sources, and debt offers another source of capital (though, of course, many lenders are willing to provide only part of the capital that a business needs).
Interest rates charged by lenders are lower than rates of return expected by owners. Owners expect a higher rate of return because they’re taking a greater risk with their money — the business is not required to pay them back the same way that it’s required to pay back a lender. For example, a business may pay 6 percent annual interest on its debt and be expected to earn a 12 percent annual rate of return on its owners’ equity. (See Chapter 13 for more on earning profit for owners.)
The disadvantages of debt are:
A business must pay the fixed rate of interest for the period even if it suffers a loss for the period or earns a lower rate of return on its assets.
A business must be ready to pay back the debt on the specified due date, which can cause some pressure on the business to come up with the money on time. (Of course, a business may be able to roll over or renew its debt, meaning that it replaces its old debt with an equivalent amount of new debt, but the lender has the right to demand that the old debt be paid and not rolled over.)
interest on time or doesn’t pay back the debt on the due date — it faces some major unpleasantness. In extreme cases, a lender can force it to shut down and liquidate its assets (that is, sell off everything it owns for cash) to pay off the debt and unpaid interest. Just as you can lose your home if you don’t pay your home mortgage, a business can be forced into involuntary bankruptcy if it doesn’t pay its debts. A lender may allow the business to try to work out its financial crisis through bankruptcy procedures, but
bankruptcy is a nasty affair that invariably causes many problems and can really cripple a business.
Recognizing the Hodgepodge of Values Reported in a Balance Sheet
In my experience, the values reported for assets in a balance sheet can be a source of confusion for business managers and investors, who tend to put all dollar amounts on the same value basis. In their minds, a dollar is a dollar, whether it’s in accounts receivable, inventory, property, plant and equipment, accounts payable, or retained earnings. But as a matter of fact, some dollars are much older than other dollars.
The dollar amounts reported in a balance sheet are the result of the
transactions recorded in the assets, liabilities, and owners’ equity accounts.
(Hmm, where have you heard this before?) Some transactions from years ago may still have life in the present balances of certain assets. For
example, the land owned by the business that is reported in its balance sheet goes back to the transaction for the purchase of the land, which could be 20 or 30 years ago. The balance in the land asset is standing in the same asset column, for example, as the balance in the accounts receivable asset, which likely is only 1 or 2 months old.
Book values are the amounts recorded in the accounting process and reported in financial statements. Do not assume that the book values reported in a balance sheet equal the current market values. Generally speaking, the amounts reported for cash, accounts receivable, and liabilities are equal to or are very close to their current market or settlement values.
For example, accounts receivable will be turned into cash for the amount recorded on the balance sheet, and liabilities will be paid off at the amounts reported in the balance sheet. It’s the book values of fixed assets, as well as
any other assets in which the business invested some time ago that are likely lower than their current replacement values.
Also, keep in mind that a business may have “unrecorded” assets. These off balance sheet assets include such things as a well-known reputation for quality products and excellent service, secret formulas (think Coca-Cola here), patents that are the result of its research and development over the years, and a better trained workforce than its competitors. These are intangible assets that the business did not purchase from outside sources, but rather accumulated over the years through its own efforts. These assets, though not reported in the balance sheet, should show up in better than average profit performance in its income statement.
The current replacement values of a company’s fixed assets may be quite a bit higher than the recorded costs of these assets, in particular for buildings, land, heavy machinery, and equipment. For example, the aircraft fleet of United Airlines, as reported in its balance sheet, is hundreds of millions of dollars less than the current cost it would have to pay to replace the planes. Complicating matters is the fact that many of its older planes are not being produced any more, and United would replace the older planes with newer models.
Businesses are not permitted to write up the book values of their assets to current market or replacement values. (Well, investments in marketable securities held for sale or available for sale have to be written up, or down, but this is an exception to the general rule.) Although recording current market values may have intuitive appeal, a market-to-market valuation model is not practical or appropriate for businesses that sell products and services. These businesses do not stand ready to sell their assets (other than inventory); they need their assets for operating the business into the future.
At the end of their useful lives, assets are sold for their disposable values (or traded in for new assets).
Don’t think that the market value of a business is simply equal to its
owners’ equity reported in its most recent balance sheet. Putting a value on a business depends on several factors in addition to the latest balance sheet of the business. My son, Tage, and I discuss business valuation in our book Small Business Financial Management Kit For Dummies (John Wiley &
Sons).