The Balance Sheet

In This Chapter

Reading a balance sheet

Understanding assets, liabilities, and owners’ equity Using the balance sheet as an investment tool

T

he balance sheet is fundamental to all managers, business analysts, investors, and anyone else who looks at a company by the numbers. It’s the first topic covered by most books about financial analysis. This book isn’t designed to turn you into an accountant or financial analyst, only to make you familiar with basic concepts and how to use them to achieve investing objectives.

As Benjamin Graham and David Dodd put it in their master work, Security Analysis: “On numerous occasions . . . we have expressed our conviction that the balance sheet deserves more attention than Wall Street has been willing to accord it for many years.” That bit of wisdom, first espoused in 1934, sets the tone for this chapter.

A Question of Balance

As you probably guessed, there is a “balance” in the balance sheet. Something must equal something else, or it doesn’t balance. There must be an equation, the sum of one side of which equals the other.

Yes, a core financial equation (a simple one: no Greek letters, symbols, or exponents) forms the heart of the balance sheet, indeed the business enter- prise itself. We’ll begin by going through the equation and discussing the nature and form of the balance sheet itself.

Balance sheet components

The entire practice of business accounting is based on the relationship between business resources and their sources. A business resource is an asset, generally defined as any resource that can be put to use by the busi- ness to achieve business results: revenue, profit, brand recognition, and so on. These assets are acquired and paid for either by borrowing or by a contribution of funds from the business owners.

So a generalized equation shows this relationship:

Assets = Liabilities + Owners’ Equity Briefly:

Assetsare the resources available to the business to produce and market its product or service, including cash, investments, receivables owed by customers, inventory, buildings, land, equipment, and an assortment of

“intangible” assets necessary to carry on the business. Assets are what a business owns.

Liabilitiesrepresent the portion of assets financed by others or borrowed, including short- and long-term borrowings, amounts owed to suppliers and others. Liabilities are what a business owes.

Owners’ equityis the portion contributed by the business owners. There are many names for this: Shareholders’ or stockholders’ equity, net worth, owner’s capital,and book valueare among them. Included in owners’

equity are not only funds contributed directly from shareholders but also past profits retained in the business known as retained earnings.

It’s important to reinforce the idea that a balance sheet must balance. That is, for every asset dollar, there must be contributed dollars produced by bor- rowing (increased liabilities) or additional funding by the owners (owners’

equity) to match.

In this chapter, each component of this equation is examined in greater detail, with an eye for what’s important the value investor.

Taking time into account

A balance sheet is a listing of assets against the liabilities and equity that fund those assets, taken at a specific point, or snapshot, in time. For invest- ment and legal reporting purposes, these snapshots are generally taken at the end of each fiscal quarter and at fiscal year-end.

A balance sheet is necessarily a consolidation of a vast number of accounts maintained by the business. That’s a good thing. Investors don’t want to see the myriad separate accounts that companies set up for each type of physi- cal asset or inventory for each operating subsidiary in each country. Balance sheets generally fit on one page.

Making sense of the balance sheet

The balance sheet can be a powerful indicator of business health. It is a static indicator. That is, it doesn’t tell much about the future of the business and particularly about future income, but rather more about where the company has been and how well it did getting to where it is now.

On a balance sheet, value investors and business analysts look for the following:

The composition of assets, liabilities, and owners’ equity (lots of inven- tory and little cash can be a bad sign)

Trends (increasing debt, decreasing owner’s equity — also bad) Quality (do stated values reflect actual values?)

Each of these examinations is done with an eye toward what the figure probably should be for a company in that line of business. A company like Starbucks, with frequent small cash sales, shouldn’t have a large accounts receivable balance. A retailer should have sizeable inventories, but they shouldn’t be out of line for the industry or category. A semiconductor manu- facturer has a large capital equipment base, but should depreciate it aggres- sively to account for technology change.

To determine whether balance sheet numbers are in line, most analysts apply specifically defined ratiosto the numbers. Ratios serve to draw comparisons among companies and their industry. By doing so, they show whether perfor- mance is better or worse than industry peers. We look at the balance sheet itself in this chapter. Because many ratios involve items found outside the balance sheet, mostly on the income statement, the discussion of ratio analy- sis is deferred to Chapter 10.

A Swift Kick in the Asset

An assetis anything a company uses to conduct its business toward producing a profit. From an accounting standpoint, an asset must

Have value toward producing a return for the business.

Be in the company’s control. (A leased airplane is still an asset even if it’s not legally “owned” by the company.)

Be recordable and have value. (Employees don’t show up as a balance sheet asset, though they’re frequently referred to as assets by their CEOs.)

Using Simpson Manufacturing as an example, here’s a short walk through the asset portion of a balance sheet (see Figure 7-1).

Simpson reports, at the end of its fiscal year 2006 (ending December 31, 2006), a total of $735.3 million in assets.

As one may expect for a manufacturer, there are large asset commitments in inventory ($217.6 million) and in property and equipment ($197.2 million).

A closer look reveals something called “current assets,” totaling five individ- ual items at $479.3million. The way this figure is broken down into compo- nents on the balance sheet is typical.

Most companies classify assets as current or noncurrent. Current assets, as the name implies, are short term in nature, actively managed, and directly tied to a current level of business. Noncurrent assetsinclude longer-term

“fixed” assets and a catchall of other types of assets not always used in day-to-day operations.

Current assets

Current assetsare items generally held for a year or a business cycle. (If you’re building a space shuttle, the business cycle, or completion of a deliverable product, is longer than a year.)

Here’s a good way to think of current assets: They (especially cash assets) are the lifeblood of the business, while noncurrent assets are the body through which they circulate. The lifeblood flows to and from customers, to and from suppliers, and around to the different locations in the business operation to produce the greatest possible business and customer benefit. Current assets are managed by the business pretty much on a daily basis. See Figure 7-1.

Current assets normally include the following:

Cash and cash equivalents Accounts receivable Inventory

Deferred taxes and other temporary asset items

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