Chapter 2: Financial Statements, Taxes, and Cash Flows

Three important examination factors of the balance sheet

Liquidity, debt versus equity, and market value versus book value are the most important things to keep in mind when examining a balance sheet.

Income Statement

Measures performance over some period of time, usually a quarter or a year. Revenues - Expenses = Income

Financial Leverage

The use of debt in a firm's capital structure. The more debt a firm has {as a % of assets}, the greater is its degree of financial leverage.

Debt Versus Equity

To the extent that a firm borrows money, it usually gives first claim to the firm's cash flow to creditors. Equity holders are entitled to only the residual value, the portion left after creditors are paid. The value of the residual portion is the shareholders' equity in the firm.

Long-Term Liabilities

A debt that is not due in the coming year is classified as this. An example would be a loan that the firm will pay off in five years. We will use the terms bond and bondholders generically to refer to this debt and these creditors, respectively.

Historical Cost

Audited financial statements in the United States show assets as this. Assets are "carried on the books" at what the firm paid for them, no matter how long ago they were purchased or how much they are worth today.

Market Value & Book Value

Difference between these is important for understanding the impact of reported gains and losses.

Current Asset

Has a life of less than one year. Will convert to cash within 12 months. For example, inventory would normally be purchased and sold within a year.

Fixed Asset

Has a relatively long life. Can either be tangible, such as a truck or a computer, or intangible, such as a trademark or patent.

Current Liabilities

Have a life of less than one year. {must be paid within one year} and are listed before long-term liabilities. Accounts payable {money the firm owes to its suppliers} are one example of this.

Balance Sheet

It is a snapshot of the firm. 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.

Liquidity

Refers to the speed and ease with which an asset can be converted to cash. Gold is a relatively liquid asset; a custom manufacturing facility is not. Has two dimensions: ease of conversion versus loss of value. A highly liquid asset is therefore one that can be quickly sold without significant loss of value. An {ill}liquid asset is one that cannot be quickly converted to cash without a substantial price reduction Most liquid assets are listed on the balance sheet first {it's in order of decreasing liquidity} Cash >>>>>>> Inventory Fixed assets are, for the most part, relatively illiquid. These consists of tangible things such as buildings and equipment that don't convert to cash at all in normal business activity. Intangible assets, such as a trademark, have no physical existence but can be very valuable. Won't ordinarily convert to cash. The more liquid a business is, the less likely it is to experience financial distress {that is, difficulty in paying debts or buying needed assets}. However, liquid assets are generally less profitable to hold.

Net Working Capital

The difference between a firm's current assets and its current liabilities. Positive when current assets > current liabilities...this means that the cash that will become available over the 12 months exceeds the cash that must be paid over the same period.

Shareholders' Equity

The difference between the total value of the assets {current & fixed} and the total value of the liabilities {current & long-term} is this. This feature of the balance sheet is intended to reflect that, if the firm were to sell all its assets and use the money to pay off its debts, then whatever residual value remained would belong to the shareholders.