The Foundation
2.2 Balance Sheet
A balance sheet reports a firm’s assets, liabilities, and owners’ (stockholders’) equity as of a given date, usually at the end of a reporting period. A firm’s assets represent its investments (what it owns), and the liabilities (what it owes), while owners’ equity represents how the firm financed these investments (assets). One way to think of a balance sheet is as a financial snapshot of the firm’s assets, liabilities, and owners’ equity at a particular point in time.
Assets Liabilities
Current assets Current liabilities Long-term assets Long-term liabilities
Total assets Total liabilities Owners’ equity
Preferred stock Common stock
Total owners’ equity
Total liabilities + Total owners’ equity
Figure 2.1 General format of a balance sheet
Constructing a balance sheet involves the basic accounting identity:
Assets = Liabilities + Owners’ equity (2.1)
Following this identity, assets often appear on the left-hand side of the balance sheet, while the liabilities and owners’ equity appear on the right-hand side, as shown in Figure 2.1.
Sometimes balance sheets are portrayed using a top-down approach with assets at the top, followed by liabilities, and lastly by owners’ equity at the bottom. Balance sheets are fre- quently shown with major balance sheet categories using a left-hand side and right-hand side structure.
Figure 2.2 shows the balance sheets for Home Depot at the fiscal year-end dates of February 3, 2002, and February 2, 2003. In the following sections, we briefly discuss the major areas within a balance sheet using Home Depot’s balance sheet.
Let’s look at the asset side of Home Depot’s balance sheet. The assets are listed in order of decreasing liquidity beginning with the firm’s current assets. Home Depot’s current assets include its cash and cash equivalents, short-term investments, receivables, inven- tories, and other current assets such as prepaid expenses. Current assets are those assets in the form of cash or that are expected to be converted into cash within 1 year. Cash and cash equivalents include cash and other negotiable instruments such as checks and money orders that the bank does not have the legal right to demand notice before withdrawal. Short-term investments include short-term money market investments that have maturities of 1 year or less. The receivables represent those credit sales that the firm has not yet collected. They are reported on a net basis, which excludes credit sales that are overdue and unlikely to be ultimately collected. Inventories represent those items that remain unsold as of the balance sheet reporting date, but are likely to be sold within the next year. Other current assets such as prepaid expenses include payments made for benefits to be received within 1 year, such as payments for rent or insurance premiums.
Home Depot’s sizable level of total current assets of about $11,917 million on the Febru- ary 2, 2003 balance sheet date represent more than a third of its total assets. Maintaining a sufficient level of current assets is essential for a firm to ensure that it has enough cash and
22 THEFOUNDATION
The Home Depot, Inc. and Subsidiaries
Amounts in millions February 2, 2003 February 3, 2002
Assets Current assets
Cash and cash equivalents $2,188 $2,477
Short-term investments 65 69
Receivables, net 1,072 920
Merchandise inventories 8,338 6,725
Other current assets 254 170
Total current assets 11,917 10,361
Property, plant and equipment (PPE), net
Land 5,560 4,972
Buildings 9,197 7,698
Furniture, fixtures, and equipment 4,074 3,403
Leasehold improvements 872 750
Construction in progress 724 1,049
Capital leases 306 257
Gross PPE 20,733 18,129
Less accumulated depreciation and amortization 3,565 2,754
Net PPE 17,168 15,375
Long-term investments 107 83
Goodwill 575 419
Other assets 244 156
Total assets $30,011 $26,394
Liabilities and stockholders’ equity Current liabilities
Accounts payable 4,560 3,436
Accrued salaries and related expenses 809 717
Sales taxes payable 307 348
Deferred revenue 998 851
Income taxes payable 227 211
Other accrued expenses 1,134 938
Total current liabilities 8,035 6,501
Long-term debt, excluding current installments 1,321 1,250
Other long-term liabilities 491 372
Deferred income taxes 362 189
Total liabilities 10,209 8,312
Stockholders’ equity
Common stock, par value $0.05 118 117
Paid-in capital 5,858 5,412
Retained earnings 15,971 12,799
Accumulated other comprehensive loss (82) (220)
Unearned compensation (63) (26)
Treasury stock (2,000) –
Total stockholders’ equity 19,802 18,082
Total liabilities and stockholders’ equity $30,011 $26,394
Figure 2.2 Consolidated balance sheets
near-cash to meet its short-term obligations and a sufficient level of inventory to meet sales in the near term. We examine the management of a firm’s current assets in Chapter 6 when we discuss the working capital decisions of a firm.
The next section of Home Depot’s balance sheet contains its property, plant, and equip- ment (PPE). Home Depot provides substantial detail in this section with separate line items provided for its land, buildings, furniture, fixtures and equipment, leasehold improvements, construction in progress, and capital leases. Home Depot reports PPE on a net basis by subtracting the accumulated depreciation and amortization that has been taken as an expense on the income statement. However, firms generally cannot depreciate land as it represents an asset that retains its economic and productive value over time.
Long-term investments, goodwill, and other assets complete the asset side of Home Depot’s balance sheet. Long-term investments include securities, bonds, and investments that Home Depot expects to hold for longer than 1 year. Goodwill is the cost in excess of the fair value of the net assets acquired. Finally, other assets may include various items such as non-current receivables and intangible assets. Non-current receivables are those receivables Home Depot expects to remain outstanding for longer than 1 year. Intangible assets, which have no physical substance, include items such as patents, copyrights, and trademarks.
The liability section of the balance sheet consists of current liabilities and long-term liabilities. Current liabilities include a firm’s short-term maturing obligations. Home Depot’s current liabilities include its accounts payable, accrued salaries, sales tax payable, deferred revenue, income taxes payable, and other accrued expenses. Home Depot expects to pay these liabilities within 1 year.
The long-term liabilities for Home Depot include the firm’s long-term debt, other long-term liabilities, and deferred income taxes. The long-term debt includes only the debt due for longer than 1 year (current liabilities include the current portion of long-term debt). Deferred income taxes result when the pretax income shown on a firm’s tax return is less than what is reported as income before taxes on the income statement. The difference in taxes is caused by different depreciation methods for reporting purposes and for tax purposes.
Other common long-term liabilities (not shown explicitly on Home Depot’s balance sheet) include capital leases and minority interest. A lease must be classified as a capital lease if the lease transfers substantially all of the benefits and risks associated with ownership of the property to the lessee. If the lease meets any of the following four criteria, the firm must treat it as a capital lease: (1) the lessor transfers ownership of the property to the lessee by the end of the lease term; (2) the lease contains a bargain purchase option; (3) the lease term is equal to 75 percent of the estimated economic life of the leased property; or (4) the present value at the beginning of the lease term of the minimum lease payments equals or exceeds 90 percent of the fair market value of the property. A firm reports the present value of a capital lease as both an asset (included in plant and equipment) and as a long-term liability on its balance sheet.
Minority interest represents the proportionate stake that outside minority shareholders have in a firm’s consolidated subsidiaries. This claim arises because a firm owns less than 100 percent of some firms whose assets and liabilities have been completely consolidated
24 THEFOUNDATION
into the parent firm’s balance sheet and income statement. The minority interest is therefore listed as a credit on the parent firm’s balance sheet. Because the minority interest is not an immediate claim on any of the parent firm’s resources, it typically appears between the debt and equity sections of the balance sheet.
The stockholders’ equity section lists Home Depot’s common stock and paid-in capital accounts that combine to tell how much capital has been raised through the issuance of common stock. Home Depot’s retained earnings represent the firm’s cumulative net in- come that has been reinvested back into the firm and not distributed to shareholders as cash dividends. Treasury stock represents shares of common stock that Home Depot repurchased from shareholders. Total stockholders’ equity for Home Depot as of February 2, 2003 was
$19,802 million, which represents about two-thirds of the total financing.
Historical Cost versus Current Market Value
The values of most items reported on a firm’s balance sheet are reported in terms of their accounting book values, which are based on historical cost or original value. The historical cost of an asset is the price paid when the firm acquires the asset. The historical cost of a liability is the amount involved when the firm incurs the liability.
Financial managers and analysts recognize that these historical values may differ sub- stantially from their current market values. This is especially true for real estate and stock- holders’ equity. For example, Home Depot reports its net property, plant, and equipment as $17,168 million on the February 2, 2003 balance sheet date. This reported value may understate the true market value of these assets. In particular, the market value of the land owned by Home Depot may be much higher due to both inflation and supply and demand conditions. This understatement problem is avoided with the long-term invest- ments reported on the balance sheet. Long-term investments are reported at their fair market value.
The total value of stockholders’ equity reported on a firm’s balance sheet might also differ substantially from the current market value of the firm’s equity. The market value of a firm’s equity is equal to the number of shares of common stock outstanding times the price per share, while the amount reported on the firm’s balance sheet is basically the cumulative amount the firm raised when issuing common stock and any reinvested net income (retained earnings).
Practical Financial Tip 2.1
A firm’s balance sheet provides important information about a firm’s assets, liabilities, and owners’ equity. Analysts should remember that the values of most items reported on a firm’s balance sheet are reported in terms of their accounting book values, which are based on historical cost or original value, not market values. As a result, some asset values on a firm’s balance sheet, such as land, may be substantially undervalued following periods of high inflation. Analysts should also recognize that the share- holders’ equity on a firm’s balance sheet does not represent current market value.
Concept Check 2.2
1 What is the basic accounting identity followed in a firm’s balance sheet?
2 An analyst suggests that firms should use market value amounts on the balance sheet. What are some of the advantages and disadvantages of this approach?
3 Why may items based on historical cost differ from their market values?