Chapter Four The Balance Sheet

The Balance Sheet Provides information about the financial position of a company at a specific point in time Also called the statement of financial position Follows the form of the accounting equation: Assets = Liabilities + Owners’ Equity (or Stockholders’ Equity) Copyright © Houghton Mifflin Company.All rights reserved

Balance Sheet Elements Stockholders’ equity: Residual interest in the assets of a firm that remains after deducting its liabilities (for a corporation) Assets: Probable future economic benefits obtained or controlled by a firm as a result of past transactions or events Liabilities: Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or perform services to other firms in the future as a result of past events Copyright © Houghton Mifflin Company.All rights reserved

Classification of Balance Sheet Elements Assets: Liabilities: Stockholders’ Equity: Current: Obligations that come due within the fiscal year Current: Cash Short-term investments Receivables Inventory Contributed capital accounts Retained earnings Other equity adjustment accounts Noncurrent: Investments Operating assets Intangible assets Other assets Noncurrent: Investments Operating assets Intangible assets Other assets Noncurrent: Obligations that come due outside the fiscal year Copyright © Houghton Mifflin Company.All rights reserved

Current Assets and Liabilities Cash and other assets that are reasonably expected to be realized in cash, sold, or consumed during the normal operating cycle or within one year of the balance sheet date, whichever is longer Current Liabilities: Economic obligations that are expected to be liquidated using current assets or refinanced by other current liabilities during the normal operating cycle or within one year of the balance sheet date, whichever is longer Copyright © Houghton Mifflin Company.All rights reserved

Types of Noncurrent Assets Operating assets (Property, plant, and equipment) – carried at acquisition cost less accumulated depreciation Capital leases—financial arrangement in which the lessee assumes most of the risk and rewards of ownership; lessee records the asset on the balance sheet Intangible assets—long-term assets with no physical substance but have value based on rights, privileges, or advantages belonging to the owner Copyright © Houghton Mifflin Company.All rights reserved

Types of Noncurrent Assets Long-term investments—investments and funds set aside for long-term use; not available to settle current liabilities. Normally carried at fair value Other assets—Might include deferred charges or assets not currently used in operations Copyright © Houghton Mifflin Company.All rights reserved

Types of Noncurrent Liabilities Might include bonds payable, mortgage payable, long-term notes payable, pension obligations, capital lease obligations, and long-term deferred taxes Obligations that will be paid over a period longer than one year Copyright © Houghton Mifflin Company.All rights reserved

Off-Balance-Sheet Financing Controversial practice in which a firm enters into transactions that obligate it to make future payments, but the payments are not recorded as actual liabilities at their present value on the balance sheet. Instead, the payments are expensed as they are paid. Critics contend that this treatment produces a balance sheet that does not adequately reflect the true financial position of the firm. Copyright © Houghton Mifflin Company.All rights reserved

International Standards and the Balance Sheet Variations on format of non-U.S. balance sheets: Separate current assets from noncurrent assets and current liabilities from noncurrent liabilities (most common format used in U.S.) Present assets and liabilities in order of liquidity (or reverse liquidity); no current/noncurrent categories Net asset presentation (assets minus liabilities) Long-term financing approach: Fixed Assets + Current Assets – Short-Term Payables = Long-Term Debt + Equity Copyright © Houghton Mifflin Company.All rights reserved

Stockholders’ Equity Contributed Capital Retained Earnings Capital Stock Additional Paid-In Capital Retained Earnings Accumulated earnings less dividends or distributions Accumulated Other Comprehensive Income Income from external events Copyright © Houghton Mifflin Company.All rights reserved

Statement of Changes in Stockholders’ Equity Summarizes the transactions that affected stockholders’ equity over the accounting period Components often include: common stock, paid-in capital, preferred stock, retained earnings, treasury stock Some firms also include comprehensive income Copyright © Houghton Mifflin Company.All rights reserved

Analyzing the Balance Sheet Ratio Analysis Benchmarking Percentage Analysis Horizontal Analysis Copyright © Houghton Mifflin Company.All rights reserved

Percentage Analysis Express each item on a financial statement in a given period as a proportion of a base figure For example, each item on a balance sheet could be divided by the total asset amount, thus expressing each item as a percentage of a whole Allows for comparisons over time for the same company Allows for comparisons with other companies Also called vertical analysis Copyright © Houghton Mifflin Company.All rights reserved

Horizontal Analysis Compare data on a financial statement for two or more time periods. Express change as a percentage of the first time period. Helps investors see trends over time; also called trend analysis Compute the difference between two accounts from one period to the next and divide the difference by the figure from the earlier period. Copyright © Houghton Mifflin Company.All rights reserved

Horizontal and Percentage Analysis: Home Depot Copyright © Houghton Mifflin Company.All rights reserved

Ratio Analysis Examines meaningful relationships between components of financial statements Liquidity ratios: Assess a firm’s ability to meet its financial obligations in the short term Leverage ratios: Provide data about the long-term solvency of a firm Activity ratios: Assess the efficiency with which a firm uses its assets Profitability ratios: Examine how successful a firm is in using its operating processes and resources to earn income Copyright © Houghton Mifflin Company.All rights reserved

Liquidity Ratios Current Ratio: Quick Ratio: Working Capital: The amount of current assets on hand that can be used to continue business operations Compares the amount of all current assets to the amount of current liabilities Compares only the most liquid of current assets to the amount of current liabilities Copyright © Houghton Mifflin Company.All rights reserved

Leverage Ratios Total liabilities to total assets: Total debt to total equity : Times interest earned: Shows what percentage of a firm’s total assets has been financed Measures a firm’s debt exposure Measures a firm’s ability to meet its interest payments as they come due Copyright © Houghton Mifflin Company.All rights reserved

Activity Ratios Accounts receivable turnover ratio: Inventory turnover ratio: Asset turnover ratio: Measures how quickly a firm collects its accounts receivable Measures the number of times inventory is sold during the year Measures how much in total assets a firm must have to generate its sales Copyright © Houghton Mifflin Company.All rights reserved

Profitability Ratios Operating margin percentage Indicates how much operating income is generated by each dollar of sales Profit margin on sales Indicates how much net income is earned on each dollar of sales Return on total assets Shows how well management is using its assets Return on stockholders’ equity Indicates how much income was earned on each dollar invested by a common stockholder Copyright © Houghton Mifflin Company.All rights reserved

Benchmarking Compares one company’s financial results with those of another company or with an industry average EdgarScan is one online benchmarking tool provided by PricewaterhouseCoopers Hoover’s Online is a subscription-based service that supplies competitive analysis, company profiles, in-depth financials, and more Copyright © Houghton Mifflin Company.All rights reserved

In most categories, Home Depot receives superior (1) rankings Benchmarking: Sample EdgarScan Benchmarking Report (Excerpt) Home Depot, Inc. (2003) Item Value Rank Cash 2,826,000,000 1 Inventory 9,076,000,000 1 Total Debt 1,365,000,000 1 Operating Income 6,846,000,000 1 Asset Turnover Ratio 2.16 3 Current Ratio 1.395 4 Net Income Growth .175 4 In most categories, Home Depot receives superior (1) rankings Copyright © Houghton Mifflin Company.All rights reserved

Limitations of the Balance Sheet Based on principles of historical cost, conservatism, and objectivity Does not reflect networking activities of a firm that may enhance its value Does not reflect unexecuted obligations that may give rise to future obligations Does not recognize intangible assets that may provide future benefits to a firm Does not reflect the risk exposures associated with interest-rate changes, foreign exchange rate changes, or economic or political conditions Copyright © Houghton Mifflin Company.All rights reserved

Check Your Understanding Explain the concept of off-balance-sheet financing. A firm enters into transactions that obligate it to make future payments, but those payments are not recorded as actual liabilities at their present value on the balance sheet. Instead the payments are expensed when paid. Copyright © Houghton Mifflin Company.All rights reserved

Check Your Understanding What type of accounts commonly make up total stockholders’ equity? Common Stock, Preferred Stock, Paid-in Capital, Retained Earnings, Treasury Stock. Sometimes Comprehensive Income is included. Copyright © Houghton Mifflin Company.All rights reserved

Check Your Understanding Explain how percentage analysis might be calculated for a company’s balance sheet. Express each amount on the balance sheet as a percentage of a base figure. For example, each line item could be divided by total assets (a base figure) and expressed as a percentage. Copyright © Houghton Mifflin Company.All rights reserved

Check Your Understanding What type of ratios might be used to assess a firm’s ability to meet its short-term financial obligations? Liquidity ratios (current ratio, quick ratio, working capital) Copyright © Houghton Mifflin Company.All rights reserved

Check Your Understanding Name several accounts that would be classified as noncurrent liabilities on the balance sheet. Bonds Payable, Mortgage Payable, Long-Term Notes Payable, Pension Obligations, Capital Lease Obligations, and Long-Term Deferred Taxes. Copyright © Houghton Mifflin Company.All rights reserved