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The Balance Sheet

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The Balance Sheet SECTION 2 What Comprises the Business? The Balance Sheet The balance sheet represents the financial position of the business as of a certain day, usually the last day of the fiscal period. This end of period most often coincides with the end of the calendar year or the end of a calendar quarter. Most balance sheets you see will show the numbers for the current period as well as those for the immediate past period for comparison. This lets you see how the various components of the business have changed from one period to the next. The balance sheet can be divided in many ways, but the most logical and easiest to understand is the separation of what we have (assets) from where it came from (includ- ing both liabilities and equity, also known as shareholders’ investment or shareholders’ equity.)6 In its most typical format, the balance sheet shows assets on one side (the left side) and liabilities and equity on the other side (the right side). Let’s see why. ASSETS The total assets of the business represent the resources the business owns, including all the goods and property owned, as well as claims against others yet to be collected. In the U.S., these assets are listed in order of their liquidity (nearness to cash) at their his- torical cost to the business, adjusted for certain items we will discuss later. When you list the assets of the business, you also need to show where these assets came from. As we said earlier, the funding for assets arise from three sources: invested capital, creditors, and profitable operations. These sources represent specific stakes that various 6 Some accountants use the term equities to mean the right side of the balance sheet—both liabilities and shareholders equity. Getting Behind the Numbers — Fletcher/NACD 9 Section 2: The Balance Sheet parties have in the business. These are categorized as either liabilities (the business owes money to the claimant) or as stockholders’ equity (shareholders’ investment in the business plus undis- tributed profits of the past). Logically, the claims against the assets will always be exactly equal to the total amount of the assets. By definition, there must always be a claim against the assets by either a creditor or an owner. Let us take a look at the development of a business and the recording of its transactions by an accountant. We will learn the concepts and the language by studying a balance sheet for ABC Laboratories (ABC) a hypothetical company based on a real publicly owned medical products/services busi- ness operated for profit. Refer to the financial statements in the back of this handbook as you go through the accounts. ABC has organized itself into various divisions, each of which could maintain their own bal- ance sheets and income statements. When ABC reports its financial results to the public it con- solidates all its units into a single set of statements. There are some exceptions to this and we will cover some of them later. Current Assets The most liquid (cash-like) assets ABC owns are its current assets (assets that will become cash within one year). These include cash, marketable securities (expected to be sold in the near future), trade receivables (amounts owed to ABC by its customers), inventories of various prod- ucts, taxes that have been prepaid, and other prepaid expenses such as rent or insurance. Cash —is just what it sounds like. ABC shows $608 million for year end 2012 and $315 million for 2011. This account balance includes bills and coins as well as amounts in checking accounts that are unrestricted in their ability to be withdrawn. Cash is drawn to the business when investors buy shares from the business, when cash is collected from customers, and when the business borrows money or when it sells one of its assets. Cash is withdrawn from the busi- ness to pay debts of the business. These might include amounts payable for items purchased on credit, for salaries due, or for utilities. The business must also pay interest and principle on the money it borrows to run the business or to buy land, plant, or equipment. When the busi- ness is profitable, it may pay cash dividends to its stockholders rather than retain the cash in the business. 10 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet Short-Term Securities —represent temporary investments in stocks that are very marketable and that usually have very little price fluctuation. ABC shows $115 million for 2012, up from $96 million at year end of 2011. Again, these investments are to enable the business to earn a return on its cash rather than have it sit idle. Trade Receivables —are established when the business sells products or services on credit to its customers. It is customary for businesses to allow its customers up to 30 days to pay the amounts due. The busi- ness must pay its own bills regardless of the agreement it has with its customers. Cash flow becomes a problem when the business pays its creditors in a timely manner but its customers pay slowly or not at all. The amount booked to trade accounts receivable is usually equal to the sales price of the deal reached with the customer. At the end of each accounting period, the accountants will assess the likelihood that all the amounts will be collected as planned. To the extent they feel some amounts will not be paid, they will estimate and book an adjustment to the account for what they refer to as allowance for bad debts—also known as doubtful accounts. The 2012 Trade Receivables account for ABC is shown at the net amount of $2.06 billion after the accounts were reduced by the allowance for doubtful accounts that same year ($239 mil- lion). The net amount for the previous year was $1.96 billion. As sales volume increases, you might expect trade receivables as well as costs to increase proportionately. Red flag: Notice and flag inconsistencies between changes in revenues, receivables, and costs.7 Inventories —is the account used to collect costs of the various products ABC has purchased or manufac- tured for resale. It is normal for a business to show its inventories at their cost to the business, whether they bought or manufactured the goods. If the market value of the inventories has fall- en below their cost, the business will usually write the amounts down to reflect this loss even before the items are sold to customers. This involves showing a loss by reducing the asset value on the balance sheet. 7 Throughout this book, we will give tips to audit committee members. However, all directors, including members of other committees such as a finance committee, may find these tips useful. Getting Behind the Numbers — Fletcher/NACD 11 Section 2: The Balance Sheet Note that three categories of inventories are listed for ABC: for 2012 the finished products total $772 million in cost, work in progress totals $339 million, and raw materials total $384 million in costs. The cost of the raw materials is easy to track, but measuring the cost of work-in- process or finished manufactured products is much harder. The accountant must keep track of the labor, material, and overhead costs attributable to each product line. This often leads to con- troversy when the business has multiple or complex product lines. Obviously, ABC must use its cash to pay for items it purchases for resale as well as purchases of raw materials for further manufacture. It must also pay for labor used to manage inventory or to manufacture goods. All of the expenses of running the business to store or to make products must also be paid. It is to ABC’s good to minimize the inventory it carries if it is to minimize cost invested. Goods do not usually earn a profit while they sit on the shelf. Yet ABC must carry inventory in order to satis- fy customer demands for just-in-time deliveries. Thus, the age old battle: should ABC carry inven- tory that costs them money sitting on the shelf and that may become obsolete, or should it carry small amounts of inventory and risk not having the items when customers demand quick delivery? Red flag: Unexplained inventory growth or decline may suggest that the company is unable to accurately forecast customer demand. Total inventories — include, a sum total of the value of all inventories (finished products, work in process, and raw materials). For 2012, the inventories totaled $1.5 billion, an increase of $83 million from the previous year. Again, as with trade receivables, an increase in sales might be associated with a proportionate increase in inventories. Prepaid expenses, taxes, and other receivables —arise when the business pays its bills before it uses the services for which it is paying. Examples are rents paid in advance, advertising expenses, and insurance premiums paid in advance. Amounts owed to the business for other than trade transactions are usually reported as a separate item from trade receivables. ABC’s 2012 statements show $1.2 billion for this com- bined account total. Total Current Assets Current assets when totaled are $6.4 billion as of December 31, 2012. The company expected these to become cash within the 2013 business year as part of the normal business cycle of cash to inventory to receivables to cash. 12 Getting Behind the Numbers — Fletcher/NACD Section 2: The Balance Sheet Investment Securities This account includes amounts invested in securities of other businesses. Only those maturing after one year or planned to be sold after one year are included here.
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