Smartbook – chapter 2 – Financial information
2.1 The Balance Sheet
The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns
(its assets), what a firm owes (its liabilities), and the difference between the two (the firm’s equity) at a given point in
time. Figure 2.1 illustrates how the balance sheet is constructed. As shown, the left-hand side lists the assets of the firm,
and the right-hand side lists the liabilities and equity.
Assets: The Left-Hand Side
Assets are classified as either current or fixed. A fixed asset is one that has a relatively long life. Fixed assets can either
be tangible, such as a truck or a computer, or intangible, such as a trademark or patent. A current asset has a life of less
than one year. This means that the asset will normally convert to cash within 12 months. For example, inventory would
normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current
asset. Accounts receivable (money owed to the firm by its customers) are also a current asset.
Liabilities and Owners’ Equity: The Right-Hand Side
The firm’s liabilities are the first thing listed on the right-hand side of the balance sheet. These are classified as either
current or long term. Current liabilities, like current assets, have a life of less than one year (meaning they must be paid
within the year), and they are listed before long-term liabilities. Accounts payable (money the firm owes to its suppliers)
are one example of a current liability. Two excellent sites for company financial information are finance.yahoo.com and
money.cnn.com.
A debt that is not due in the coming year is classified as a long-term liability. A loan that the firm will pay off in five
years is one such long-term debt. Firms borrow over the long term from a variety of sources. We will tend to use the
terms bonds and bondholders generically to refer to long-term debt and long-term creditors, respectively. Disney has a
good investor site at thewaltdisneycompany.com.
Finally, by definition, the difference between the total value of the assets (current and fixed) and the total value of the
liabilities (current and long-term) is the shareholders’ equity, also called common equity or owners’ equity. This
feature of the balance sheet is intended to reflect the fact that, if the firm were to sell all of its assets and use the money
to pay off its debts, then whatever residual value remained would belong to the shareholders. So, the balance sheet
“balances” because the value of the left-hand side always equals the value of the right-hand side. That is, the value of the
firm’s assets is equal to the sum of its liabilities and shareholders’ equity:
Assets = Liabilities + Shareholders’ equity
This is the balance sheet identity, or equation, and it always holds because shareholders’ equity is defined as the
difference between assets and liabilities.
,Net Working Capital
As shown in Figure 2.1, the difference between a firm’s current assets and its current liabilities is called net working
capital. Net working capital is positive when current assets exceed current liabilities. Based on the definitions of current
assets and current liabilities, this means that the cash that will become available over the next 12 months exceeds the
cash that must be paid over that same period. For this reason, net working capital is usually positive in a healthy firm.
Table 2.1 shows simplified balance sheets for the fictitious U.S. Corporation. There are three particularly important things
to keep in mind when examining a balance sheet: liquidity, debt versus equity, and market value versus book value.
Example 2.1 Building the Balance Sheet
A firm has current assets of $100, net fixed assets of $500, short-term debt of $70, and long-term debt of $200.
What does the balance sheet look like? What is shareholders’ equity? What is net working capital?
In this case, total assets are $100 + 500 = $600 and total liabilities are $70 + 200 = $270 so shareholders’ equity is the
difference: $600 – 270 = $330. The balance sheet would thus look like:
Net working capital is the difference between current assets and current liabilities, or $100 – 70 = $30.
Liquidity
Liquidity refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a
custom manufacturing facility is not. Liquidity really has two dimensions: ease of conversion versus loss of value. Any
asset can be converted to cash quickly if we cut the price enough. A highly liquid asset, therefore, is one that can be
quickly sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a
substantial price reduction.Annual and quarterly financial statements (and lots more) for most public U.S. corporations
can be found in the EDGAR database at www.sec.gov.
Assets are normally listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are
listed first. Current assets are relatively liquid and include cash and those assets that we expect to convert to cash
, over the next 12 months. Accounts receivable, for example, represent amounts not yet collected from customers
on sales already made. Naturally, we hope these will convert to cash in the near future. Inventory is probably the least
liquid of the current assets, at least for many businesses.
Fixed assets are, for the most part, relatively illiquid. These consist of tangible things such as buildings and equipment
that don’t convert to cash at all in normal business activity (they are, of course, used in the business to generate cash).
Intangible assets, such as trademarks, have no physical existence but can be very valuable. Like tangible fixed assets,
they won’t ordinarily convert to cash and are generally considered illiquid.
Liquidity is valuable. The more liquid a business is, the less likely it is to experience financial distress (i.e., difficulty in
paying debts or buying needed assets). Unfortunately, liquid assets are generally less profitable to hold. For example,
cash holdings are the most liquid of all investments, but they sometimes earn no return at all—they just sit there. There
is, therefore, a trade-off between the advantages of liquidity and forgone potential profits.
Debt versus Equity
To the extent that a firm borrows money, it usually gives first claim to the firm’s cash flow to creditors. Equity holders
are entitled only to the residual value, the portion left after creditors are paid. The value of this residual portion is the
shareholders’ equity in the firm, which is the value of the firm’s assets less the value of the firm’s liabilities:
Shareholder’s equity = Assets – Liabilities
This is true in an accounting sense because shareholders’ equity is defined as this residual portion. More importantly, it
is true in an economic sense: If the firm sells its assets and pays its debts, whatever cash is left belongs to the
shareholders. The home page for the Financial Accounting Standards Board (FASB) is www.fasb.org.
The use of debt in a firm’s capital structure is called financial leverage. The more debt a firm has (as a percentage of
assets), the greater is its degree of financial leverage. As we discuss in later chapters, debt acts like a lever in the sense
that using it can greatly magnify both gains and losses. So, financial leverage increases the potential reward to
shareholders, but it also increases the potential for financial distress and business failure.
Market Value versus Book Value
The true value of any asset is its market value, which is the amount of cash we would get if we actually sold it. In
contrast, the values shown on the balance sheet for the firm’s assets are book values and generally are not what the
assets are actually worth. Under Generally Accepted Accounting Principles (GAAP), audited financial statements in
the United States generally show assets at historical cost. In other words, assets are “carried on the books” at what the
firm paid for them (minus accumulated depreciation), no matter how long ago they were purchased or how much they
are worth today.
For current assets, market value and book value might be somewhat similar because current assets are bought and
converted into cash over a relatively short span of time. In other circumstances, they might differ quite a bit. Moreover,
for fixed assets, it would be purely a coincidence if the actual market value of an asset (what the asset could be sold for)
were equal to its book value. For example, a railroad might own enormous tracts of land purchased a century or more
ago. What the railroad paid for that land could be hundreds or thousands of times less than what it is worth today. The
balance sheet would nonetheless show the historical cost. There are exceptions to this practice.
Managers and investors frequently will be interested in knowing the market value of the firm. This information is not on
the balance sheet. The fact that balance sheet assets are listed at cost means that there is no necessary connection
between the total assets shown and the market value of the firm. Indeed, many of the most valuable assets that a firm
might have—good management, a good reputation, talented employees—don’t appear on the balance sheet at all. To
give one example, one of the most valuable assets for many well-known companies is their brand name. According to
one source, the names “Coca-Cola,” “Microsoft,” and “IBM” are all worth in excess of $50 billion.
Similarly, the owners’ equity figure on the balance sheet and the true market value of the equity need not be related. For
financial managers, then, the accounting value of the equity is not an especially important concern; it is the market value
that matters. Henceforth, whenever we speak of the value of an asset or the value of the firm, we will normally mean its
market value. So, for example, when we say the goal of the financial manager is to increase the value of the stock, we
mean the market value of the stock.
