large global companies is ‘non-current’ liabilities.

Owners’ funds (OF)

Owners’ funds are the most exciting section of the balance sheet. Included here are all claims by the owners on the business. Here is where fortunes are made and lost. It is where entrepreneurs can exercise their greatest skills and where takeover battles are fought to the finish. Likewise it is the place where ‘financial engineers’ regularly come up with new schemes designed to bring ever-increasing returns to the brave. Unfortunately, it is also the area where most confusing entries appear in the balance sheet.

In place of the term ‘owners’ funds’ you may find the following alternatives in practice (which largely mean the same thing):

• owners’ funds
• ordinary funds
• shareholders’ funds
• total equity.

For the newcomer to the subject the most important thing to remember is that the total in the box is the figure that matters, not the breakdown between many different entries. We will discuss this section at length in Chapter 11 on investor ratios. It is important to note that while our discussions centre on publicly quoted companies, everything said applies equally strongly to non-quoted companies. The rules of the game are the same for both.

Note the three major subdivisions of owners’ funds below:

• issued common stock
• capital reserves
• revenue reserves.

1 Issued common stock

The issuing of common stock for a cash consideration is the main mechanism for bringing owners’ capital into the business. Three different values are associated with issued common stock:

• nominal value
• book value
• market value.

These will be covered in detail in Chapter 11 on investor ratios.

2 Capital reserves

The heading ‘capital reserves’ is used to cover all surpluses accruing to the common stockholders that have not arisen from trading. The main sources of such funds are:

• revaluation of fixed assets
• premiums on shares issued at a price in excess of nominal value
• currency gains on balance sheet items and some non-trading profits.

A significant feature of these reserves is that they cannot easily be paid out as dividends. In many countries there are also statutory reserves where companies are obliged by law to set aside a certain portion of trading profit for specified purposes – generally to do with the health of the firm. These are also treated as capital reserves.

3 Revenue reserves

These are amounts retained in the company from normal trading profit. Many different terms, names, descriptions can be attached to them. Here are the most common:

• revenue reserves
• general reserve
• retained earnings.

This breakdown of revenue reserves into separate categories is unimportant and the terms used are also unimportant. All the above items belong to the common stockholders. They have all come from the same source and they can be distributed as dividends to the shareholders at the will of the directors.

Key balance sheet terms

The following four key terms used in the balance sheet are very simple but important:

• total assets
• capital employed
• net worth
• working capital.

In any discussion of company affairs, these terms turn up again and again, under many different guises and often with different names. Each of these terms will be defined and illustrated in turn. The five-box balance sheet layout will assist us greatly in this section.

Total assets (TA)

You will see from Figure 2.6 that the definition is straightforward:

TA = FA + CA

$1,000 = $600 + $400

However, very often we use the term ‘total assets’ when we are really more interested in the right-hand side of the balance sheet where the definition more properly is:

TA = OF + LTL + CL

$1,000 = $450 + $250 + $300

We must be able to see in our mind’s eye the relationship that exists between this and other balance sheet definitions.

‘Total assets’ is a value we will use often. As can be seen, it is simply the sum of everything in the balance sheet from top to bottom. This is the same number whether we use the right-hand or left-hand side.

Sometimes it will make more sense to look at this value from the point of view of the assets and sometimes from the point of view of the funds.

We may use the same expression ‘total assets’ in both situations.

Please note that sometimes we come across the term ‘total tangible assets’ in addition to ‘total assets’.

Capital employed (CE)

This is the second important balance sheet term and it is one that is used very widely. Most books on finance give the definition of capital employed as being:

Fixed assets + investments + inventory + accounts receivable + cash, less accounts payable and short-term loans.

To disentangle this definition, look at Figure 2.7 and you will see that it means:

CE = FA + CA — CL

$700 = $600 + $400 — $300

From Figure 2.7, we can see that it also comprises the two upper right-hand boxes of the balance sheet, which gives the definition:

CE = OF + LTL

$700 = $450 + $250

These definitions are identical.

In the first case, we start off at the top left-hand side, work down through fixed assets and current assets to the very bottom and then come back up through current liabilities to end up at the long-term loans line.

In the second case, we start at the top right-hand side and work our way down through owners’ funds and long-term loans.

Either way, we can see that the distinction between total assets and capital employed is that all the short-term liabilities in the current liabilities box are deducted from capital employed. Capital employed, therefore, includes only the long-term funds sections the balance sheet.

Capital employed is a widely used term. We will often see a rate of return expressed as a percentage of this value. Many analysts place great emphasis on capital employed. They say, with justification, that it represents the long-term foundation funds of the company. In looking at company performance they are concerned to ensure that profits are sufficient to keep this foundation intact. However, others will argue that in the current liabilities category we have, normally, bank borrowings that are, in theory, very short-term but are, in reality, permanent funds. They should therefore be included in the funding base when calculating rates of return.

Net worth (NW)

This third term includes the top right-hand box only of the balance sheet. This box is such a significant section of the balance sheet that it has many names attached to it.

We have already looked at this box in some detail under the heading ‘owners’ funds’. An alternative name for ‘owners’ funds’ is ‘net worth’. As a reminder the following values are included here:

• issued common stock
• capital reserves
• revenue reserves.

Accordingly, the first definition of net worth is the sum of the above three items, amounting to $450 (see Figure 2.8).

For the second definition we can use the same method that we used for capital employed. That is, we work our way down through the assets and back up through the liabilities to arrive at the same value:

NW = FA + CA — CL — LTL

$450 = $600 + $400 — $300 — $250

This latter definition conveys more accurately the significance of the value in this box. It says to us that the value attributable to the owners in a company is determined by the value of all the assets less all external liabilities, both short and long. This is simple common sense. The shareholders’ stake in the company is simply the sum of the assets less loans outstanding to third parties. In a set of published accounts this is commonly referred to as ‘net assets’.

The first way of looking at this box is by means of the accounting definition, where shares are issued and reserves are accumulated over time using various accounting rules and conventions. The second definition gives a more pragmatic approach: simply take all the values on the assets side of the balance sheet and deduct outstanding loans – anything left is shareholders’ money, no matter what name we give it. If recorded book values for assets are close to actual values, both approaches will give almost the same answer.

The amount of realism in the net worth figure, then, depends entirely on the validity of the asset values.

Working capital (WC)

Our fourth balance sheet term is illustrated in Figure 2.9. It is an important term that we will come back to again and again in our business ratios.

The widely used definition of working capital is:

WC = CA — CL

$100 = $400 — $300

Working capital is an important value. It represents the amount of day-to-day operating liquidity available to a business. We can consider liquidity as an indicator of cash availability. It is clearly not the same thing as wealth: many people and companies who are very wealthy do not have a high degree of liquidity. This happens if the wealth is tied up in assets that are not easily converted into cash. For instance, large farm and plantation owners have lots of assets, but may have difficulty in meeting day-to-day cash demands – they have much wealth but they are not liquid. This can be true for companies also.

It is not sufficient to have assets; it is necessary to ensure that there is sufficient liquidity to meet ongoing cash needs. A company can be very rich in assets, but short of liquidity if these assets cannot readily be converted into cash.

We have an alternative definition in Figure 2.10, that looks at working capital from the right-hand side of the balance sheet. This definition gives perhaps a more significant insight. Here, we see that it can be calculated as:

WC = OF + LTL — FA

$100 = $450 + $250 — $600

This definition is not often used in the literature but it is a very important way of looking at the structure of a company.

The amount of working capital available to a company is determined by the long-term funds that are not tied up in long-term assets. When a business is being set up, long-term funds are injected from the owners and other long sources. A considerable amount of these will be spent to acquire fixed long-term assets. However a sufficient amount must remain to take care of short-term day-to-day working capital requirements. Normally as time goes on this need grows with the development of the company. This need can be met only from additional long-term funds, e.g. retained earnings, or long loans, or from the disposal of fixed assets.