balance sheet - bfa.docx

Balance Sheet In this module, we're going to talk about the balance sheet. The balance sheet tracks to the cash cycle, both the investment part of the cycle and the financing part of the cycle. Where did the money come from in financing? Where did the money go in investing? So that's where the asset...

Balance Sheet In this module, we're going to talk about the balance sheet. The balance sheet tracks to the cash cycle, both the investment part of the cycle and the financing part of the cycle. Where did the money come from in financing? Where did the money go in investing? So that's where the assets come in. Assets represent what we spent the money on. Liabilities and equity is who we owe. So a balance sheet measures investment, and it also tracks the financing. What's different about a balance sheet rather than an income statement is where an income statement looks at a period of time, a month, a quarter, a year balance sheet is a snapshot at a point in time. It's today. How much cumulatively have we invested as of today? What do we own as of today? So a balance sheet is as a particular day. And so, the best way to think about a balance sheet is if you ever purchase a home. If you buy the house, the house is the asset. If you finance the house with a bank, a mortgage, that's the liability, and your down payment is the equity. So the mortgage plus the down payment is what you spend in the house. If you bought a $600,000 house, you would need $600,000 worth of financing. If you bought a $200,000 house, you would need $200,000 worth of financing. So in the balance sheet, we would actually match the two together – the assets and the financing. How much you spend in the house would be the asset. How much you owe the bank and how much you put in and owe yourself essentially would be the liabilities and the equity. And what's key is that investment equals financing. Whatever I spent, the money had to come from somewhere, so the balance sheet essentially matches it up, and it involves the concept of what's called double-entry accounting. This was a process created by Luca Pacioli back in 1494. So here's the key. When accountants put the balance sheet into play, they're tracking all these expenses. They actually tracked them at what's called book value or historical cost, meaning what you originally spent as opposed to what it's worth today. And the main reason they do that is it's too difficult to figure out the market value on a daily basis of assets, so the accountants don't. They actually just track what was originally spent. So oftentimes, people will tell you a balance sheet tells you what you're worth. It really doesn't. It tells you what you've historically spent and what you've historically spent may be worth more or less today. So that's one of the challenges with a balance sheet. It doesn't really give us a sense of value, but it does track our spending, and that's why it's a useful statement because it tells us what we spent, and it tells us where the money came from and who we owe money to based on what was originally spent. Balance sheets are a list of tangible assets, things that you can touch and feel, things that you've assigned a value to by buying them – or more simply things that can be converted into cash. What a balance sheet doesn't list is intangible assets, the value of a brand, the value of the patents, the values of the employee know-how that's not on a balance sheet. This is often know as intellectual property. So for example, if you take a company like Coca-Cola or Google Alphabet or Apple, these are companies that have tremendous brands, but if you were to look on their balance sheet, you won't see the value of the brands because it's too hard to measure. Now, you might see it in the value of the company in terms of their share price, but you won't see it on the balance sheet. So the balance sheet is going to look at things based on what they actually spent on the tangible assets, things that you can touch and feel, like inventory or buildings, land, equipment, et cetera. So when you have an intangible with a brand of a company like Apple or Coca-Cola, you're not going to see that on the balance sheet because it's intangible, with one exception. If I buy somebody else's intangible asset, I've assigned a value to that asset, and then I can put it on my balance sheet. That is something you'll see called goodwill. So if you ever see goodwill listed on a balance sheet, what it represents is a purchased intangible where you bought the intangible of somebody else. So if we build up the intellectual property value, intangible value ourselves, too hard to measure, doesn't show up on a balance sheet. Let's look at each of the sides of the balance sheet in detail. We will start with the assets. Assets are listed in order of liquidity on a balance sheet, which means the things that are closest to cash are listed first. The things that'll take longer to convert into cash are listed last. So one of the categories of assets are called current assets or short-term assets. The rule of thumb is anything that can be converted into cash in less than a year is a short-term or a current asset. Anything that takes longer than a year is what's known as a long-term or a fixed asset. Examples of current assets could include cash, accounts receivable or money owed from customers, and inventory. Examples of long term assets could include property plant and equipment often known as PP&E and something called goodwill which represent any purchased intangibles. Liabilities and equity are also listed in the order of which they are to be paid. The things with the highest payment priority are listed first. The things with the lowest priority are listed last. So again, you may not know what the item is, but just look at where it is compared to the other items. The things that are near the top are going to have the higher priority. In this case, anything that must be paid within a year is called a current liability or short-term liability. Anything that's due after a year is called a longer term liability. Examples of current liabilities can include accounts payable which is money owed to vendors, wages and salaries payable, accrued liabilities, income taxes due within 1 year, dividends payable, and short term interest bearing debt from a line of credit or other interest bearing debt which is due to the lender within one year. Examples of longer term liabilities can include long term interest bearing debt, capital leases, post retirement benefits, long term deferred taxes, long term customer deposits and contractual obligations and unfunded pension liabilities. And finally, there is equity. Accounting equity is what's left after everybody else has been paid. And so, in a way, equity is what's known as a plug. So as liabilities go up and the assets don't change, equity goes down. If liabilities go down and the assets don't change, equity goes up. So equity is what ultimately forces the balance sheet to balance, and what belongs to the owner's after all liabilities have been paid. In the equity accounts you will typically see up to three categories. You may see minority interest, preferred equity and common equity. Minority interest represents the owners interest of other shareholders and assets for businesses that you have consolidated but do not own 100% of. Preferred equity has a higher priority payment right than a common shareholder. Common shareholders are the last to get paid but also have their voting rights in the firm which include the ability to elect the board of directors. Under common equity you will see two further subaccounts. One is called common stock at par value And additional paving capital which represents the amount of money that shareholders originally gave to the firm when the company sold the shares to them directly. You will also see an account called retained earnings which represents any profits or income that the firm has made overtime that it is not paid out in dividends. The final account you might see under equity it's called treasury stock. When a company repurchases shares of stock from investors it pays market prices and the total value of the stock repurchased is listed as a negative amount or what's called a Contra account as treasury stock. This would be a reduction to the overall equity balance of the firm.