In Understanding the balance sheet Parts 1 and 2, Buffettpedia told starters that:
(a) Assets = Liabilities + Equity
(b) Alternatively: Assets – Liabilities = Equity
Then we went on to say assets are what a company owns, liabilities are what it owes and equity comes from shareholders.
After that we broke down assets into current assets and non-current assets; and liabilities into currrent liabilities and non-current liabilities.
Buffettpedia further gave the following examples:
Examples of current assets: (a) cash and equivalents and short-term investments (b) accounts receivable (c) inventories.
Examples of non-current assets: (a) property, plant and equipment (b) investments (c) intangible assets.
Examples of current liabilities: (a) accounts payable (b) short-term borrowings.
Examples of non-current liabilities: long-term debt, such as bonds and bank loans.
Examples of equity: (a) money raised from the issue of new shares (b) retained earnings
Understanding the balance sheet (Part 3) in today’s post examines the components of the abovementioned examples to understand what they are:
(a) Cash and equivalents and short-term investments: Cash itself needs no explanation. The cash equivalents refer to money market funds or anyting that can be easily liquated and turned into cash. Examples of short-term investments are bonds that have less than a year to maturity.
(b) Accounts receivable: This is money owed to the company resulting from a sale and which the firm is expecting to receive payment soon. Let’s illustrate. When a company makes a sale and ships the goods ordered, it records the amount of sale as revenue in its profit and loss statement (more about profit and loss statement in subsequent postings) . Let’s say the order is $2 million. The recorded revenue is $2 million. But the sale does not mean that the company now has $2 million in cash in its hands. The company may allow the customer to pay the money within 60 days. So until the bill is collected, the amount of $2 million remains an accounts receivable. There is a potential red flag here: if the accounts receivable is growing much faster than the firm’s sales, it may mean the company is more easy going on credit terms for customers in order to boost its revenue. The risk of payment default is higher in such a case.
(c) Inventories: raw materials, partiall finished products and finished products.
(d) Property, plant and equipment: land,buildings, factories, furniture, equipment and the like. These are long-term assets that a firm needs to run a business.
(e) Intangible assets: normally refers to goodwill. How does this come about? Let’s say firm ABC is acquiring full control of XYZ. The tangible value of XYZ is say $80m. But because XYZ is well-known as a brand, ABC is prepared to pay above the tangile value. Let’s say ABC pays $130m to acquire XYZ. The difference between $130m and $80m is the intangible assets – known as goodwill in this case – of $50m.
(f) Accounts payable: This is the reverse of accounts receivable. Accounts payable are bills the firm owes others and are expected to be paid up within a year. Let’s say the firm buys $20,000 worth of raw materials and the supplier gives the firm a credit period of 60 days to pay up. This bill of $20,000 will be recorded as accounts payable.
(g) Short-term borrowings: A firm may have short-term needs and borrow money with repayment expected to be made within a year. The borrowing could be in the form of a bank overdraft. Short-term borrowings could be a portion of a long-term debt that is due for repayment within a year.
(h) Long-term debts: this is money the firm owes and where repayment is expected after at least one year. The debt can be in the form of bonds issued by the company or it can be long-term borrowing from banks.
