Chapter2: REVIEWING FINANCIAL STATEMENTS
2.1 Balance Sheet
Figure 2.1 illustrates a basic balance sheet and Table 2.1 presents a simple balance sheet for DPH Tree Farm, Inc. as of December 31, 2007 and 2008. The left side of the balance sheet lists assets of the firm and the right side lists liabilities and equity. Both assets and liabilities are listed in descending order of liquidityThe ease of conversion of an asset into cash at a fair value., that is, the time and effort it takes to convert the accounts to cash. The most liquid assets—called current assets—appear first on the asset side of the balance sheet. The least liquid, called fixed assets, appear last. Similarly, current liabilities—those obligations that the firm must pay within a year, appear first on the right side of the balance sheet. Stockholders equity, which never matures, appears last on the balance sheet.
Figure 2.1 shows that assets fall into two major categories: current assets and fixed assets. Current assetsAssets that will normally convert to cash within one year. will normally convert to cash within one year. They include cash and marketable securities, accounts receivable, and inventory. Fixed assetsAssets with a useful life exceeding one year. have a useful life exceeding one year. This class of assets includes physical (tangible) assets, such as net plant and equipment, and other, less tangible, long-term assets, such as patents and trademarks. We find the value of net plant and equipment by taking the difference between gross plant and equipment (or the fixed assets original value) and the depreciation accumulated against the fixed assets since their purchase.
Liabilities and Stockholders Equity
Lenders provide funds, which become liabilitiesFunds provided by lenders to the firm., to the firm. Liabilities fall into two categories as well: current or long-term. Current liabilitiesObligations of the firm that are due within one year. constitute the firms obligations due within one year, including accrued wages and taxes, accounts payable, and notes payable. Long-term debtObligations of the firm that are due in more than one year. includes long-term loans and bonds with maturities of more than one year.
The difference between total assets and total liabilities of a firm is the stockholders (or owners) equity. The firms preferred and common stock owners provide the funds known as stockholders equityFunds provided by the firms preferred and common stock owners.. Preferred stockCash that preferred stockholders paid to the firm when it originally issued stock. appears on the balance sheet as the cash proceeds when the firm sells preferred stock in a public offering. Similarly, the proceeds from common stock and paid-in surplusCash that common stockholders paid to the firm when it originally issued the stock. appear as the other component of stockholders equity. If the firms managers decide to reinvest cumulative earnings rather than pay the dividends to stockholders, the balance sheet will record these funds as retained earningsThe cumulative earnings the firm has reinvested rather than pay out as dividends. (p. 30).
Managing the Balance Sheet
Managers must monitor a number of issues underlying items reported on their firms balance sheets. These include:
The accounting method for fixed asset depreciation.
The level of net working capital.
The liquidity position of the firm.
The method for financing the firms assets—equity or debt.
The difference between the book value reported on the balance sheet and the true market value of the firm.
ACCOUNTING METHOD FOR FIXED ASSET DEPRECIATION Firm managers can choose the accounting method they use to record depreciation against their fixed assets. Two choices include the straight-line method and the modified accelerated cost recovery system (MACRS). Companies often calculate depreciation using MACRS when computing the firms taxes and the straight-line method when reporting income to the firms stockholders. The MACRS method accelerates deprecation, which results in higher deprecation expenses and lower taxable income and lower taxes in the early years of a projects life. The straight-line method results in lower depreciation expenses, but also results in higher taxes in the early years of a projects life. Firms seeking to lower their cash outflows from tax payments will favor the MACRS depreciation method.
NET WORKING CAPITAL We arrive at a net working capitalThe difference between a firms current assets and current liabilities. figure by taking the difference between a firms current assets and current liabilities. So, clearly, net working capital is positive when the firm has more current assets than current liabilities. Table 2.1 shows the 2007 and 2008 year-end balance sheets for DPH Tree Farm, Inc. At year-end 2007, the firm had $190 million of current assets and $110 million of current liabilities. So the firms net working capital was $80 million. A firm needs cash and other liquid assets to pay its bills as expenses come due. Liability holders monitor net working capital as a measure of a firms ability to pay its obligations. Positive net working capital values are usually a sign of a healthy firm.p. 32
LIQUIDITY As we noted above, any firm needs cash and other liquid assets to pay its bills as debts come due. Liquidity actually refers to two dimensions: the ease with which the firm can convert an asset to cash, and the degree to which such a conversion takes place at a fair market value. You can convert any asset to cash quickly if you price the asset low enough. But clearly, you will wish to convert the asset without giving up a great portion of its value. So a highly liquid asset can be sold quickly at its fair market value. An illiquid asset, on the other hand, cannot be sold quickly unless you reduce the price far below fair value.
Current assets, by definition, remain relatively liquid, including cash and assets that will convert to cash within the next year. Inventory is the least liquid of the current assets. Fixed assets, then, remain relatively illiquid. In the normal course of business, the firm would have no plans to liquefy or convert these tangible assets such as buildings and equipment into cash.
Liquidity presents a double-edged sword on a balance sheet. The more liquid assets a firm holds, the less likely the firm will be to experience financial distress. However, liquid assets generate no profits for a firm. For example, cash is the most liquid of all assets, but it earns no return for the firm. In contrast, fixed assets are illiquid, but provide the means to generate revenue. Thus, managers must consider the trade-off between the advantages of liquidity on the balance sheet and the disadvantages of having money sit idle rather than generating profits.
DEBT VERSUS EQUITY FINANCING Ever since your high school physics class, you have known that levers are very useful and powerful machines—given a long enough lever, you can move almost anything. Financial leverageThe extent to which debt securities are used by a firm. is likewise very powerful. Leverage in the financial sense refers to the extent to which a firm chooses to finance its ventures or assets by issuing debt securities. The more debt a firm issues as a percentage of its total assets, the greater its financial leverage. We discuss in later chapters why financial leverage can greatly magnify the firms gains and losses for the firms stockholders.
When a firm issues debt securities—usually bonds—to finance its activities and assets, debt holders usually demand first claim to a fixed amount of the firms cash flows. Their claims are fixed because the firm must only pay the interest owed to bondholders and any principal repayments that come due within any given period. Stockholders—who buy equity securities or stocks—claim any cash flows left after debt holders are paid. When a firm does well, financial leverage increases shareholders rewards, since the share of the firms profits promised to debt holders is set and predictable.
However, financial leverage also increases risk. Leverage can create the potential for the firm to experience financial distress and even bankruptcy. If the firm has a bad year and cannot make its scheduled debt payments, debt holders can force the firm into bankruptcy. But managers generally prefer to fund firm activities using debt, precisely because they can calculate the cost of doing business without giving away too much of the firms value. So managers often walk a fine line as they decide upon the firms capital structureThe amount of debt versus equity financing to hold on the balance sheet.—the amount of debt versus equity financing to hold on the balance sheet—because it can determine whether the firm stays in business or goes bankrupt.
The “book value versus market value” issue really arises when we try to determine how much a firms fixed assets are worth. In this case, book value is often very different from market value. For example, if a firm owns land for 100 years, this asset appears on the balance sheet at its historical cost (of 100 years ago). Most likely, the firm would reap a much higher price on the land upon its sale than the historical price would indicate.
Again, accounting tools reflect the past: Balance sheet assets are listed at historical cost. Managers would thus see little relation between the total asset value listed on the balance sheet and the current market value of the firms assets. Similarly, the stockowners equity listed on the balance sheet generally differs from the true market value of the equity. In this case, the market value may be higher or lower than the value listed on the firms accounting books. So financial managers and investors often find that balance sheet values are not always the most relevant numbers. The following example illustrates the difference between the book value and the market value of a firms assets.