UNDERSTANDING FINANCIAL STATEMENTS
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THE BALANCE SHEET
The balance sheet is a snapshot of the firm. It is a financial statement showing a firm’s accounting value on a particular date. 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. The diagram below illustrate 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) is 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) is one example of a current liability.
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. 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 below, 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.
The balance sheet is a snapshot of the firm. It is a financial statement showing a firm’s accounting value on a particular date. 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. The diagram below illustrate 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) is 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) is one example of a current liability.
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. 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 below, 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.
The table below shows a simplified balance sheet 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.
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 is therefore 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.
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 a trademark, 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 (that is, 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 only entitled 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 just the value of the firm’s assets less the value of the firm’s liabilities:
Shareholders’ 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 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 simply 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, 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 since 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.
Managers and investors will frequently 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.
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 is therefore 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.
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 a trademark, 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 (that is, 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 only entitled 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 just the value of the firm’s assets less the value of the firm’s liabilities:
Shareholders’ 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 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 simply 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, 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 since 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.
Managers and investors will frequently 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.
Hereunder is a video of a simple example of a Balance Sheet, (Retrieved from Khan Academy)
THE INCOME STATEMENT
The income statement measures performance over some period of time, usually a quarter or a year. The income statement equation is:
Revenues - Expenses = Income
If you think of the balance sheet as a snapshot, then you can think of the income statement as a video recording covering the period between a before and an after picture. Hereunder is a table that gives a simplified income statement for U.S. Corporation. The first thing reported on an income statement would usually be revenue and expenses from the firm’s principal operations. Subsequent parts include, among other things, financing expenses such as interest paid. Taxes paid are reported separately. The last item is net income (the so-called bottom line). Net income is often expressed on a per-share basis and called earnings per share (EPS).
As indicated, U.S. paid cash dividends of $103. The difference between net income and cash dividends, $309, is the addition to retained earnings for the year. This amount is added to the cumulative retained earnings account on the balance sheet. If you look back at the two balance sheets for U.S. Corporation, you’ll see that retained earnings did go up by this amount, $1,320 + 309 = $1,629.
When looking at an income statement, the financial manager needs to keep three things in mind: GAAP, cash versus noncash items, and time and costs.
GAAP and the Income Statement
An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the recognition principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.
Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described above and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is recognized at the time of sale. The production and other costs associated with the sale of that product would likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some very different times. Thus, as a result of the way revenues and expenses are reported, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.
Noncash Items
A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. The most important of these is depreciation. Suppose a firm purchases a fixed asset for $5,000 and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year period. If the depreciation is straight-line and the asset is written down to zero over that period, then $5,000/5 = $1,000 would be deducted each year as an expense.2 The important thing to recognize is that this $1,000 deduction isn’t cash—it’s an accounting number.
The actual cash outflow occurred when the asset was purchased. The depreciation deduction is simply another application of the matching principle in accounting. The revenues associated with an asset would generally occur over some length of time. So the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.
As we will see, for the financial manager, the actual timing of cash inflows and outflows is critical in coming up with a reasonable estimate of market value, so we need to learn how to separate the cash flows from the noncash accounting entries. In reality, the difference between cash flow and accounting income can be pretty dramatic. For example, in the third quarter of 2004, Delphi Corporation, the automobile electronics supplier (and manufacturer of XM satellite radios), reported a loss of $114 million. Sounds bad, but Delphi also reported a positive cash flow of $360 million! In part, the difference was due to noncash accounting expenses related to a restructuring the company had undertaken.
Time and Costs
It is often useful to think of the future as having two distinct parts: the short run and the long run. These are not precise time periods. The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.
If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (property taxes, for example). Other costs such as wages to laborers and payments to suppliers are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.
The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide as to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.
Product costs include such things as raw materials, direct labor expense, and manufacturing overhead. These are reported on the income statement as costs of goods sold, but they include both fixed and variable costs. Similarly, period costs are incurred during a particular time period and might be reported as selling, general, and administrative expenses. Once again, some of these period costs may be fixed and others may be variable. The company president’s salary, for example, is a period cost and is probably fixed, at least in the short run.
Earnings Management
The way that firms are required by GAAP to report financial results is intended to be objective and precise. In reality, there is plenty of wiggle room, and, as a result, companies have significant discretion over their reported earnings. For example, corporations frequently like to show investors that they have steadily growing earnings. To do this, they might take steps to over- or understate earnings at various times to smooth out dips and surges. Doing so falls under the heading of earnings management.
Hereunder is a video about Financial Statement. (Retrieved from Khan Academy)
GAAP and the Income Statement
An income statement prepared using GAAP will show revenue when it accrues. This is not necessarily when the cash comes in. The general rule (the recognition principle) is to recognize revenue when the earnings process is virtually complete and the value of an exchange of goods or services is known or can be reliably determined. In practice, this principle usually means that revenue is recognized at the time of sale, which need not be the same as the time of collection.
Expenses shown on the income statement are based on the matching principle. The basic idea here is to first determine revenues as described above and then match those revenues with the costs associated with producing them. So, if we manufacture a product and then sell it on credit, the revenue is recognized at the time of sale. The production and other costs associated with the sale of that product would likewise be recognized at that time. Once again, the actual cash outflows may have occurred at some very different times. Thus, as a result of the way revenues and expenses are reported, the figures shown on the income statement may not be at all representative of the actual cash inflows and outflows that occurred during a particular period.
Noncash Items
A primary reason that accounting income differs from cash flow is that an income statement contains noncash items. The most important of these is depreciation. Suppose a firm purchases a fixed asset for $5,000 and pays in cash. Obviously, the firm has a $5,000 cash outflow at the time of purchase. However, instead of deducting the $5,000 as an expense, an accountant might depreciate the asset over a five-year period. If the depreciation is straight-line and the asset is written down to zero over that period, then $5,000/5 = $1,000 would be deducted each year as an expense.2 The important thing to recognize is that this $1,000 deduction isn’t cash—it’s an accounting number.
The actual cash outflow occurred when the asset was purchased. The depreciation deduction is simply another application of the matching principle in accounting. The revenues associated with an asset would generally occur over some length of time. So the accountant seeks to match the expense of purchasing the asset with the benefits produced from owning it.
As we will see, for the financial manager, the actual timing of cash inflows and outflows is critical in coming up with a reasonable estimate of market value, so we need to learn how to separate the cash flows from the noncash accounting entries. In reality, the difference between cash flow and accounting income can be pretty dramatic. For example, in the third quarter of 2004, Delphi Corporation, the automobile electronics supplier (and manufacturer of XM satellite radios), reported a loss of $114 million. Sounds bad, but Delphi also reported a positive cash flow of $360 million! In part, the difference was due to noncash accounting expenses related to a restructuring the company had undertaken.
Time and Costs
It is often useful to think of the future as having two distinct parts: the short run and the long run. These are not precise time periods. The distinction has to do with whether costs are fixed or variable. In the long run, all business costs are variable. Given sufficient time, assets can be sold, debts can be paid, and so on.
If our time horizon is relatively short, however, some costs are effectively fixed—they must be paid no matter what (property taxes, for example). Other costs such as wages to laborers and payments to suppliers are still variable. As a result, even in the short run, the firm can vary its output level by varying expenditures in these areas.
The distinction between fixed and variable costs is important, at times, to the financial manager, but the way costs are reported on the income statement is not a good guide as to which costs are which. The reason is that, in practice, accountants tend to classify costs as either product costs or period costs.
Product costs include such things as raw materials, direct labor expense, and manufacturing overhead. These are reported on the income statement as costs of goods sold, but they include both fixed and variable costs. Similarly, period costs are incurred during a particular time period and might be reported as selling, general, and administrative expenses. Once again, some of these period costs may be fixed and others may be variable. The company president’s salary, for example, is a period cost and is probably fixed, at least in the short run.
Earnings Management
The way that firms are required by GAAP to report financial results is intended to be objective and precise. In reality, there is plenty of wiggle room, and, as a result, companies have significant discretion over their reported earnings. For example, corporations frequently like to show investors that they have steadily growing earnings. To do this, they might take steps to over- or understate earnings at various times to smooth out dips and surges. Doing so falls under the heading of earnings management.
Hereunder is a video about Financial Statement. (Retrieved from Khan Academy)
Another video below shows the relationship between Balance Sheet and Financial Statement. (Retrieved from Khan Academy)