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4.2 The Balance Sheet

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Describe what a balance sheet is.
  2. Explain how to read a balance sheet.
  3. Describe what factors influence a balance sheet.

Unlike the financial movie the income statement, a balance sheet is a snapshot of a company’s financial position. A balance statement represents a company’s finanical position at a specific date in time (the company’s year end). During different times of the year the balance sheet may change as sales, assets and receivables change. If a firm does seasonal business such as Toro (lawnmowers and snowblowers), its inventory levels, sales and receivables will all vary dramatically throughout the year.

The balance sheet is divided into two sections: assetsA resource with value. on the left side and liabilitiesA company’s debts or legal obligations. and equity on the right side. The left side lists all assets including cash, accounts receivable and investments. The right side lists the firm’s liabilities including accounts payable and debts. The right side also includes shareholder’s equityThe equity stake in a firm held by the firm’s investors. which is the value of the firm held by its stockholders and retained earningsEarnings not paid out as dividends but retained by the firm to pay its debt or reinvest in firm..

Items on the balance sheet are listed in order of liquidityEase with which an asset can be converted to cash., or the length of time it takes to convert them to cash. The longest term items are listed last because they are the least liquid. On the right side, stockholders are listed last because they are the least liquid and will be paid in the event of bankruptcy only after all other debts have been satisfied. The values listed on a balance sheet are book values which are based on purchase price. Book values (purchase price) may be very different from market value (current fair market values).

Assets

Assets are divided by liquidity into two categories: current assetsItems that can be expected to be converted to cash in under one year. and fixed assetsItems not expected to be converted to cash in under one year.. Current assets consist of cash, accounts recievable and inventories. These items can be expected to be coverted to cash in under one year. Inventory includes raw materials, work-in-progress and actual product. Accounts recievable generate when a company sells its product to a customer but it is waiting to receive payment. Fixed assets are both tangible such as buildings, machinery and land and intangible such as patents. Companies also may hold investments in other companies or other securities. These assets are also included on the balance sheet and are listed in order of liquidity. The sum of all of these assets is a company’s total asset number.

Liabilities and Equity

The right side of the balance sheet is for liabilities and equity and are also listed in order of liquidity. Liabilities are listed first and are money owed. Current liabilitiesLiability items that are expected to be converted to cash in under one year. are payments due within one year. Accounts payable are generated when a company makes a purchase for raw materials or advertising but does not pay for it immediately. Listed next are longer term liabilities such as notes payable and accruals. Accruals are wages owed to employees and taxes owed to the government. Notes payable are loans taken out by the company. These may also be longer term and listed under long term debt.

The equity component includes Shareholder’s Equity and Retained Earnings. Retained earnings are the cumulative amount of earnings earned by a firm since inception that have not been paid out as dividends. Retained earnings are not cash but rather earnings used to finance corporate activities. Stockholder’s equity is stockholder’s claim on the firm. The sum of common stock and retained earnings is called ‘common equity’ or simply equity. Sometimes common equity is also referred to as net worth, a company’s assets net of its liabilities. A pro-forma balance sheet is shown in Figure 4.2 "Pro-Forma Balance Sheet".

Figure 4.2 Pro-Forma Balance Sheet

Key Takeaways

  • A balance sheet is a snapshot of a company’s financial position.
  • Balance sheet lists assets on the left side and liabilities and shareholder’s equity on the right.

Exercises

  1. Review the following 10-K statements

    1. Here is a link to Nike’s 10-K.

      http://nike.q4cdn.com/25140a27-0622-47e1-9f85-99892a766984.pdf?noexit=true

      Look at the Balance Sheet on page 57. Can you identify current assets? Current liabilities? Shareholder’s equity?

    2. Here is a link to Starbuck’s 2011 10-K.

      http://investor.starbucks.com/phoenix.zhtml?c=99518&p=irol -SECText&TEXT=aHR0cDovL2lyLmludC53ZXN0bGF3YnVzaW5lc3MuY29tL2RvY3VtZW50L3YxLzAwMDExOTMxMjUtMTEtMzE3MTc1L3htbA%3d%3d#toc232803_21

      Look at the Balance Sheet on page 44. Can you identify total assets? Total liabilities? Shareholder’s equity?

  2. Last year Sun Skateboards had $80,000 in current assets and $95,000 in current liabilities. It had $40,000 in fixed assets. Determine the amount of shareholder’s equity and construct a balance sheet for Sun Skateboards.