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C H A P T E R 5

Building a

Balance Sheet

TThis chapter identifies and explains the various assets and liabilities used by a business in making profit. A business invests in a portfolio of operating assets and takes on certain operating liabilities in the process of making sales and incurring expenses. The main theme of the chapter is that the profit-making activities of a business (revenue and expenses) drive the assets and liabilities that make up its balance sheet.

SIZING UP TOTAL ASSETS

Figure 5.1 presents an abbreviated income statement for a business’s most recent year. Previous chapters explain that income statements include more information about expenses and do not stop at the earnings before interest and income tax (EBIT) line of profit. Interest and income tax expenses are deducted to arrive at bottom-line net income. However, the condensed and truncated income statement shown in Figure 5.1 is just fine for the purpose at hand.

This business example, like the examples in earlier chapters, is a hypothetical but realistic composite based on a variety of financial reports over the years. Any particular business you look at will differ in one or more respects from the example.

Some businesses are smaller or larger than the one in the example; their annual sales revenue may be lower or higher.

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Note:
Amounts are in in millions of dollars.

Sales revenue

$52.0

Cost-of-goods-sold expense

$31.2

Gross margin

$20.8

Operating expenses

$16.9

Earnings before interest and income tax (EBIT)

$ 3.9

FIGURE 5.1
Abbreviated income statement.

The business in the example sells products, and therefore it has cost-of-goods sold expense. Many businesses sell services instead of products, and they don’t have this expense. But the example serves as a good general-purpose template that has broad applicability across many lines of businesses.

A final comment about the example: I selected annual sales of $52 million as a convenient figure to work with (i.e., $1

million sales per week). This simplifies the computations in the following discussion and avoids diverting attention from the main points and spending too much time on number crunching.

Two Key Questions

TEAMFLY

Block by block this chapter builds the foundation of assets the business used to make sales of $52 million and to squeeze out $3.9 million profit (EBIT) from its sales revenue. Let me immediately put a question to you: What amount of total assets would you estimate that the business used in making annual sales of $52 million? Annual sales divided by total assets is called the
asset turnover ratio
(see Chapter 4). Indirectly, what I’m asking you is this: What do you think the asset turnover ratio might be for the business?

The asset turnover ratios of businesses that manufacture and sell products tend to cluster in the range between 1.5 and 2.0.

In other words, their annual sales revenue equals 1.5 to 2

times total assets for these kinds of businesses. To keep the arithmetic easy to follow in the discussion, assume that the
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Team-Fly®

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total assets of the business in the example are $26 million. So its asset turnover ratio is 2.0: ($52 million annual sales revenue ÷ $26 million total assets = 2.0). An asset turnover ratio of 2.0 is on the high side, but I’ll stick with it in the first part of the chapter.

The second question is this: Where did the business get the $26 million invested in its assets? The money for investing in assets comes from two different sources—liabilities and owners’ equity. This point is summarized in the well-known accounting equation:

Assets = liabilities + owners’ equity

The accounting equation is the basis for double-entry bookkeeping. The balance sheet takes its name from the balance between assets on one side of the equation and liabilities plus owners’ equity on the other. The balance sheet is the financial statement that reports a business’s assets, liabilities, and owners’ equity accounts.

Return on Assets

The business used $26 million total assets to earn $3.9 million before interest and income tax, or EBIT. Dividing EBIT by total assets gives the rate of
return on assets
(ROA) earned by the business. In the example, the business earned a 15.0 percent ROA for the year ($3.9 million EBIT ÷ $26 million total assets =

15.0%). Is this ROA merely adequate, fairly good, or very good? Well, relative to what benchmark or point of reference?

The business has borrowed money for part of the total $26

million total capital invested in its assets. The average annual interest rate on its debt is 8.0 percent. Relative to this annual interest rate the company’s 15.0 percent ROA is more than adequate. Indeed, the favorable spread between these two rates works to the advantage of the business owners. The business borrows money at 8.0 percent and manages to earn 15.0 percent on the money. Chapter 6 explores the very important issue regarding debt versus owners’ equity as sources of capital to finance the assets of a business and discusses the advantages and risks of using debt capital.

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This chapter deals mainly with the types and the

amounts of assets needed to make profit. The non-

interest-bearing operating liabilities of businesses are also included in the discussion. These short-term payables occur spontaneously when a business buys inventory on credit, receives money in advance for future delivery of products or services to customers, and delays paying for expenses.

Payables arising from these sources are called
spontaneous
liabilities.
In contrast, borrowing money from lenders and raising money from shareholders are anything but spontaneous. Persuading lenders to loan money to the business is a protracted process, as is getting people to invest money in the business as shareowners.

ASSETS AND SOURCES OF CAPITAL FOR ASSETS

Continuing the example introduced previously, the business has several different assets that at year-end add up to $26

million. One of its assets is inventories, which are products being held by the business for sale to customers. These products haven’t been sold yet, so the cost of the products is held in the asset account and will not be charged to expense until the products are sold. The cost of its inventories at year-end is $7.2 million. Of this amount, $2.4 million hadn’t been paid for by the end of the year. The business has an excellent credit rating. Its suppliers give the business a month to pay for purchases from them.

In addition to the amounts it owes for inventory purchases, the business also has short-term liabilities of $2.6 million for unpaid operating expenses at year-end. Of its $16.9 operating expenses for the year (see Figure 5.1), $2.6 million had not been paid by the end of the year. Both types of liabilities—payables for purchases of inventory on credit and for unpaid operating expenses—are short-term, non-interest-bearing obligations of the business. These are called
operating liabilities,
or
spontaneous liabilities
(as mentioned). The total of these two short-term operating liabilities is $5 million in the example.

To summarize, the company’s total assets, operating liabilities, and sources of capital for investing in its assets are shown in Figure 5.2.

In Figure 5.2 note that the $5 million of operating liabilities
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Note:
Amounts are in millions of dollars.

Total assets

$26.0

Short-term and long-term debt

$ 7.5

Less operating liabilities

$ 5.0

Owners’ equity

$13.5

Capital needed for assets

$21.0

Capital from debt and owners’ equity

$21.0

FIGURE 5.2
Summary of assets, operating liabilities, and sources of capital.

is deducted from total assets to determine the $21 million amount, which is the total capital needed for investing in its assets. I favor this layout for management analysis purposes because it deducts the amount of spontaneous liabilities from the total assets of the business. Recall that the normal operating liabilities from buying things on credit and delaying payment of expenses are called
spontaneous
because they arise in the normal process of carrying on the operations of the business, not from borrowing money at interest.

Operating liabilities do not bear interest (unless the business delays too long in paying these liabilities). If the business had paid all its operating liabilities by year-end, then its cash balance would have been $5 million lower and its total assets would have been $21 million. (I should mention that the business probably would not have had enough cash to pay all its operating liabilities before the end of the year.) A company’s cash balance benefits from the float, which is the time period that goes by until the company pays its short-term operating liabilities. It’s as if the business gets a $5 million interest-free loan from its creditors.

Debt versus Equity as Sources of Capital

The $21 million of its assets ($26 million total assets minus the $5.0 million of its operating liabilities) is the amount of money that the business had to obtain from three general sources: (1) The business borrowed money; (2) the business raised money from shareowners; and (3) the business retained a good part of its annual earnings instead of distributing all of its annual profits to shareowners. These three sources of capital have provided the $21 million
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invested in its assets. Of this total capital, $7.5 million is from short-term and longer-term debt sources. The rest of the company’s total capital is from owners’ equity, which consists of the amounts invested by shareowners over the years plus the accumulated retained earnings of the business. Figure 5.2

does not differentiate between the cumulative amounts invested by shareowners and the retained earnings of the business—only the total $13.5 million for owners’ equity is shown in Figure 5.2.

Interest is the cost of using debt capital, of course. In contrast, a business does not make a contractual promise to pay shareowners a predetermined amount or a percent of distribution from profit each year. Rather, the cost of equity capital is an imputed cost, equal to a sought-after amount of net income that the business should earn annually relative to the owners’ equity employed in the business. The owners’ equity is $13.5 million of the company’s $21 million total capital.

Shareowners expect the business to earn annual net income on owners’ equity that is higher than the interest rate on its debt. Shareowners take more risk than lenders. Assume, therefore, that the business’s objective is to earn a 15.0 percent or higher annual net income on owners’ equity. In the example, therefore, net income should be at least $2,025,000

($13.5 million owners’ equity × 15.0% = $2,025,000 net income benchmark).

A company’s actual earnings before interest and income tax (EBIT) for a year may not be enough to pay interest on its debt capital, pay income tax, and achieve its after-tax net income objective relative to owners’ equity. What about this example, for instance? The business made $3.9 million EBIT, as reported in Figure 5.1. The annual interest rate on its debt was 8.0 percent, as mentioned earlier. So, its annual interest expense was $600,000 ($7.5 million total debt × 8.0% annual interest rate = $600,000).

So the business made $3.3 million earnings after interest and before income tax. Its income tax rate is 34 percent of this amount. Thus, its income tax is $1,122,000 and its net income, or earnings after interest and income tax, is $2,178,000. The business achieved its goal of earning 15.0

percent or better of net income on owners’ equity ($2,178,000

net income ÷ $13,500,000 owners’ equity = 16.1%). The shareowners may be satisfied with this 16.1 percent return on
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their capital, or they may insist that the business should do better.

Chapter 6 explores the strategy of using debt to enhance net income performance (as well as the risks of using debt capital, which a business may or may not be willing to take).

The rest of this chapter focuses on the assets and operating liabilities that are driven by the profit-making activities of a business. A large chunk of a company’s balance sheet (statement of financial condition) consists of these assets and operating liabilities.

CONNECTING SALES REVENUE AND

EXPENSES WITH OPERATING ASSETS

AND LIABILITIES

Figure 5.3 shows the lines of connection from sales revenue and expenses to the company’s respective assets and operating liabilities. (The foregoing business example is continued in this section.) The assets and operating liabilities shown in Figure 5.3 are explained briefly as follows:

• Making sales on credit causes a business to record
accounts receivable.

Note:
Amounts are in millions of dollars.

Income Statement

Assets

Sales revenue

$52.0

Accounts receivable

Cost-of-goods-sold expense

$31.2

Inventories

Gross margin

$20.8

Prepaid expenses

Operating expenses

$16.9

Property, plant, and equipment

Earnings before interest and

income tax (EBIT)

$ 3.9

Operating Liabilities

Accounts payable

Accrued expenses payable

FIGURE 5.3
Operating assets and liabilities driven by sales revenue and
expenses.