Balance sheet terms
Introduction
It sounds extraordinary but it’s a fact that balance sheets can make fascinating reading.
MARY ARCHER (1989)
Introduction
In order to understand and use business ratios we must be clear about what it is that is being measured. Definitions and terms used must be precise and robust. We will define four terms each from the balance sheet and the profit and loss account. These are critical values in the accounts that we come across all the time. In any discussion of company affairs, these terms turn up again and again, under many different guises and often with different names. The five-box balance sheet layout will assist us greatly in this section.
The terms used
The four terms used in the balance sheet are very simple but important:
- total assets
- capital employed
- net worth
- working capital.
Each of these terms will be defined and illustrated in turn, with a further one introduced in chapter 17 (invested capital).
Total assets (TA)
You will see from figure 3.1 that the definition is straightforward:
However, very often we use the term ‘total assets’ when we are really more interested in the right-hand side of the balance sheet where the definition more properly is:
We must be able to see in our mind’s eye the relationship that exists between this and other balance sheet definitions.
Note: Sometimes we come across the term ‘total tangible assets’ (the matter of intangibles is discussed further in appendix 1).
Figure 3.1 Defining total assets
Capital employed (CE)
This is the second important balance sheet term and it is one that is used very widely. Most books on finance give the definition of capital employed as being:
Fixed assets + investments + inventory + accounts receivable + cash, less accounts payable and short-term loans. |
To disentangle this definition, look at figure 3.2 and you will see that it means:
From figure 3.2, we can see that it also comprises the two upper right-hand boxes of the balance sheet, which gives the definition:
These definitions are identical.
In the first case, we start off at the top left-hand side, work down through fixed assets and current assets to the very bottom and then come back up through current liabilities to end up at the long-term loans line.
In the second case, we start at the top right-hand side and work our way down through owners’ funds and long-term loans.
Either way, we can see that the distinction between total assets and capital employed is that all the short-term liabilities in the current liabilities box are omitted from capital employed. Capital employed, therefore, includes only the long-term funds sections of the balance sheet.
Many analysts place great emphasis on capital employed. They say, with justification, that it represents the long-term foundation funds of the company. In looking at company performance they are concerned to ensure that profits are sufficient to keep this foundation intact. However, others will argue that in the current liabilities category we have, normally, bank borrowings that are, in theory, very short-term but are, in reality, permanent funds. They should therefore be included in the funding base when calculating rates of return. We will deal with this matter in chapter 17.
Net worth (NW)
This third term includes the top right-hand box only of the balance sheet. We have already looked at this box in some detail (see chapter 2), but it emerges here again with a new name – net worth. We know from the previous pages that the following values are included here:
Figure 3.2 Defining capital employed
Accordingly, the first definition of net worth is the sum of the above three items, amounting to $450 (see figure 3.3).
For the second definition we can use the same method that we used for capital employed. That is, we work our way down through the assets and back up through the liabilities to arrive at the same value:
This latter definition conveys more accurately the significance of the value in this box. It says to us that the value attributable to the owners in a company is determined by the value of all the assets less all external liabilities, both short and long. This is simple common sense. The shareholders’ stake in the company is simply the sum of the assets less loans outstanding to third parties.
The first way of looking at this box is by means of the accounting definition, where shares are issued and reserves are accumulated over time using various accounting rules and conventions. The second definition gives a more pragmatic approach: simply take all the values on the assets side of the balance sheet and deduct outstanding loans – anything left is shareholders’ money, no matter what name we give it. If recorded book values for assets are close to actual values, both approaches will give almost the same answer.
The amount of realism in the net worth figure, then, depends entirely on the validity of the asset values.
Working capital (WC)
This fourth and final balance sheet term is illustrated in figure 3.4. It is an important term that we will come back to again and again in our business ratios.
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This figure is a measure of liquidity. We can consider liquidity as an indicator of cash availability. It is clearly not the same thing as wealth: many people and companies who are very wealthy do not have a high degree of liquidity. This happens if the wealth is tied up in assets that are not easily converted into cash. For instance, large farm and plantation owners have lots of assets, but may have difficulty in meeting day-to-day cash demands – they have much wealth but they are not liquid. This can be true for companies also. It is not sufficient to have assets; it is necessary to ensure that there is sufficient liquidity to meet ongoing cash needs.
Figure 3.4 Defining working capital
 We have an alternative definition in figure 3.5, that looks at working capital from the right-hand side of the balance sheet. This definition gives perhaps a more significant insight. Here, we see that it can be calculated as: |
This definition is not often used in the literature but it is a very important way of looking at the structure of a company.
The amount of working capital available to a company is determined by the long-term funds that are not tied up in long-term assets. When a business is being set up, long-term funds are injected from the owners and other long sources. A considerable amount of these will be spent to acquire fixed long-term assets. However a sufficient amount must remain to take care of short-term day-to-day working capital requirements. Normally as time goes on this need grows with the development of the company. This need can be met only from additional long-term funds, e.g. retained earnings, or long loans, or from the disposal of fixed assets.
Figure 3.5 Alternative definition of working capital
