How to Read a Balance Sheet: The Bottom Line On What You Need To Know About Cash Flow, Assets, Debt, Equity, Profit. . .And How It All Comes Together (BUSINESS SKILLS AND DEVELOPMENT) - Softcover

Makoujy, Rick

Softcover

ISBN 10: 0071700331 ISBN 13: 9780071700337

Publisher: McGraw-Hill, 2010

Synopsis

Put the most valuable business tool to work for you!

The balance sheet is the key to everything--from efficient business operation to accurate assessment of a company’s worth. It’s a critical business resource--but do you know how to read it? How to Read a BalanceSheet breaks down the subject into easy-to-understand components.

If you're a business owner or manager, this book helps you . . .

• Manage working capital
• Generate higher returns on assets
• Maximize your inventory dollars
• Evaluate investment opportunities

If you're an investor, this book helps you . . .

• Determine the market value of a company's assets and operations
• Predict future earnings and trends
• Assess the impact of capital expenditures
• Identify potential "red flags" before the crowd

How to Read a Balance Sheet gives you the bottom line of what you need to know about:
Cash Flow * Assets * Debt * Equity * Profit and how it all comes together.

About this title

About the Author

Rick J. Makoujy, Jr., is the author of Accounting in an Hour, a 60-minute interactive DVD and e-learning course that promotes financial literacy to nonfinancial employees. He lives in Woolwich Township, NJ.

Excerpt. © Reprinted by permission. All rights reserved.

How to READ a Balance Sheet

By Rick J. Makoujy, Jr.

The McGraw-Hill Companies, Inc.

Copyright © 2010 The McGraw-Hill Companies, Inc.
All right reserved.
ISBN: 978-0-07-170033-7

Contents

Chapter One

PRIMER ON THE BALANCE SHEET AND INCOME STATEMENT

WHAT IS A BALANCE SHEET?

The good news is that reading financial statements is easy. Let's start with a short overview of the first of two important financial statements, the balance sheet.

The balance sheet shows what a company's assets are (what it owns), what its liabilities are (what it owes), and what its equity is (what's left over) at a specific point in time.

That's it. Memorize that sentence—it's pretty important. By the way, the specific point in time is usually the end of the year or the end of a quarter. Simplistically, what did I own and what did I owe at the end of last year, and what was the difference between the two?

To start, there are three principal components of a balance sheet. The first, assets, is things that are owned. There are many types of assets. Assets that are readily converted into or used as cash are deemed short term in nature. Examples of short-term, or current, assets are cash, monies due from customers (called "accounts receivable"), inventory (stocked items for sale), or any other owned items that are expected to be liquidated or used as cash within one year from the date on the balance sheet.

Assets such as real estate, furniture, or equipment used to operate the business are generally not expected to be sold within 12 months. Consequently, these owned items are classified as long term in nature. Long-term assets maintain their value over an extended time frame based on their estimated useful lives. A building, for example, will not decline in value as quickly as a computer, and less of its cost is lost each year as a result.

On the other side of the ledger, a company that owns assets typically also owes money to various people or entities in the form of liabilities. Liabilities are simply IOUs. A business or individual might owe money to employees in the form of accrued payroll or vacation time, to vendors (suppliers who have shipped product or provided services with the expectation of payment in 30 or 60 days, called "accounts payable"), to banks in the form of credit cards or other debt, to the Internal Revenue Service, or to other creditors. Those debts that must be paid within a year from the balance sheet's date are considered short-term liabilities. Obligations that needn't be paid for at least 12 months are deemed long-term liabilities.

The difference between assets and liabilities is called "net worth," or equity. In short, if you were to sell the assets shown on a balance sheet at their listed values and use the proceeds to pay off the stated liabilities, whatever is left would be considered equity. Equity is the value the owners have in the business. Similarly, an individual might sell his or her possessions, satisfy all creditors with the proceeds, and keep whatever is left over for himself or herself. Keep in mind that it is possible to have negative equity if the proposed asset sales wouldn't result in enough cash to pay off the listed liabilities.

Let's look at an easy example. Imagine buying a house for $100,000, with a $10,000 down payment and a $90,000 mortgage. You've just created a balance sheet. A $100,000 asset (the house) equals the $90,000 liability (the mortgage) plus $10,000 in equity (also called "net worth"). In other words, if you sell the asset and use the proceeds to pay off the liabilities, you get net worth, or equity.

Of course, companies (and individuals) have assets of varying kinds in addition to real estate. These include cash, inventory, equipment, and patents. We owe money in forms other than mortgages, such as taxes, utility bills, credit cards, and payroll. Net worth, or equity, is calculated by subtracting total liabilities from total assets. It's simple.

PRIMER ON THE INCOME STATEMENT

To fully understand the balance sheet, you need to be familiar with another major financial statement, the income statement (also called the "P&L," or "profit and loss statement"). Here's an overview.

The income statement (P&L) shows how much money a company generates, how much it spends, and what is left over during a period of time.

Easy. By the way, the income statement's period of time is often one year or one calendar quarter. I'll illustrate the income statement through the use of a simple example: Jackie's Hardware Store.

The first component of the income statement is revenue. Revenue is the money an organization receives before paying any expenses. Sales are the portion of revenue that comes from selling products or services to customers, such as retailers getting money for stocked goods, or legal fees paid to an attorney. Other sources of revenue include proceeds from a tenant's rent to a landlord or royalties received by an author from a publisher.

For nonprofit organizations, annual revenue may be referred to as "gross receipts" and may come from donations from individual or corporate donors, fund- raising, membership dues, grants from government agencies, or return on investments. Tax revenue is money that a government receives from taxpayers. In many countries, including the United Kingdom, revenue is called "turnover."

The price of goods or services multiplied by the number of those items sold determines a company's annual revenue. In Jackie's Hardware Store, Jackie receives money from selling products like hammers, saws, and nails to her customers. Let's imagine that she sold 1,000 hammers last year for $10 each. She would have generated $10,000 in hammer revenue. Similarly, she sold 2,000 saws last year for $20 each, creating $40,000 in saw revenue. If we add the total revenue from hammers and saws to the revenue from all of the other products in her store last year, we'll assume that she generated $1 million in total revenue, which in her case comes from sales.

The next piece of the income statement is direct costs. Direct costs are those expenses that are directly correlated with sales. In other words, if Jackie generates zero revenue, theoretically, her direct costs should also be zero. Examples of direct costs are commissions (which are paid only when sales occur) and the cost of the goods that she sells. Jackie does not have any commissioned salespeople in her store, so her only direct costs are from the products that she sells.

It is important to note that the purchase of inventory is not an expense when Jackie buys the goods. This transaction is simply the transfer of one asset, cash, to another asset, inventory. The expense occurs when the value is lost. When the hammer becomes someone else's property and the customer walks out of the store, Jackie's Hardware Store no longer owns it. The value is lost at the time of the sale. The recording of the sale (generation of revenue) occurs simultaneously with the expensing of the inventory even though it was previously purchased.

Last year, as we learned, Jackie sold 1,000 hammers. Her cost per hammer was $5 each, so her direct cost associated with the sale of hammers was $5,000. Her cost per saw was $10 each, so her direct costs for saws last year on the 2,000 that she sold was $20,000. Let's add her direct costs for hammers to her direct costs for saws to all of her other direct costs last year. We'll suppose that she had total direct costs for the year of $500,000. For example:

Direct Costs
Commissioned salespeople $ 0
Cost of good
Hammers $ 5,000
Saws 20,000
Other Cost of Goods 475,000
_________
Total Direct Costs $500,000

Subtracting direct costs from revenue yields gross profit. Jackie's gross profit last year can be simply calculated as $1,000,000 of revenue less $500,000 of direct costs equals $500,000 of gross profit:

Revenue $1,000,000
Direct Costs -500,000
___________
Gross Profit $ 500,000

Her gross margin is $500,000 of gross profit divided by total revenue of $1,000,000, or 50 percent:

$5000,000 ÷ $1,000,000 = 0.50

or 50% gross margin

In other words, half of her revenue goes to purchase the items she sells, her inventory. Obviously, the higher the gross profit, the better. If a company has a negative gross profit because its sales don't even cover the cost of goods that are sold, it might as well close its doors, as there is no money left over to fund the other expenses the business has to incur.

Different types of businesses have vastly differing gross margins. A software company (e.g., Microsoft) that creates a program (e.g., Microsoft Office) once may sell it many, many times. Once the code is written, the cost of burning a disk and putting it into a box is trivial relative to the purchase price of a couple of hundred dollars. Obviously, the more copies that are sold, the easier it will be to absorb the cost of content creation over a larger customer base.

Grocery stores, on the other hand, have notoriously low gross margins. Many items are sold below cost as "loss leaders" to induce customers to enter the store. Some food, such as fruit and vegetables, dairy products, bread products, and meat and chicken or seafood, is perishable and is thrown away regularly because realistically it is never completely sold. Due to the slim gross margins under which these companies must operate, it is imperative that they sell large volumes of products in order to generate sufficient gross profit to cover operating expenses (see below).

Generally speaking, when a company is able to raise prices, few of its expenses increase in tandem. Increasing revenue through higher prices to customers usually has a substantially beneficial impact on gross margin and gross profit. Conversely, when competitive pressures require discounting to retain customers and associated sales, gross margin and gross profit suffer.

Operating expenses are those costs that are incurred regardless of revenue generation. Examples are rent, noncommissioned payroll, health insurance premiums, utility bills, and real estate taxes. Operating expenses are sometimes referred to as "overhead." In Jackie's case, her operating expenses last year consisted of $120,000 of noncommissioned payroll, $20,000 of advertising and promotion, $10,000 of utilities, $10,000 of insurance premiums, and $140,000 of other operating expenses, for a total of $300,000 in operating expenses:

Operating Expenses
Payroll $120,000
Advertising and Promotion 20,000
Utilities 10,000
Insurance 10,000
Other Operating Expenses 140,000
___________
Total Operating Expenses $130,000

Operating profit is simply the difference between gross profit and operating expenses. Fortunately, in Jackie's case, her gross profit of $500,000 was more than sufficient to cover her operating expenses of $300,000, leaving her with an operating profit of $200,000.

Operating profit divided by revenue is operating margin. Jackie's operating margin last year was $200,000 divided by $1,000,000, or 20 percent. Operating profit is an indicator of how much money a business generates after paying its regular costs to operate. This figure helps business buyers or lenders understand how much money is left over to pay debt service, to provide a return to the owners of the company, or both.

Reaching breakeven at the operating profit level is an important milestone for a business. Once administrative costs and overhead are effectively paid for, incremental gross profit flows through to the operating income level (provided that the extra revenue does not warrant additional staff). You likely don't need another accountant or receptionist with higher sales. Nor would you need to rent another facility or increase utility costs. For this reason, a company that is able to "cover its nut" with existing revenue may take on more customers, even if those sales are less profitable. Every additional dollar of gross profit flows through to operating profit at that point, adding value to the business.

It is from operating profit that Jackie must pay nonoperating expenses, such as interest and taxes. Jackie's only interest-bearing obligation is the $900,000 mortgage on her building. This mortgage bears interest at 10 percent per year. Her interest expense, consequently, was $90,000 last year (simply calculated as mortgage balance of $900,000 times the interest rate of 10 percent). Subtracting her interest expense of $90,000 from her operating profit of $200,000 left her with pretax income of $110,000 for the 12-month period.

The government's only concession to a business's success is to tax income after expenses are deducted. Assuming a 30 percent tax bite, Jackie's Hardware Store had a $33,000 tax obligation last year [calculated simply as pretax income of $110,000 times 0.30 (a tax rate of 30 percent)]. Subtracting the $33,000 tax amount from her $110,000 pretax income left her with $77,000 of net income last year.

Net income is simply operating profit less any nonoperating expenses, such as interest, taxes, or losses on stocks. Here are the calculations for Jackie's Hardware Store:

Revenue $1,000,000
Direct Costs -500,000
____________
Gross Profit $ 500,000
Operating Expenses -300,000
____________
Operating Profit $ 200,000
Interest Expense -90,000
____________
Pretax Income $ 110,000
Taxes -33,000
____________
Net Profit (or Loss) $ 77,000

Interest can be either an expense or a source of income. If a business borrows money, the cost of doing so is deemed interest expense and is deducted from pretax income. On the other hand, a company that maintains cash balances that generate interest income would add this amount to pretax income. A blend of the two (some interest-bearing cash or short-term investments along with a number of obligations requiring interest payments) are often combined in a net interest expense or net interest income figure on the income statement.

For example, if a company had $1 million in cash and short-term investments last year, which provided 5 percent interest, the firm would have received $50,000 in interest income. During the same period, a $2 million equipment loan cost the company 8 percent interest. This $160,000 interest expense ($2,000,000 times 8 percent) would more than exceed the interest income. The net interest expense figure recorded by the business would have been $110,000, calculated simply as $160,000 in interest expense less the $50,000 of interest income generated.

Taxes suck. The monies that constitute aggregate pretax income are subject to income taxes. (If you have negative pretax income, you wouldn't have the obligation.) Income taxes are based on the state in which the business is based, the level of pretax income generated, and the type of business organization involved. C corporations (more on company types in Chapter 4), for example, pay income tax on pretax income. S corporations, partnerships, and limited liability companies generally do not pay income taxes. Instead, S corporations, partnerships, and limited liability companies' pretax income is "passed through" to the owners in their pro rata ownership percentages. An S corporation with $1 million of pretax income that has four individual equal shareholders (owners) would allocate this pretax income to the owners. The $250,000 each shareholder would be assessed would obligate the owners to assume the responsibility for the taxes due on their profit share, regardless of whether or not any distributions were made to help cover the cost of the tax. If no distributions are made in this case and the shareholders had to pay their share of taxes due, the allocated pretax income would be called "phantom income."

Payroll taxes and collected sales taxes are not lumped in with nonoperating expenses like income taxes. Payroll taxes and sales taxes are considered operating or direct expenses. Payroll taxes on direct expense employees like commission-only salespeople would be deemed direct expenses, as would sales taxes that are collected and paid only upon the occurrence of revenue generation. Payroll taxes for employees who get paid regardless of sales are considered an operating expense along with their associated payroll.

Gains or losses on stocks also are "below the operating line," or nonoperating expense items, because the investments are not necessarily correlated with the company's performance. These gains or losses are often deemed to be one-time charges or benefits due to their nonrecurring nature. An example of what is generally deemed a onetime expense is a restructuring charge, which is a cost of making a large organizational change, such as a mass layoff along with the associated severance payments to the terminated workers as well as other costs like plant closings or office consolidation moving expenses.

Another nonoperating item is the net income or loss associated with discontinued operations. Once a company makes plans to sell or liquidate a portion of its business, the net result of the piece being sold is labeled "discontinued" and is included as a nonoperating item. This is done because the inclusion of these segments with continuing operations would mislead investors about the future consistency of operating income.

For what it is worth, some companies might consider advertising (or other items considered here to be operating costs) to be a direct expense. The more important issue is not whether an expense is classified as direct or indirect but rather the timing of the recording and the amount the expense being recorded. A recent example of differing expense classifications is illustrated in the accounting statements of International Business Machines Corporation (IBM) and Hewlett-Packard Company (HP) in their provisions for restructuring costs within their service businesses. IBM considers restructuring costs to be operating expenses, while HP views them as nonoperating costs (below the line).

(Continues...)

Excerpted from How to READ a Balance Sheetby Rick J. Makoujy, Jr. Copyright © 2010 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Edition details

• Publisher: McGraw-Hill
• Publication date: 2010
• Language: English
• ISBN 10: 0071700331
• ISBN 13: 9780071700337
• Binding: Paperback
• Number of pages: 208