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The balance sheet, or statement of financial condition, reports the debt and equity capital sources of a business and the assets in which the business has invested. Several different types of assets are listed in the balance sheet. The balance sheet also reports the operating liabilities of a business that are generated by its profit-making activities and not from borrowing money. Operating liabilities are non-interest-bearing payables of a business, which are quite different from its interest-bearing debt obligations.

The relationships of sales revenue and expenses reported in a company’s income statement to the assets and operating liabilities reported in its balance sheet are not haphazard. Far from it! Sales revenue and the different expenses in the income statement match up with particular assets and operating liabilities. Business managers, lenders, and investors should understand these critical connections between the components of the income statement and the components of the balance sheet. In particular, the amount of accounts
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receivable should be reasonable in comparison with annual sales revenue, and the amount of inventories should be reasonable in comparison with annual cost-of-goods-sold expense.

In short, the balance sheet of a business fits tongue and groove with its income statement. These two financial statements are presented separately in financial reports, but business managers, lenders, and investors should understand the interlocking nature of these two primary financial statements.

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C H A P T E R 6

Business Capital

Sources

TThis chapter explores the two basic sources of business capital:
debt
and
owners’ equity.
Every business must make a fundamental decision regarding how to finance the business, which refers to the mix or relative proportions of debt and equity. By borrowing money, a business enlarges its equity capital, so the business has a bigger base of capital to carry on its profit-making activities. More capital generally means a business can make more sales, and more sales generally mean more profit.

Using debt in addition to equity capital is referred to as
financial leverage.
If you visualize equity capital as the fulcrum, then debt may be seen as the lever that serves to expand the total capital of a business. The chapter explains the gain or loss resulting from financial leverage, which often is a major factor in bottom-line profit.

It’s possible, I suppose, to find a business that is so antidebt that the only liabilities it has are normal
operating liabilities
(i.e., accounts payable and accrued expenses payable).

These short-term liabilities arise
spontaneously
in making purchases on credit and from delaying the payment of certain expenses until sometime after the expenses have been
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recorded. A business can hardly avoid operating liabilities.

But a business doesn’t have to borrow money. A business could possibly raise all the capital it needs from shareowners and from retaining all or a good part of its annual earnings in the business. In short, a business theoretically could rely entirely on equity capital and have no debt at all—but this way of financing a business is very rare indeed.

BUSINESS EXAMPLE FOR THIS CHAPTER

Figure 6.1 presents a very condensed balance sheet and an abbreviated income statement for a new business example.

The income statement is truncated at earnings before interest and income tax (EBIT). The two financial statements in Figure 6.1 are telescoped into a few lines. In this chapter we don’t need all the details that are actually reported in these two financial statements. (See Figure 4.2 for the full format of a balance sheet and Figure 4.1 for a typical format of an external income statement.)

To support its $18.5 million annual sales, the business used $11.5 million total assets. Operating liabilities provided $1.5

million of its assets. In Figure 6.1 the company’s operating liabilities are deducted from its total assets to get a very important figure
—capital invested in assets.
The business had to raise $10 million in capital from debt and owners’ equity. The business borrows money on the basis of short-term and long-term notes payable. The business built up its owners’ equity
Balance Sheet

Income Statement

Assets used in making profit

$11,500,000

Sales revenue

$18,500,000

Operating liabilities

All operating

(accounts payable and

expenses

($16,700,000)

accrued expenses payable) ($ 1,500,000)

Earnings before

Capital invested in assets

$10,000,000

interest and income

Debt and equity sources of

tax expenses (EBIT)

$ 1,800,000

capital

$10,000,000

FIGURE 6.1
Condensed financial statements.

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from money invested by shareowners plus the cumulative amount of retained earnings over the years (undistributed net income year after year).

Once Again Quickly: Assets

and Operating Liabilities

Chapter 5 explains that a business that sells products on credit needs four main assets in making profit: cash, accounts receivable, inventories, and long-lived resources such as land, buildings, machinery, and equipment that are referred to as
fixed assets
(or, more formally, as
property, plant, and equipment
). The chapter goes into the characteristics of each asset, explaining how sales revenue and expenses are connected with these assets. Chapter 5 also explains how expenses drive the
operating liabilities
of a business. In the process of making profit a business generates certain short-term, non-interest-bearing operating liabilities that are inseparable from its profit-making transactions. These payables of a business are called
spontaneous
liabilities because operating activities, not borrowing money, causes them. Operating liabilities are deducted from total assets to determine the amount of capital that has been raised by a business.

CAPITAL STRUCTURE OF BUSINESS

The capital a business needs for investing in its assets comes from two basic sources:
debt
and
equity.
Managers must convince lenders to loan money to the company and convince sources of equity capital to invest their money in the company.

Both debt and equity sources demand to be compensated for the use of their capital. Interest is paid on debt and reported in the income statement as an expense, which like all expenses is deducted from sales revenue to determine bottom-line net income. In contrast, no charge or deduction for using equity capital is reported in the income statement.

Rather, net income is reported as the reward or payoff on equity capital. In other words, profit is defined from the shareowners point of view, not from the total capital point of view. Interest is treated not as a division of profit to one of the two sources of capital of the business but as an expense, and
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profit is defined to be the residual amount after deducting interest.

Sometimes the owners’ equity of a business is referred to as its
net worth.
The fundamental idea of net worth is this: Net worth = assets − operating liabilities − debt

Net income increases the net worth of a business. The business is better off earning net income, because its net worth increases by the net income amount. Suppose another group of investors stands ready to buy the business for a total price equal to its net worth. This offering price, or market value, of the business increases by the amount of net income. Cash distributions of net income to shareowners decrease the net worth of a business, because cash decreases with no corresponding decrease in the operating liabilities or debt of the business.

The amounts of cash distributions from net income are reported in the statement of cash flows, which is explained in Chapter 2. Dividends are also reported in a separate statement of changes in owners’ equity accounts if this particular schedule is included in a financial report (see Figure 4.4 for an example).

The valuation of a business is not so simple as someone buying the business for an amount equal to its net worth.

Business valuation usually takes into account the net worth reported in its balance sheet, but many other factors play a role in putting a value on a business. The amount a buyer is willing to offer for a business can be considerably higher than the company’s net worth based on the figures reported in the company’s most recent balance sheet. The valuation of a privately owned business is quite a broad topic, which is beyond the scope of this book. Likewise, the valuation of stock shares of publicly owned business corporations is a far-reaching topic beyond the confines of this book.

At its most recent year-end, the business had $10 million invested in assets to carry on its profit-making operations (total assets less its operating liabilities). Suppose that debt has provided $4 million of the total capital invested in assets and owners’ equity has supplied the other $6 million. Collec-tively, the mix of these two capital sources are referred to as the
capitalization
or the
capital structure
of the business. Be
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careful about the term capitalization: Similar terms mean something different. The terms
market capitalization, market
cap,
or
cap
refer to the total market value of a publicly traded corporation, which is equal to the current market price per share of stock times the total number of stock shares outstanding (in the hands of stockholders).

A perpetual question that’s not easy to answer concerns whether a business is using the optimal or best capital structure. Perhaps the business in the example should have carried more debt. Maybe the company could have gotten by on a smaller cash balance, say $500,000 less—which means that $500,000 less capital would have been needed. Perhaps the business should have kept its accounts receivable and inventory balances lower, which would have reduced the need for capital. Every business has to make tough choices regarding debt versus equity, asking shareowners for more money versus retaining earnings, and working with a lean working cash balance versus a larger and more comfortable cash balance.

The answers to these questions are seldom easy and clear cut.

Basic Characteristics of Debt

Debt may be very short term, which generally means six months or less, or it may be long term, which generally means 10 years or longer—or for any period mutually agreed on between the business and its lender. The term
debt
means
interest-bearing
in all cases. Interest rates can be fixed over the life of the debt contract or subject to change, usually at the lender’s option. On short-term debt, interest usually is paid at the end of the loan period. On long-term debt, interest usually is paid monthly or quarterly (sometimes semiannually).

A key feature of debt is whether the principal of the loan (the amount borrowed) is
amortized
over the life of the loan instead of being paid at the end of the loan period. In addition to paying interest, the business (who is the borrower, or debtor) may be required to make payments peri-odically that reduce the principal balance of the debt instead of waiting until the final maturity date to pay off the entire principal amount at one time. For example, a loan may call for equal quarterly amounts over five years. Each quarterly
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payment is calculated to pay interest and to reduce a part of the principal balance so that at the end of the five years the loan principal will be paid off. Alternatively, the business may negotiate a
term
loan. Nothing is paid to reduce the principal balance during the life of a term loan; the entire amount bor-

rowed (the principal) is paid at the maturity date of the loan.

The lender may demand that certain assets of the business be pledged as
collateral.
The lender would be granted the right to take control of the property in the event the business defaults on the loan. Real estate (land and buildings) is the most common type of collateral, and these types of loans are called
mortgages.
Inventory and other assets also serve as col-

lateral on some business loans. Debt instruments such as bonds may have very restrictive
covenants
(conditions) or, conversely, may be quite liberal and nonbinding on the busi-

ness. Some debt is convertible into equity stock shares, though generally this feature is limited to publicly held corporations whose stock shares are actively traded. The debt of a business may be a private loan, or debt securities may be issued to the public at large and be actively traded on a bond market.

Lenders look over the shoulders of the managers of the business. Lenders do not simply say, “Here’s the money and call us if you need more.” A business does not exactly have to bare its soul when applying for a loan, but the lender usually demands a lot of information from the business. If a business TEAMFLY

defaults on a loan (not making an interest payment on time or not being able to pay off the loan at maturity), the terms of the loan give the lender legally enforceable options that in the extreme could force the business into bankruptcy. If a busi-

ness does not comply fully with the terms and provisions of its loans, it is more or less at the mercy of its lenders, which could cause serious disruptions or even force the business to terminate its operations.

Basic Characteristics of Equity

One person may operate a business as the sole proprietor and provide all the equity capital of the business. A
sole propri-