Introduction

• The balance sheet
• Balance sheet structure – fixed assets
• Balance sheet structure – liabilities
• Summary

Business is really a profession often requiring for its practice quite as much knowledge, and quite as much skill, as law and medicine; and requiring also the possession of money.

WALTER BAGEHOT (1826–1877)

Introduction

To have a coherent view of how a business performs, it is necessary, first, to have an understanding of its component parts. This job is not as formidable as it appears at first sight, because:

• much of the subject is already known to managers, who will have come in contact with many aspects of it in their work;
• while there are, in all, hundreds of components, there are a relatively small number of vital ones;
• even though the subject is complicated, it is based on common sense and can, therefore, be reasoned out once the ground rules have been established.

This last factor is often obscured by the language used. A lot of jargon is spoken and, while jargon has the advantage of providing a useful shorthand way of expressing ideas, it also has the effect of building an almost impenetrable wall around the subject that excludes or puts off the non-specialist. I will leave it to the reader to decide for which purpose financial jargon is usually used, but one of the main aims here will be to show the common sense and logic that underlies all the apparent complexity.

Fundamental to this level of understanding is the recognition that, in finance, there are three – and only three – documents from which we obtain the raw data for our analysis. These are:

• the balance sheet
• the profit and loss account
• the cash flow statement.

A description of each of these, together with their underlying logic, follows.

The balance sheet (B/S)

The balance sheet can be looked on as an engine with a certain mass/weight that generates power output in the form of profit. You will probably remember from school the power/weight concept. It is a useful analogy here that demonstrates how a balance sheet of a given mass of assets must produce a minimum level of profit to be efficient.

The profit and loss (P/L) account

The profit and loss account measures the gains or losses from both normal and abnormal operations over a period of time. It measures total income and deducts total cost. Both income and cost are calculated according to strict accounting rules. The majority of these rules are obvious and indisputable, but a small number are less so. Even though founded on solid theory, they can sometimes, in practice, produce results that appear ridiculous. While these accounting rules have always been subject to review, recent events have precipitated a much closer examination of them. Major changes are under way in the definition of such items as cash flow, subsidiary companies and so on.

The cash flow (C/F) statement

The statement of cash flow is a very powerful document. Cash flows into the company when cheques are received and it flows out when cheques are issued, but an understanding of the factors that cause these flows is fundamental.

Summary

These three statements are not independent of each other, but are linked in the system, as shown in figure 2.1. Together they give a full picture of the financial affairs of a business. We will look at each of these in greater detail.

The balance sheet

The balance sheet is the basic document of account. Traditionally it was always laid out as shown in figure 2.2, i.e., it consisted of two columns that were headed, respectively, ‘Liabilities’ and ‘Assets’. (Note that the word ‘Funds’ was often used together with or in place of ‘Liabilities’.)

The style now used is a single-column layout (see figure 5.3). This new layout has some advantages, but it does not help the newcomer to understand the logic or structure of the document. For this reason, the two-column layout is mainly used in this publication.

Assets and liabilities

The ‘Assets’ column contains, simply, a list of items of value owned by the business.

The ‘Liabilities’ column lists amounts due to parties external to the company, including the owners.

Figure 2.1 Three basic financial statements

Figure 2.2 The balance sheet – traditional layout

Assets are mainly shown in the accounts at their cost (or unexpired cost). Therefore the ‘Assets’ column is a list of items of value at their present cost to the company. It can be looked on as a list of items of continuing value on which money has been used or spent.

The ‘Liabilities’ column simply lists the various sources of this same sum of money.

The amounts in these columns of course add up to the same total, because the company must identify exactly where funds were obtained from to acquire the assets.

All cash brought into the business is a source of funds, while all cash paid out is a use of funds. A balance sheet can, therefore, be looked on from this angle – as a statement of sources and uses of funds (see figure 2.3). You will find it very helpful to bear this view of the balance sheet in mind as the theme is further developed (see chapter 11 for hidden items that qualify this statement to some extent).

Balance sheet structure

Figure 2.4 shows the balance sheet divided into five major blocks or boxes. These five subsections can accommodate practically all the items that make up the total document. Two of these blocks are on the assets side and three go to make up the liabilities side. We will continually come back to this five-box structure, so it is worthwhile becoming comfortable with it, as we go through each box in turn.

Let us look first at the two asset blocks. These are respectively called:

• fixed assets (FA)
• current assets (CA).

These can also be considered as ‘long’ and ‘short’ types of assets. We will see that while this distinction is important in the case of assets, it is even more significant in the case of funds.

Current assets (CA)

This box in the south-west corner contains all the short-term assets in the company. By short-term we mean that they will normally convert back into cash quickly, i.e., in a period of less than 12 months.

The various items that find their home in this box can be gathered together under four headings:

• inventories (stocks)
• accounts receivable (trade debtors)
• cash
• miscellaneous current assets.

These items (see figure 2.5) are in constant movement. Inventories of raw materials are converted into finished goods. These when sold are transformed into accounts receivable which in due course are paid in cash to the company.

Figure 2.3 The balance sheet – sources and uses of funds approach

Figure 2.4 The balance sheet – basic five-box layout

Figure 2.5 The balance sheet – current assets box

The ‘miscellaneous’ heading covers any short-term assets not included elsewhere and is usually not significant. The amount of cash held is often small also, because it is not the function of a company to hold cash. Indeed, where there are large cash balances, there is usually a very specific reason for this, such as a planned acquisition.

The two significant items in current assets therefore are the inventories and accounts receivable. They are very important assets that often amount to 50 per cent of the total balance sheet of the company.

Balance sheet structure – fixed assets

Fixed assets comprise the second major block of assets. They, occupy the north-west corner of the balance sheet (see figure 2.6).

We use the term ‘fixed assets’ even though the block contains items that do not strictly fall under this heading. A more accurate description would be ‘long investment’, but the term ‘fixed assets’ is more commonly used.

The items that fall into this block are grouped under three headings:

1 Intangibles

Included under the heading intangibles are all assets taht do not have a physical presence. The main item is goodwill. This is a component that gives rise to some controversy and is dealt with in appendix 1.

2 Net fixed assets

Large, expensive, long-lasting, physical items required for in the operations of the business are included here. Land, buildings, machinery, and office and transport equipment are the common entries. The standard method of valuation is to take original cost and deduct accumulated depreciation. In the case of property, adjustments may be made to reflect current values (see overleaf).

3 Investments

‘Investments/other assets’ include long-term holdings of shares in other companies for trading purposes. Not all such investments are shown in this way. Where the holding company has dominant influence – then the accounts of the subsidiary company are totally consolidated. This means that the separate assets and liabilities of the subsidiary are aggregated with corresponding items in the parent company’s balance sheet. It is only investments in non-consolidated companies that are shown here.

Figure 2.6 The balance sheet – the fixed assets box

The question as to whether the balance sheet values should be adjusted to reflect current market values has, for years, been a contentious question. In times of high inflation, property values get out of line – often considerably so – and it is recommended that they be revalued. However, it is important to note that the balance sheet does not attempt to reflect the market value of either the separate assets or the total company. Prospective buyers or sellers of course examine these matters closely.

Balance sheet structure – liabilities

Figure 2.7 shows three subdivisions of the liabilities column:

• owners’ funds (OF)
• long-term loans (LTL)
• current liabilities (CL).

(There are certain types of funds that do not fit comfortably into any one of the above listed classes. At this stage we will ignore them. Usually the amounts are insignificant and they are dealt with in appendix 1.)

Current liabilities (CL)

Current liabilities (see figure 2.7) have a strong parallel relationship with current assets. ‘Accounts payable’ counterbalance ‘accounts receivable’, ‘cash’ and ‘short-term loans’ reflect the day-to-day operating cash position at different stages. We will return to the relationship between current assets and current liabilities again.

Long-term loans (LTL)

These include mortgages, debentures, term loans, bonds, etc., that have repayment terms longer than one year.

Owners’ funds (OF)*

This is the most exciting section of the balance sheet. Included here are all claims by the owners on the business. Here is where fortunes are made and lost. It is where entrepreneurs can exercise their greatest skills and where takeover battles are fought to the finish. Likewise it is the place where ‘financial engineers’ regularly come up with new schemes designed to bring ever-increasing returns to the brave. Unfortunately, it is also the area where most confusing entries appear in the balance sheet.

Figure 2.7 The balance sheet – the three subdivisions of the liabilities column

For the newcomer to the subject the most important thing to remember is that the total in the box is the figure that matters, not the breakdown between many different entries. We will discuss this section at length in chapter 12. It is important to note that while our discussions center on publicly quoted companies, everything said applies equally strongly to non-quoted companies. The rules of the game are the same for both.

Note the three major subdivisions illustrated in figure 2.8:

• issued common stock
• capital reserves
• revenue reserves.

1 Issued common stock

The issuing of common stock for a cash consideration is the main mechanism for bringing owners’ capital into the business. Three different values are associated with issued common stock:

• nominal value
• book value
• market value.

These will be covered in detail in chapter 12.

2 Capital reserves

The heading ‘capital reserves’ is used to cover all surpluses accruing to the common stockholders that have not arisen from trading. The main sources of such funds are :

• revaluation of fixed assets
• premiums on shares issued at a price in excess of nominal value
• currency gains on balance sheet items, some non-trading profits, etc.

A significant feature of these reserves is that they cannot easily be paid out as dividends. In many countries there are also statutory reserves where companies are obliged by law to set aside a certain portion of trading profit for specified purposes – generally to do with the health of the firm. These are also treated as capital reserves.

Figure 2.8 The balance sheet – owners’ funds in more detail

3 Revenue reserves

These are amounts retained in the company from normal trading profit. Many different terms, names, descriptions can be attached to them:

• revenue reserves
• general reserve
• retained earnings, etc.

This breakdown of revenue reserves into separate categories is unimportant and the terms used are also unimportant. All the above items belong to the common stockholders. They have all come from the same source and they can be distributed as dividends to the shareholders at the will of the directors.

Summary

We use this five-box balance sheet for its clarity and simplicity. It will be seen later how powerful a tool it is for cutting through the complexities of corporate finance and explaining what business ratios really mean.

* The terminology here is not easy. For this publication the following terms are identical:

• owners’ funds
• ordinary funds
• common funds (US)