ENGG 401 X2 Fundamentals of Engineering Management Spring 2008 Chapter 4: The Balance Sheet Dave Ludwick Dept. of Mechanical Engineering University of Alberta

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Balance Sheets balance sheet point in timeA balance sheet is a snapshot of a business’s financial position at a point in time (usually the last day of the accounting period). Statement ofFinancial Position –Also called a Statement of Financial Position The balance sheet balances a business’s assets against its liabilities, and owner’s equity: Assets = Liabilities + Equity current assetsfixed assetsAssets include current assets and fixed assets. current liabilitieslong-term liabilitiesLiabilities include current liabilities and long-term liabilities. sharesretained earningsOwner’s equity includes shares and retained earnings.

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Balance Sheets (2) Assets: –If the asset is useful (helps to earn revenue), it is recorded at book value (the lesser of original cost minus depreciation or market value). neverIf market value is higher, it is never recognized in advance of being realized. –If it is useless or worn out, it is written off. depreciation and writedowns –Accounting is always conservative. In times of high inflation, book values deviate from real values intangible –Some long-term assets are intangible. Something that can’t be seen or touched but has value to a company

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management A sample Balance Sheet Balance Sheet Current Assets Cash10000 Current Liabilities Accounts Payable5000 Accounts Receivable20000 Wages Payable25000 Notes Receivable15000 Utilities Payable2000 Marketable Securities25000Long-Term Debt Inventory Notes Payable20000 Capital Assets Bonds Payable Equipment250000Owner’s Equity Buildings Common Stock Goodwill60000 Retained Earnings48000 Total Assets Total Liabilities + OE

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Sample Balance Sheet #1 Source:

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Sample Balance Sheet #1 (2) Source:

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Sample Balance Sheet #2 Source:

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Balance Sheets: General Observations All finance statements are created at the end of or after the accounting period –Typically this is once per year but can be monthly, quarterly, semi- annually List assets in ascending order of liquidity. –Cash at top, then receivables, and so on. Prepaid expenses are bills paid annually but tracked monthly or quarterly (ex: rent, insurance). Fixed assets usually list the purchase value as well as an accumulated depreciation as a reduction. –This gives the ability to have a sense of the “age” of the assets. Capital shares (cash injection) are distinguished from retained earnings (cash retention).

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Goodwill and Intangibles GoodwillGoodwill is the premium you paid to purchase a company. –Equivalent to the purchase price minus the book value of the business. –Goodwill can be depreciated, just like any other asset. –But you can’t just say you have Goodwill. The only time Goodwill is created is when one company buys another for more than its net assets (Net Assets = Total Assets – Total Liabilities) Intangible assets can be depreciated as well. –e.g., patents have a finite lifetime

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Credit Issues Receivables occur when you sell your product or service on credit -> effectively the company provides a short-term loan –Customers agree to pay you within a defined period of time (30 Days) Liabilities represent value that you have, in effect, borrowed from others. –Just like you can sell on credit to your customers, so too can you buy on credit from your suppliers Creditworthiness is a key issue throughout: –You check the credit rating of your customers. –Your suppliers check your credit rating. –Your short term lender focuses on the quality of your current assets. –Your long term lender usually has the right to take over assets that “securitize” the loan. –Certain government charges transfer to board members.

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Working Capital Working capitalWorking capital is the difference between current assets and current liabilities. –The extra cost of being in business over and above fixed assets. –A good measure of a company's efficiency and its financial health. Working capital ratioWorking capital ratio is current assets divided by current liabilities. Adequacy of working capital is one key test for the provision of a short term credit line by a bank. –A positive working capital means you can pay off your short-term liabilities. –A negative working capital means you can’t meet your short-term liabilities with your current assets.

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Working Capital (2) Working capital generally increases with sales level. –Typically, inventory, payables and receivables are proportional to sales. –Failure to recognize this has sunk many a business. Inventory and receivables are often measured in terms of days. –As a ratio of daily sales –Often in the 30 to 60 days range More businesses fail for a lack of available cash than for a lack of profit. –Businesses need to make sure they collect on their receivables –Businesses need to ensure they turnover (sell) their inventory

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Example: Working Capital Deficiency Imagine a start-up “magic box” business with the following characteristics: –Your “rich uncle” gave you $500k to see what you could do. –You and some friends spent two years and $400k doing the software. –Your losses to date from two years of prototyping are $95k. –Your sales strategy is a CM of 50%. –Material is 90% of COGS, contract labour is 10%. –You are selling $25k/mo of boxes to larger companies, who are testing the product. You are at break even. –One company gives you an order for $1,000,000!! Can you survive the order?

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Example: Working Capital Deficiency (2) The sequence: –You order the material at time zero, terms net 30. –You receive the material a month later. –You pay for the material on time. –You hire the labour force in month two to finish the product. –You ship the product at the start of month three, terms net 30. You book the earnings at this time. –Your large customer takes 60 days to pay, due to testing of the first large shipment. Follow the balance sheet and “think like a banker”.

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Example: Goodco versus Badco Goodco and Badco have the same income statement for a one year period:

Dave Ludwick, Dept. of Mech. Eng. The Balance Sheet Summer ENGG 401 X2 – Fundamentals of Engineering Management Example: Goodco versus Badco (2) Goodco and Badco have very different balance sheets this year.