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The Balance Sheet
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Now THAT YOU have a good idea of how businesses generate cash and how profits are recorded on financial statements, let's look at each of the three main financial statements in detail. Unfortunately, not all businesses are as simple as a hot dog stand, so we need to introduce some additional complexity if we want to analyze real companies. But fear not—as we walk through the balance sheet, income statement, and cash flow statement, we'll look at a few real-world companies to see what their financial statements can tell us about how their businesses are functioning.

Wherever possible, I'll refer to excerpts from the financial statements of Dell and Hewlett-Packard (H-P), taken from the two firms' IO-K filings with the SEC. (The Dell excerpts contain data through January 31, 2003 , and the H-P excerpts contain data through October 31, 2OO2.) We'll start with the balance sheet, move on to the income statement, and finish with the statement of cash flows. At the start of each section, you'll see a financial statement from the originally named (and fictitious) "Acme Corporation" that will show you how each statement is organized.

Warning: This chapter may be tough going in parts, but it's possibly the most important chapter of the entire book, since reading financial statements is the foundation for analyzing companies. If you find yourself confused about a concept or getting tired, put down the book and take a break. There's no rush—it'll be here when you get back!

The Balance Sheet

The balance sheet (see Figure 5.1)—sometimes called a "statement of financial position"—tells you how much a company owns (its assets), how much it owes (its liabilities), and the difference between the two (its equity). Equity represents the value of the money that shareholders have invested in the firm, and if that sounds odd, think of it just like your mortgage—your equity in your home is the home's value minus the mortgage. Stockholders' equity in a firm is the value of the firm's assets minus its liabilities.

Figure 5.1 A balance sheet for the fictitious ACME Corporation. Source: Morninqstar, Inc.

Figure 5.1 {Continued).

The basic equation underlying a balance sheet is:

Assets — Liabilities = Equity which can also be expressed as:

Assets = Liabilities + Equity

The key thing to understand about a balance sheet is simply that it must balance at all times, hence the name. An increase in liabilities—issuing a bond, for example—causes an increase in assets—the cash received from the sale of the bond. If a firm generates huge profits that drive an increase in assets, equity also increases. This makes sense because the value of shareholders' investment in the firm rises if that firm starts making a ton of money. Let's go through the balance sheet bit by bit to get a better grasp on how it's put together.

Asset Accounts: Current Assets

The accounting gods define current assets as those likely to be used up or converted into cash within one business cycle, usually defined as one year. The major portions of this category are cash and equivalents, short-term investments, accounts receivable, and inventories.

Cash and Equivalents and Short-Term Investments: These line items don't necessarily refer to actual greenbacks sitting around in a vault but to money in low-risk, fairly liquid investments. "Cash and equivalents" usually contains money market funds or anything that can be liquidated quickly and with minimal price risk, whereas "short-term investments" is similar to cash—usually, bonds that have less than a year to maturity and earn a higher rate of return than cash but would take a bit of effort to sell. In most cases, you can mentally lump this in with cash when considering how much a firm has on hand to meet an immediate need.

Accounts Receivable: As we saw in the hot dog example, accounts receivable are bills that the company hasn't yet collected but for which it expects to receive payment soon. Watch how this account changes relative to the company's sales—if accounts receivable are rising much faster than sales, the firm is booking a large amount of revenue for which it has not yet received payment. This can be a sign of trouble because it may mean that the firm is offering looser credit terms to increase sales—remember, a firm can record a sale as soon as it has shipped the product—but has less likelihood of ever receiving the cash it's owed.

In Figure 5.2, Dell looks like it was in fine shape on this front. Dell's accounts receivable rose about 14 percent, but sales increased by the same amount, as we'll see later when we look at the company's income statement.

However, H-P's accounts receivable (see Figure 5.3) took a huge jump from $4,488 billion to $8,456 billion, which was a 90 percent increase, whereas sales rose only about 25 percent. (Remember, comparing the growth rate of accounts receivable with the growth rate of sales is a good way to judge whether a company is doing a good job collecting the money that it's owed by customers.) Although H-P's results were somewhat distorted by its acquisition of Compaq during this time period, that's still a big discrepancy. At the time, H-P investors would have wanted to keep an eye on accounts receivable to make sure that the firm collected the cash that it was owed by customers.

Figure 5.2 Dell's current assets. Source: Del SEC filings.

You'll often see an "allowance for doubtful accounts" just after accounts receivable on the balance sheet. This is the company's estimate of how much money it's owed by deadbeat customers, and which it's consequently unlikely to collect. For example, on H-P's balance sheet, you can see that the firm was assuming that it wouldn't collect $495 million of the money that customers owed it as of October 2OO2.

Inventories: There are several types of inventories, including raw materials that have not yet been made into a finished product, partially finished products, and finished products that have not yet been sold. Inventories are especially important to watch in manufacturing and retail firms, and their value on the balance sheet should be taken with a grain of salt. Because of the way inventories are accounted for, their liquidation value may very well be a far cry from their value on the balance sheet. Use your common sense "when judging this: Although a construction firm could probably get a decent price if it needed to sell off some extra steel girders it had lying around in inventory, a retailer that needed to sell last fall's teen fashions would likely have to take pennies on the dollar.

Figure 5.3 Hewlett-Packard's assets. Source: Hewlett-Packard SEC filings.

More Importantly, inventories soak up capital—cash that's been converted into inventory sitting in a warehouse can't be used for anything else. The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time it's available for use elsewhere. Ifou can calculate a metric called inventory turnover by dividing a company's cost of goods sold by its inventory level.

For example, Dell's cost of goods sold for 2OO2 was S2J.6 billion (see Figure 5.4) and inventory was $278 million (see Figure 5.2), yielding an incredible inventory turnover rate of 92. In other words, Dell went through its entire inventory 92 times over the course of the year. Contrast this with H-P, which had a cost of goods sold of $34.5 billion (see Figure 5.5) and inventory of $5.8 billion for 2OO2, yielding much lower inventory turns of just 6. As you

can see, H-P lets inventory sit around much longer than Dell, which is not a great idea when you consider how fast high-tech equipment loses its value.

Asset Accounts: Noncurrent Assets

Noncurrent assets are assets that are not expected to be converted into cash or used up within the reporting period. The big parts of this section are prop­erty, plant, and equipment (PP&E); investments; and intangible assets.

Property, Plant, and Equipment: These are long-term assets that form the infrastructure of the company: land, buildings, factories, furniture, equipment, and so forth. Dell, for example, had about $913 million in PP&E at the end of 2OO2, whereas H-P had $6.9 billion.

Figure 5.5 Hewlett-Packard's revenue breakdown. Source/Hewlett-Packard SEC filings.

Figure 5.6 Dell's assets. Source: Dell SEC filings.

If we compare these numbers to the firms' total assets (see Figures J.(5 and 5.7, we can get a feel for how capital-intensive the firms are—Dell's PP&E makes up about 6 percent of its total assets, whereas almost IO percent of H-P's assets are in PP&E. Therefore, H-P is more capital-intensive than Dell.

Investments: This is money invested in either longer term bonds or in the stock of other companies, ranging from a token amount to a substantial stake. It's not nearly as liquid as cash and might be worth more or less on the market than the amount shown on the balance sheet. You'll need to dig around in the notes to the financial statements to see what exactly is in this account and with how much skepticism you should view its value. You can see in Figures 5.6 and 5.7 that H-P has no long-term investments, but Dell has a pretty sizeable amount—about $5.3 billion—sitting on its balance sheet. Because that's almost a third of Dell's total assets, it's definitely something you'd want to dig into. (Turns out that Dell's investments were mainly bonds, so you wouldn't need to worry too much about them—if they were equities or venture capital, you'd want to find out more about that $5.3 billion value.)

Figure 5.7 Hewlett-Packard's assets. Source: Hewlett-Packard SEC filings.

Intangible Assets: The most common form of intangible assets is goodwill, "which arises when one company acquires another. Goodwill is the differ­ence between the price the acquiring company pays and tangible value—or equity—of the target company. Essentially, goodwill represents the value of all of the other stuff that one company gets when it acquires another. For example, the majority of Coca-Cola's value is not in the firm's buildings and equipment; it's in the powerful brand that Coke has built up over the past several decades. If some firm were to buy Coke, it would have to pay far more than the book value of Coke's equity, and that extra amount is called goodwill.

You should view this account with extreme skepticism because most companies tend to overpay for their targets, which means the value of goodwill that shows up on the balance sheet is very often far more than the asset is actually worth. (In 2003, for example, AOL Time Warner reduced the value of the goodwill on its balance sheet by an amazing 40 percent with the stroke of a pen, essentially admitting that it had far overpaid for AOL when the two companies merged. If you'd been counting on this goodwill account as an asset that the company had at its disposal, you'd have been sorely disappointed.)

As you can see in Figure 5.7, H-P had more than $15 billion—or almost 20 percent of its total assets of $71 billion—in its goodwill account for 2OO2. Was Compaq really worth $15 billion more than the value of its cash, inventory, fixed assets, customer lists, and patents? Maybe it was—but if it's not, H-P will have to reduce the value of this account at some point in the future, which means the value of the firm's total assets will also drop.

Now that we know what the company owns, we can look at the other side of the coin—what it owes.

Current liabilities are the flip side of current assets: money the company expects to pay out within a year. You should focus on accounts payable and short-term borrowings or payables.

Accounts Payable; These are bills the company owes to somebody else and are due to be paid within a year, like Mike's IOU to the grocer for the extra hot dog buns. Large companies that have a lot of leverage over their suppliers can push out some of their payables, which means they hold on to the cash longer—and that's good for cash flow.

Short-Term Borrowings: This refers to money the company has borrowed for a term of less than a year, usually to meet short-term needs. It's often a line of bank credit that the firm has temporarily drawn down, though it might also be a portion of long-term debt that's due within the next year. This line item becomes especially important for companies in financial distress because the entire amount often has to be paid back quickly. H-P's notes payable and short-term borrowings (see Figure 5.8) were about Si.8 billion, which is fairly small relative to the size of the firm's assets, so no worries there.

Liability Accounts: Noncurrent Liabilities

Noncurrent liabilities are the flip side of noncurrent assets. They represent money the company owes one year or more in the future. Though you'll sometimes see a variety of line items under this heading, the most important one by far is long-term debt. This represents money the company has borrowed—usually by issuing bonds, though sometimes from a bank—that doesn't need to be paid back for a few years.

Stockholders' Equity

Remember, shareholders' equity is equal to total assets minus total liabilities, and it represents the part of the company owned by shareholders. This can be the most confusing section of any firm's financial statements, because it's filled with many anachronistic line items that have little practical relevance.

The only account worth looking at is retained earnings, which basically records the amount of capital a company has generated over its lifetime— minus dividends and stock buybacks, which represent funds that have already been returned to shareholders. Retained earnings is a cumulative account; therefore, each year that the company makes a profit and doesn't pay it all out as dividends, retained earnings increase. Likewise, if a company has lost money over time, retained earnings can turn negative and is often renamed "accumu­lated deficit" on the balance sheet. Think of this account as a company's long-term track record at generating profits.

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