Foundations of Financial Management: An Analysis (part 5)

All money is a matter of belief.

Adam Smith

Review of Accounting (part B)

by

Charles Lamson

Balance Sheet

 The balance sheet indicates what the firm owns and how these assets are financed in the form of liabilities or ownership interest. While the income statement (see last post) purports to show the profitability of the firm, the balance sheet delineates the firm's holdings and obligations. Together, these statements are intended to answer two questions: How much did the firm make or lose, and what is a measure of its worth? A balance sheet for the Kramer Corporation is presented in Table 1.

Table 1

Note that the balance sheet is a picture of the firm at a point in time---in this case December 31st, 2019. It does not purport to represent the result of transactions for a specific month, quarter, or year, but rather is a cumulative chronicle of all transactions that have affected the corporation since its inception. In contrast, the income statement measures results only over a short, quantifiable period. Generally, balance sheet items are stated on an original cost basis rather than at current market value. 

Interpretation of the Balance Sheet

Asset accounts are listed in order of liquidity (convertibility to cash). The first category of current assets covers items that may be converted to cash within one year or within the normal operating cycle of the firm. A few items are worthy of mention. Marketable securities are temporary Investments of excess cash. The value shown in the account is the lower of cost or current market value. Accounts receivable include an allowance for bad debts (based on historical evidence) to determine their anticipated collection value. Inventory may be in the form of raw material, goods in process, or finished goods, while prepaid expenses represent future expense items that have already been paid, such as insurance premiums or rent.

Investments, unlike marketable securities, represent a longer-term commitment of funds for at least one year. They may also include stocks, bonds, or investments in other corporations. Frequently, the account will contain stock in companies that the firm is acquiring.

Plant and equipment is carried at original cost minus accumulated depreciation. Accumulated depreciation is not to be confused with the depreciation expense item indicated in the income statement (see last post). Accumulated depreciation is the sum of all past and present depreciation charges on currently owned assets, while depreciation expense is the current year's charge. If we subtract accumulated depreciation from the original value, the balance ($500,000) tells us how much of the original cost has not been expensed in the form of depreciation.

Total assets are financed through either liabilities or stockholders' equity. Liabilities represent financial obligations of the firm and move from current liabilities (due within one year) to longer-term obligations, such as bonds payable in 2030. 

Among the short-term obligations, accounts payable represents amounts owed on open account to suppliers, while notes payable are generally short-term signed obligations to the banker or other creditors. An accrued expense is generated when a service has been provided or an obligation incurred and payment has not yet taken place. The firm may owe workers additional wages for services provided or the government taxes on earned income.

In the balance sheet we see $1,000,000 in total assets of the Kramer Corporation was financed by $300,000 in debt and $700,000 in the form of stockholders' equity. Stockholders equity represents the total contribution and ownership interest of preferred and common stockholders. 

The preferred stock investment position is $50,000 based on 500 shares at $100 par. in the case of common stock, 100,000 shares have been issued at a total par value of $100,000, plus an extra $250,000 in capital paid in excess of par for a sum of $350,000. We can assume that the 100,000 shares were originally sold at $3.50 each as shown below.

Finally, there is $300,000 in retained earnings in Table 2. This value, previously determined in the statement of retained earnings (from last post), represents the firm's cumulative earnings since inception minus dividends and any other adjustments. 

Concept of Net Worth

Stockholders' equity minus the preferred stock component represents the net worth, or book value, of the firm. There is some logic to the approach. If you take everything that the firm owns and subtract the debt and preferred stock obligation, the remainder belongs to the common stockholder and represents net worth. In the case of the Kramer Corporation, using data from Table 1 we show:

The original cost per share was $3.50; the net worth, or book value, per share is $6.50; and the market value (based on assumed P/E ratio of 15 and earnings per share of $1) is $15. This last value is of primary concern to the financial manager, security analyst, and stockholders.

Limitations of the Balance Sheet

Lest we attribute too much significance to the balance sheet, we need to examine some of the underlying concepts supporting its construction. Most of the values on the balance sheet are stated on a historical or original cost basis. This may be particularly troublesome in the case of plant and equipment and inventory, which may now be worth two or three times the original cost or---from a negative viewpoint---may require many times the original cost for replacement. 

*SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED, PP. 28-30*

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