The Balance Sheet Lecture 2 This lecture is part of Chapter 1: The Basic Financial Statements

Today’s Lecture Understand the elements of the Balance Sheet Use MS Excel to make a simple Balance Sheet

Elements of a Balance Sheet A balance sheet, also called the statement of financial position, lists: Assets Liabilities Owners Equity as of a specific date. It gives an idea of what the company is worth. Let us now look at these terms in more detail. $ IN $ OUT ?

Elements of a Balance Sheet Assets Assets are all those things a company owns which are of value to the business. Assets can be tangible like e.g. a manufacturing plant, computers or cash in the bank. Tangible assets like cash or goods for sale that can easily (i.e. within an accounting year) be converted into cash are called current assets while other assets like properties and equipment are called fixed assets. Assets can also be intangible like e.g. copyrights. $ IN

Elements of a Balance Sheet Liabilities Liabilities are all those things for which the company eventually needs to pay. There are two types of liabilities: Current Liabilities need to be paid within one accounting year. Examples are: Outstanding rent, goods bought on credit. Long Term Liabilities are those liabilities which will not be paid during the current accounting year. Examples are: Long term debts, bank loans. $ OUT

Elements of a Balance Sheet Owner’s Equity Owner’s Equity is by definition the difference between the Assets of a company and its Liabilities. Owner’s Equity is the sum of two parts: Contributed Capital is the money that the owners invested in the company. Retained Earnings are those earnings which were not distributed to the owners. These can accumulate to a large sum over the years. ?

Elements of a Balance Sheet Let me stress again: A Balance Sheet must balance the assets, liabilities and owner’s equity. Assets – Liabilities = Owner’s Equity Most commonly, the assets are on top and the liabilities and owner’s equity on the bottom. Let’s now have a look at a balance sheet. $ IN$ OUT

A Simple Balance Sheet Let’s first clean this up a bit … and then look at it in more detail … Beam Me Up Scottie! Cheer Up!

A Simple Balance Sheet Let’s first clean this up a bit … and then look at it in more detail … Beam Me Up Scottie! Cheer Up! Is that what you call simple???? As often, the scientific method can come in handy here. To paraphrase: Divide and Conquer! Or: Look at things bit by bit, present them clearly and understand… (Still feel like drowning? I should have chosen a different background!)

A Simple Balance Sheet Use the Center and Merge Button Change the Font Make the totals bold Underline before the subtotals Make the main items italic

Some Notes Note how the top and bottom parts balance Presentation indeed makes a big difference. In a sense ‘design’ is an important ingredient of financial modeling. After all, what is the use of great information if no-one understands it? Now, let us look at the items in the balance sheet one by one.

Elements of a Balance Sheet Assets – Current Assets Cash and Cash Equivalents Cash is all the cash the company has, be it in bank accounts or in the cash box. Cash Equivalents are short term investments that can be converted to cash with no or very little delay. Examples of Cash Equivalents are: Money Market Investments, Government Bonds. Accounts Receivable Most businesses do not immediately receive payment for (some or all) of the goods or services they sell. Assuming that payment will indeed be made in the near future, a receivable account is an asset. $ IN

Elements of a Balance Sheet Assets:Total Current Assets In this case, of course, its just the sum of ‘Cash and Equivalents’ and ‘Accounts Receivable’, but there could be many more ‘current’ items. Total current assets is an important item since it indicates how much money the company has to run its business.

Elements of a Balance Sheet Assets: Fixed Assets Plant and Equipment In order to run a business one usually will need to buy some equip- ment (even when one is in the service business) like e.g. machines and computers. The total cost price of the bought equipment is listed in this item (note, the fact that equipment becomes worth less is accounted for in the next item). Accumulated Depreciation Naturally, when one uses equipment it will get old and thus become worth less. It is therefore necessary to subtract a certain amount from the original equipment value every year. Since one would like to keep the original value listed above, one needs to ‘accumulate’ i.e. sum up all the previous year’s depreciations.

Elements of a Balance Sheet Assets: Net Fixed Assets In this case the net fixed assets are ‘Plant and Equipment’ minus ‘Accumulated Depreciation’, but there could be many more items. Note that having a lot of fixed assets does not necessarily mean that the company is ‘rich’. It is also important to realize that fixed assets do not provide cash for running the business (though they could be use as collateral for a loan).

Elements of a Balance Sheet Assets: Total Assets Total Assets = Current Assets + Net Fixed Assets Note: While total assets in a sense represent the current value of the business, they do not necessarily represent the resale value or the liquidation value of the business. The total assets are the value of the business as seem from the perspective of a continuation of the currently operating business.

Elements of a Balance Sheet Liabilities: Current Liabilities Accounts Payable Just as there are accounts receivable, there are also accounts payable. Businesses usually do not need to pay immediately upon delivery but have e.g. 30 or 60 days ‘credit-terms’. In other words, ‘accounts payable’ are unpaid bills due soon. Other Current Liabilities All the liabilities which are due within one accounting year and which are not separately listed (in this case only accounts payable) are lumped together here. Examples are: unpaid salaries, interest, short term loans. $ OUT

Elements of a Balance Sheet Liabilities: Total Current Liabilities The total current liabilities are an important indicator of how much money a company will need in the near future. If the total current liabilities are much bigger than the total current assets great caution is warranted.

Elements of a Balance Sheet Liabilities: Long Term Liabilities Long Term Debt While in daily life having debts (especially credit card debts!) is usually not a good thing, the proper use of long term loans is an essential part of many business activities. It is for example very rare that a company has enough cash to build a new state of the art manufacturing plant. The idea is of course that you earn more than you pay in interest. (This is somewhat similar to buying a condo with a mortgage). Other Long Term Liabilities All other liabilities which do not need to be returned within one accounting year and which are not separately listed. E.g. Royalties, asbestos claims.

Elements of a Balance Sheet Liabilities: Total Liabilities Total Liabilities = Total Current + Long Term Liabilities Note: If the Total Liabilities exceed the Total Assets, the company is almost certainly in some sort of danger. But there are exceptions to this! (Especially companies in new hot industries like e.g. dot.coms or genetics).

Elements of a Balance Sheet Liabilities: Shareholder’s Equity Common Stock When a corporation is set up or when it needs money and desires to do so, it can issue common stock. The amount received is entered under this item. Note that the value printed on the stock certificate may be quite different from what one actually pays. Retained Earnings At the end of an accounting year, a company can have a profit or a loss. The profit or loss (in case of loss, naturally with a minus sign) is added to the retained earnings. The retained earnings sum up all the profits and losses since the inception of the company (minus paid out dividends).

Elements of a Balance Sheet Liabilities: Total Shareholder’s Equity This is the amount the company ‘owes’ its shareholders. Note that from an operational point of view, these debts have no impact on the daily running of the business since they do not need to be repaid.

Elements of a Balance Sheet Liabilities: Total Liabilities and Owner’s Equity As such this item is mainly a cross check for the accuracy of the balance sheet. It must be exactly the same number as the total assets or something is wrong!

A Simple Balance Sheet May be, it’s quite simple after all! Same It’s a Balance Sheet

A Simple Balance Sheet May be, it’s quite simple after all! Sum Equals

A Simple Balance Sheet May be, it’s quite simple after all! Sum Equals

A Simple Balance Sheet May be, it’s quite simple after all! Sum Equals

A Simple Balance Sheet Hey! This is like in Ally McBeal. Sum …. Equals We should start singing a song. Any good rappers around?

A Simple Balance Sheet Guess what: The liabilities side is the same. Sum Equals I think you’ll get the picture …

Key Points of the Day The Balance Sheet provides a snapshot of the assets and liabilities of a company. The Balance Sheet is one of the most important financial statements. Remember: Assets – Liabilities = Owner’s Equity And again: Assets – Liabilities = Owner’s Equity $ IN $ OUT