Balance Sheet Introduction

The balance sheet is a summary of the assets and liabilities that a company has. A good analogy for an income statement and balance sheet is to compare it to a person’s income on his tax statements and his assets. For example a person’s income is what he earns from his job, the interest he gets on the money in his account, the profit/loss he makes in trading securities in his personal account, the rent he gets from real estate that he owns and subtracting his travel and other costs associated with earning his income.

The balance sheet can be compared to all the assets /liability an individual has. For example an individual might own a house, car, real estate, stocks and a 410-k plan. These would be considered the individuals assets. He also could have taken a mortgage to buy the house and real estate. These would be considered his liabilities. The difference between the value of the assets and liabilities is the net equity. A company’s balance sheet works in a similar way, except that the components are broken down in greater detail.

A companies balance sheet are made up of the assets, which is what the company owns, liabilities which mainly includes debt and the net equity which is the net worth of the company.

Example Balance Sheet:

We will begin by giving a description of assets. Assets are split into short term and long term assets.

The first entry is usually

Cash & Equivalents and Short Term Investments [1]

This is simply the amount of cash and short term liquid assets which can be converted into cash. Short term investments include money market securities with short maturities and other investments where the company is expecting to liquidate it in the near future.

The second entry is

Accounts Receivable [2]

This is the money which the company is expecting to receive for having sold goods or rendered services. There are cases where clients need some time to pay for the products and this will be in the accounts receivable.

The third entry is

Notes Receivables [3]

This entry refers to the amount owed usually by clients which do not have the regular payment periods or payments are not collected within the typical collection period.

Other Current Assets [4]

Adding the entries from 1 to 4 will give you the total short term assets.

Now we can look at the long term assets. These are assets that cannot be easily transferred to cash.

Property, Plant and Equipment. [5]

These comprise of non investment real estate, manufacturing devises and any other buildings used in the operation of business and production of goods. Due to their illiquid state they are considered long term.

Less Accumulated depreciation and Amortization [6]

This entry is how much the value of wear and tear is for any of the manufacturing devices. The sum of the total accumulated wear and tear over the years is referred to as accumulated depreciation.

Net property plant and equipment [8]

This is simply the difference between the value of [5] and [6].

Most balance sheets distinguish between long term assets that are associated with the actual operation and production of the goods and other more subtle assets. These are referred to as “Other Assets” which include:-

Goodwill [9]

This is simply the amount extra a company is willing to pay to take over the company. For example if a company has already established a corporation with offices and production facilities in the right place as well as a strong brand, another company is willing to pay for these extra “values” so as not to build the whole company from scratch and go through the time consuming efforts of establishing a brand and reputation.

Intangibles [10]

Intangibles are other assets which doesn’t have a physical presence it is still valuable. In some companies this includes non-compete rights.

Deferred Tax Assets [11]

Total Assets [12]

Total Assets are simply the sum of all long term and short term assets.

Liabilities

Like assets these are split into long term and short term components.

Components of short term liabilities include:-

Short Term Money Market Securities Issued (Commercial Paper) [13]

Just as some companies invest in commercial papers some companies issue them if they need short term financing.

Accounts Payable [14]

Just as when a company sells goods it has a time lag between the time the goods are sold and the time the money is received, known as accounts receivable when a company buys goods such as raw material it might have a small time lag until it pays them. This is referred to as the accounts payable. These are very short term liabilities because provided that the company has liquid cash it should pay them as soon as possible.

Dividends Payable [15]

When a public company which is in its maturing stage in business and has enough cash, will be expected to pay dividends to its shareholders. These dividends are a liability because a company owes it to the shareholders.

Income and other Taxes Payable [16]

If a company was able to defer some taxes or if a company wasn’t able to establish certain taxes that it had to pay in the past a separate entry is accounted for as “Income and other Taxes Payable”. This also includes fixed taxes which are not necessarily proportional to the profit a company makes. For example if a company owns a piece of real estate in a residential area it might have to pay for school taxes.

Other Liabilities [17]

Total Current Liabilities [18]

This is the sum of [13] to [17]

Long Term Liability

These are liabilities which are not expected to be paid within the next year. Majority of cases refer to debt.

Long Term Debt [19]

These are usually long term bonds which are issued by the company. It could be issued for 1 year or even up to 20 years. The company receives money for selling the bonds and in turn pays coupon and repays the full principle when the bonds mature. Long term liabilities are usually used to finance long term assets. For example a company might own a factory or plant and to acquire it, the company could’ve either taken out a mortgage and used the property as collateral or simply issued long term bonds.

Total Liabilities [20]

This is simply short term and long term liabilities, namely [18] + [19].

Net Equity

Net Equity is simply the net worth of a company. This is calculated as

Net Equity = Total Assets – Total Liabilities [21]

However it is important to know that the net equity is broken down into a number of components.

Net Equity = Preferred Equity +Minority Interest + Total Common Equity [22]

Equation [22] simply describes the way the equity is distributed amongst different stakeholders. For example in equation [22] the stakeholders are the minority Interest, which are the accumulated earnings for the subsidiary companies. Preferred Equity are equity holders who have seniority to common equity holders. Usually preferred shareholders get a fixed dividend, like a bond, but the securities do not have a maturity.

Total Common Equity is also referred to as

Total Common Equity = Share Capital and Additional Paid in Capital + Cumulative Undistributed Earnings [23]

Ratio’s Relating to Balance Sheets

Current Ratio = Current Assets / Current Liabilities [24]

Short term lenders would prefer a high quick ratio because it enables the firm to pay short term loans. Company owners however would generally prefer to have a lower figure because they want short term assets to be working.

Quick Ratio = (Current Assets – Inventory)/ Current Liabilities [25]

The quick ratio is a better ratio to indicate liquidity because it subtracts inventories which cannot always be sold in the short term.

Debt Ratio = Total Debt / Total Assets [26]

Debt to Common Equity = Total Debt / Total Common Equity [27]

Interest Coverage = EBIT / Interest Charges [28]

This ratio is especially important if a company has a lot of bonds with high interest coupons outstanding. An analyst might be interested to see how much of a company’s gross profits are eaten away by interest charges. This ratio is also often used as one of the parameters to determine a company’s credit rating.

Ratio’s that Incorporate Balance Sheer and Income Statement Entries

Return on Assets = Net Income / Total Assets [29]

This ratio determines how effectively a firm is using it’s assets to generate profits.

Return on Equity = Net Income / Total Equity [30]

Return on Invested Capital = Net Income / Invested Capital [31]

Please read my article “Hazard Check for Stocks: Quantitative Factors” on how return on invested capital and other ratios are refined to pick specific details.

Dividend Yield = Dividends per Share/ Price per Share [32]

Not too much attention should be paid if a company is a growing and the dividend yield is low. Very often a company will use the income generated and reinvested it in the business. Only when a company feels that its growth is slowing down will they start to pay dividend.

Payout Ratio = Dividend per Share / Earning per Share [33]

As discussed above the payout ratio will increase as the company approaches its maturing stage in the life cycle.