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A. The Balance Sheet

 

The balance sheet provides a snapshot of the company’s assets and liabilities at a given moment in time; typically, companies publish their financial statements at the end of every fiscal exercise, which usually corresponds to the end of the calendar year – December 31rst –. We provide you with a model of balance sheet below and will then move on to introduce a simpler one and explain every item, one after the other (note that the simplified balance sheet is largely enough for the purpose of this course, which is to train you as a future entrepreneur; if you happen to be interested in the technicalities of accounting and want to have a more thorough introduction to the topic, then you will be able to find an abundant specialized literature on the web):

 

Balance sheet at the end of year n:

 

 

 

Overview of Assets

 

On a balance sheet, we can distinguish between two types of assets: the current assets and the non-current assets. Current assets are, conceptually, these assets which can be liquidated easily (i.e. which can be turned into cash easily); on the contrary, non-current (fixed) assets are those which are more difficult to liquidate (for instance, the buildings of a factory).

 

We will start by looking at non-current assets.

 

Property & Equipment: accounts for land, buildings, heavy machinery, etc … owned by the company. Only net values are given, that is to say historical (purchase) values diminished by the cumulated depreciations for the previous periods. For instance, if you purchased a building B for $120K at the end of year n-2, and if you decided to depreciate this building by $10K the first year and another $10K the second year, then the net value of B will be $100K, which is the value to be reported on the balance sheet. More on the topic of depreciation & amortization will be explained later.

 

Other Intangible Assets: accounts for licenses, patents, copyrights, trademarks, know-how, etc …

 

Investments in associates: accounts for the stakes (shares) owned in other companies for investment purpose.

 

Provisions for depreciation: this denotes the amount of money put aside by the firm in anticipation of the impairment of an asset (i.e., we are anticipating that an asset is going to undergo an unusual loss in value in the future). In order for a provision to be recorded, the drop in value of the asset must be likely enough.

 

Let’s now turn to current assets.

 

Inventories: inventories of finished products (or goods purchased, or raw materials) which are being stocked by the company. There are several method of accounting for them, each method leading to a different value:

 

-          the FIFO method (“First In First Out”): every finished product (good purchased for resale, raw material) is recorded at its production (or purchasing) cost, and every time the inventories are depleted, these products which were stocked first are also the first ones to be taken out of the inventories (still at their original production cost). An example of this is as below.

 

Assume that your company has inventories worth 0 at the end of year n, and that during year n+1, it is producing 10 finished products at $1 apiece, selling 5 of them, and stocking the remaining 5 in its inventories. Assume now that in year n+2 the company is producing another 4 of these finished products, but this time at a cost of $2 (because of high inflation). No finished product is sold during that year. In year n+3, the company sells 6 finished products from its inventories. What will be the state of the company’s inventories at the end of year n+3 ? A solution is given by the following table, which details the state of the inventories at the end of each year:

 

 

 

 

Note that in year n+3, out of the 6 finished products being sold, 5 are considered to incur production costs of $1 and only 1 of them is considered to incur production costs of $2 (which is the basis of the FIFO method).

 

-          the Weighted Average Cost method: according to this method, finished products (raw materials, goods purchased) which enter the firm’s inventories during the period are accounted for at production (purchasing) cost, but as inventories are depleted, the exit value of these products is the average cost of production (of purchase) over all the products contained within the inventories. In order to illustrate this method, let’s go back to the above example and have a look at the state of our inventories at the end of each year when adopting this inventory valuation method:

 

 

 

 

            One of the reasons why the Weighted Average Cost method might be used is that it   

            allows the company to smooth down its revenues (in case the costs of production                     vary too much from one year to the other).

 

-          the LIFO method: (“Last In First Out”) every finished product (good purchased for resale, raw material) is recorded at its production (or purchasing) cost, and every time the inventories are depleted, these products which were stocked last are the first ones to be taken out of the inventories (still at their original production cost). The above example is detailed below, where we employ the LIFO method:

 

 

 

           

            The LIFO method offers the company a way to manipulate its earning. Can you see how ? Very simply, if production costs have been extremely high in year n+1, and are subsequently falling to a much lower level in year n+2, managers will be inclined to switch to the LIFO method in order to minimize their production costs on paper (and thus maximize the operating profits over the period n+2). However, this is just an accounting trick since a part of the inventory has effectively been very costly to produce, and this is precisely what managers are trying to hide.

 

Trade receivables: accounts for all the payments that your customers owe you but haven’t issued yet. Obviously, your goal is too minimize the value of your trade receivables because they represent funds that you would be able to profitably invest if you had already recovered them.

 

Cash and cash equivalents: they represent the most liquid category of assets: cash (hold in the company’s bank account) and marketable securities (securities that you can sell anytime in order to convert them into cash and use the proceeds to pay your debts or invest otherwise).

 

We will now examine the liabilities side of the balance sheet, starting with equity.

 

Contributed capital: this corresponds to the capital (equity) initially invested by the owners (shareholders, if the company is listed).

Please note that this is not equal to the market value of the shareholders’ equity: indeed, the market value indicates the value at which one would be able to sell the shares of the company today. In particular, this reflects the present level of earnings of the company, their future growth, and the cost of equity required by shareholders.

On the contrary, contributed capital is only an accounting notion based on historical values of the capital contributed by shareholders, and as such it may be greater or smaller than the market value of equity today.      

 

Reserves and Retained losses: accounts for the amount of funds cumulated from past profits: whenever net income is positive, the company can decide to allot its profits in two different ways:

 

-          it can transfer them to its Reserves (or to its Retained Losses, if the company posted losses for the period) , thereby saving the funds for future use (for instance, for future investments).

 

-          it can distribute them as dividends paid to shareholders (or equivalently as share buybacks, by purchasing back shares of the company from shareholders at a high price).

 

We now move on to introduce non-current liabilities.

 

Long-term debt, less current portion and Current portion of long-term debt: accounts for the amounts borrowed and to be paid back in the future; “long-term” means that the principal of the debt will need to be repaid more than one year after debt issuance (typically several years after). Moreover, that part of long-term debt which needs to be repaid in less than one year is called the “current portion of long-term debt” and is recorded as a current liability, since it falls due very soon; for instance, in year n you are issuing debt for a notional amount of $1M to be repaid in 10 years, that is to say in year n+10. In this situation, $1M will be recorded as long-term debt in years n, …,n+8, while it will be recorded as current portion of long-term debt in year n+9, since then there will be only one year left before repayment.

 

Provisions: this denotes the amount of money put aside by the firm in anticipation of:

 

-          unrecoverable receivables, i.e. of customers not paying out the money they owe to the company; such provisions are often called “provisions for doubtful accounts”.

 

-          Expected legal fees, or any other expenses linked to a risk which may hurt the income statement in the future (provided that the probability that this happens is judged high enough; if the damaging event is judged unlikely to happen, provisions cannot be constituted); for instance, a competitor has recently filed a lawsuit against your company for copyright infringement, and your firm is expected to incur expenses of up to $1M for a settlement. Such expenses, provided that they are likely to happen in the future, can be recorded as a provision today; such provisions are often called “provisions for risks and charges”.

 

Short-term borrowings: as suggested by the name of this field, this tracks the amount of short-term loans that the company will have to pay back in the near future (typically within one year).

 

Accounts payable: accounts for the amounts that the company still owes to its suppliers. Of course, it is in your interest that this amount is as high as possible, because high accounts payable means that your suppliers are granting you very generous payment terms (in other words, you are able to keep your funds for a little longer before transferring them to your suppliers).