Chapter 2: Financial Statements, Taxes, and Cash Flow

Examining a Balance Sheet

1. Liquidity 2. Debt vs. Equity 3. Market Value vs. Book Value

Assets: The Left Side

Assets are classified as either current or fixed. A fixed asset is one that has a relatively long life. Fixed assets can be either tangible, such as a truck or a computer, or intangible, intangible, such as a trademark or patent. A current asset has a life of less than one year. This means that the asset will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year and is thus classified as a current asset. Obviously, cash itself is a current asset. Accounts receivable (money owed to the firm by its customers) are also current assets.

Balance Sheet

Financial statement showing a firm's accouting value on a particular date. The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm's equity) at a given point in time. Figure 2.1 illustrates how the balance sheet is constructed. As shown, the left side lists the assets of the firm, and the right side lists the liabilities and equity.

Debt vs. Equity

Shareholders' equity = Assets - Liabilities

Liquidity

The ease with which an asset can be converted into cash. Has two dimensions: 1. Ease of conversion versus loss of value. Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be sold without significant loss of value. An illiquid asset is one that cannot be quickly converted to cash without a significant price reduction. *Assets are listed on the balance sheet in order of decreasing liquidity, meaning that the most liquid assets are listed first. 2. Current assets are relatively liquid, whereas fixed assets are for the most part, illiquid. *Cash holdings are the most liquid of investments, but they sometimes offer no return at all - therefore, there is a tradeoff between the advantages of liquidity and forgone potential profits.

Net Working Capital

current assets - current liabilities (positive for a healthy firm)