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The Balance Sheet (Part II)
The steps to full liquidity for inventory exceeds by one the steps to full liquidity for accounts receivable. In the case of accounts receivable, the cash have to be collected from the customer to end the liquidity process. In the case of inventory, the items have to be sold (inventory now reflected as accounts receivable – assuming credit sale), after which the cash is collected from the customers.Cash, Accounts Receivable and Inventory are the three main current assets on the typical balance sheet, however from time to time other items such as Prepaid expenses, Notes Receivable and Deferred Income Tax may be included.
After completing the list of current assets, the next grouping is Fixed Assets. Fixed assets are assets that are not easily converted to cash and items bought by the company, but not for resale. The assets are usually major investment for the company, with useful life exceeding 12 months.
Typical fixed assets are:
- Land
- Plant & Equipment
- Leasehold Improvement
Because fixed assets generally last for a long time, their contribution to the company is not all charged against profit at the time the item is purchased. Instead, an amount is charged against profit each year based on the pre-determined life of the asset. Based on the life of the asset and its salvage value, the asset is depreciated on a yearly basis, with the depreciation charged against profit. The value of the asset is shown on the balance sheet net of accumulated depreciation.
Given the cost involved in replacing fixed assets, and their importance for the operational success of the business, proper maintenance of fixed assets is always high on a company's list of priorities.
Finally, proper record keeping of fixed assets is very important to a company. This is so because without the appropriate record, the company may be unable to carry out maintenance when needed and assess the asset's benefit and value.
Liabilities represents a company's obligations and is divided between current and long-term on a typical balance sheet. Current liabilities are the company's debts that are due for payment in twelve months or less, while long-term liabilities are debt due some time after 12 months.
As with current assets which, are listed from most liquid to least liquid, current liabilities are listed on the balance sheet from most current to least current. On the typical balance sheet, current liabilities will start with Accounts Payable.
Accounts Payable represents trade purchases made on credit and are usually due for payment within 12 months. Given the time value of money (always better to pay tomorrow than today), companies will strive to extend accounts payable as much as possible.
Next on the list of current liabilities is Accrued Expenses. These are costs (usually, but not necessarily trade costs) incurred by the company but for which it is not yet invoiced. An accrued expense (an accrual) is therefore an estimate of the actual cost of the service bought. These charges are usually paid within a short time or may be transferred to accounts payable.
The Current Portion of Long-term Liabilities (CPLL) will probably be the third item on the list of current liabilities. This represents portions of long-term debt due within the next twelve months. Debt of this nature is usually non-trade and is usually contractual in nature. The company will therefore not have the same kind of payment flexibility when dealing with CPLL as it does when dealing with accounts payable or accrued expenses.
Along with CPLL, the current liabilities may also include Notes Payable. These are debts held by the company maturing between one to ten years. Of course, for the Notes Payable to be classified as a current liability it has to be due for payment within the next twelve months, and its that portion of the Note that is shown as current liabilities.
Other current liabilities include Deferred Income Tax, Customer Deposits etc. As is the case with current assets, it is important to the operational efficiency of the company that current liabilities are properly managed. Failure to meet current liabilities when due may result in fundamental problems for the company; including inventory shortage (as suppliers refuse to ship) and bankruptcy (as major creditors demand payment).
Long-term liabilities are debt payable by the company and due for payment sometime after the next 12 months. This includes Notes Payable, Outstanding Bonds (debt maturing in greater than ten years) and other long-term debts. Other long-term debts may include items such as Deferred Income Taxes, Employee benefit obligations etc.
The balance sheet is completed with a section on Shareholders' Equity. This section contains the equity supplied by the owners (including Preferred Stock) of the company and the Earnings of the company not paid-out as dividends (retained earnings). There are a few different nomenclatures that are used to describe this section, namely Net Worth, Net Book Value, Equity, and Capital.
Additional Paid-In Capital is the premium paid by common stockholders when the stocks were initially sold. This is carried on the balance sheet as part of the company's net worth.
The next item in this category will probably be Retained Earnings. This is the accumulated earning (net of dividends) of the company from the first day of operation. Retained earnings essentially represent a source of capital for the company and should not be viewed as cash, because it isn't. As the company maintains its profitability, retained earnings will increase, adding to the company's net worth and increasing the value of the owners' investment.
Along with the above, this section of the balance sheet may also include Preferred Stock - (See right column for more info on Preferred Stock.) -, Treasury Stock - (See right column for more info on Treasury Stock.) -, and Accumulated Other Comprehensive Loss and a few other items.
That's it for our look at the content of the balance sheet. As you know, a completed balance sheet implies that total assets is equaled to total liabilities plus shareholders' equity (T = L + E). This equation is easy to understand given the double entry system of accounting. The Double Entry System of Accounting.
A very simple example of why the balance sheet will always balance is explained below:
- A company starts with shareholders purchasing $20,000 of stock and creditors offering $5,000 in loan. The inflow of resource is therefore ($20,000 + $5,000) $25,000
- The company use $12,000 to purchase Equipment and $8,000 to purchase Inventory. The outflow of resource is therefore ($12,000 + $8,000) $20,000 and the present cash level at ($25,000 - $20,000) $5,000.
| Assets | |
| Cash | $5,000 |
| Inventory | $8,000 |
| Equipment | $12,000 |
| Total Assets | $25,000 |
| Liabilities & Equity | |
| Owed to Creditors | $5,000 |
| Common Stock | $20,000 |
| Total Liab./Equity | $25,000 |
Balance Sheet "Stocks"
Unlike Debt holders, Stockholders are not guaranteed any returns and are the last to be considered in the event of complete company failure.
Common Stockholders maintains four basic rights:
- Voting Rights: Votes on membership of the board of directors and major corporate policies.
- Pre-emptive Rights: This provides the stockholders with the right to subscribe to any new issue of shares that might reduce their ownership in the company.
- Earnings Distribution Rights: The right to dividends when paid.
- Residual Asset Distribution Rights: The right to the assets remaining after liquidation and the payment of all other claims.
Like creditors, preferred stockholders are not given the rights (see above) of the common stockholders and like creditors, preferred stockholders are aware of the rate of dividend payment (interest payment for the creditor). Instead, preferred stockholders are guaranteed dividends, and first claim on the company's assets at liquidation. The fundamental difference between a preferred stock and a debt is that the debt will be repaid, but the amount paid for the preferred stock will not be.
Preferred Stock comes in many forms, however "Cumulative" preferred stock are the most popular and will probability be on the next balance sheet you review. The cumulative feature provides the stockholder with dividend guarantee in future years if the company is unable to pay the dividend this year.
Preferred stock may also be convertible; that is the stock may be converted to common stock based on the stock agreement and a pre-determined conversion ratio. The balance sheet may show the preferred stock as follows:
10% cumulative convertible preferred stock $20,000
This indicates that dividends will be paid at a 10% rate and will be cumulative. It also shows that the preferred stock agreement calls for convertibility. Treasury Stock: Treasury stock is negative equity, which would make it an asset, right? Nope! A company cannot invest in itself by repurchasing its stock. Treasury stock arises when a company repurchases its own stock, and is reflected on the balance as negative equity.
The company can do a number of things with these stocks. It may reissue them, retire them or just hold onto them indefinitely.
Treasury stocks are not included in outstanding shares and hold none of the typical rights accompanying common stock.
The anti-dilution effect of treasury stock means that remaining shareholders will have even a bigger share of the company.