Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina. He recently wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. Check out both the physical book and the Kindle version and feel free to contact Greg at Greg at ControlYourCash dot com.
Last month the folks at Money Under 30 graciously allowed me a few kilobytes in which to explain how income statements work, punctuated by the softest of softcore images. Some diligent readers even made it to the end of the post. For them, here’s Part II in a cross-blog trilogy. If you’re joining late, don’t worry. You should be able to jump right in and follow. I’ve included cute animal pictures to break the monotony.
The balance sheet is the second of the three major financial statements. The first one, the income statement, tells you how much money a company took in and how big a profit it generated. The balance sheet tells you the size of the company, measured by taking its assets and subtracting its liabilities. The difference is called shareholders’ equity and is as helpful a measure as any of the worth of a company.
You don’t have to be Oracle or Bristol-Myers Squibb to have a balance sheet. This works on the micro level, too. Your net worth is your own assets minus your own liabilities. It’s one reason why our mantra at Control Your Cash, repeated until people cry for some respite from hearing it, is buy assets, sell liabilities. Do that often enough and you’ll get rich in spite of yourself.
The word asset has a favorable connotation, but you can’t look only at the positives without giving the negatives comparable attention. With a balance sheet, you don’t. Hence the equal mention of liabilities. Tim Couch won 22 games as an NFL quarterback. Good for him, but he also lost 37.
If you buy up everything in sight – other companies, discounted factories, raw materials to make whatever it is your company makes, you’ll grow your assets and theoretically be halfway to increasing the size of your company. If you borrow and mortgage your future to get your hands on those assets, you’ll increase your liabilities, too. Net gain to your balance sheet, nil.
This is a killer example of how true wealth can differ radically from apparent wealth. We’re all familiar with the stereotype of the bon vivant with the ostentatious car, indulgent house and impressive array of passport stamps; the person whose corresponding 12% dealer financing, interest-only mortgage and 5-digit American Express bill are slightly less visible.
There’s nowhere to hide those last items on a balance sheet. If your company turns a profit, it’s reflected in your shareholders’ equity. If the assets are yours, as opposed to yours with some help from the credit department, ditto.
One big difference between the income statement and the balance sheet is the length of time each one refers to. Obviously, knowing income doesn’t tell you much unless you associate it with a particular period. Convention dictates that we use a year or, less frequently, a quarter.
A balance sheet doesn’t operate under the same restraints. We’re not measuring what came in and went out, we’re measuring what’s on hand as we speak. At any given picosecond, Company X is going to have a certain amount of assets it owns, and a certain amount of liabilities it owes. A minute later those numbers can change, but the concept of instantaneous shareholder’s equity will be as valid then as it was before. It makes sense to say that an income statement refers to the period January 1 – December 31, but that wouldn’t make any sense for a balance sheet. Instead we’d say that a particular balance sheet was effective on December 31.
We used Microsoft for our income statement example, so we might as well use them again for the balance sheet:
Current assets are cash (the most current asset you can have) and its equivalents. What’s an equivalent? Well, if your company makes enough money and thus has enough cash lying around, it doesn’t make sense to just stick it in a drawer somewhere. Instead, the company will spend it on certificates of deposit, maybe government bonds. It’ll earn tiny interest, but if the principal is big enough the return can buy bagels for the break room or covered parking for the executives.
Accounts Receivable is money coming in – stuff the company is owed for but hasn’t gotten yet. That’s not unusual. Most companies, if their orders are big enough, expect 30, 60, 90, maybe 120 days to get paid.
Inventories, as you might imagine, refers to goods the company has possession of but hasn’t yet sold. A company like Home Depot* has plenty of inventories, mostly as a result of its market category: a lumber warehouse without any unsold lumber on the premises couldn’t stay in business long. But Microsoft’s products are easy and fast to replicate. Inventory of this year’s Office Suite wouldn’t take up much space, thus Microsoft inventory numbers are low.
That’s it for current assets, mostly. Other assets include property and equipment, which is hopefully self-explanatory. Equity, in the case of Microsoft’s asset column, means investments in other companies’ stock. Goodwill could use a post unto itself, but it’s the difference between what another company’s assets were valued at and what Microsoft paid for them. (Microsoft would have overpaid to avoid losing out to someone else on those assets.) Intangibles are copyrights, patents etc.
Now on to liabilities, again divided among current and other. But first, a puppy and kitten.
Current means it’ll be resolved, ideally, within a year. Accounts payable is the mirror image of accounts receivable, money the company owes for services rendered or goods received and that’s due either immediately or within 30, 60, 90 or 120 days. Short-term (and later on the balance sheet, long-term) debt is money the company borrowed, while accrued compensation is just salaries and benefits owed to contracted employees. Unearned revenue refers to stuff that the company has been paid for but hasn’t yet delivered (as an independent businessman, I assure you that this is the smallest entry on my personal balance sheet.) Securities lending payable is a rare category that only Microsoft and a few other companies use: it refers to Microsoft borrowing stocks and bonds from other companies. (Tax laws treat this more favorably than they do a straight loan of cash.)
Finally, commitments and contingencies are debts the company owes and money set aside for debts the company might owe, respectively. Microsoft was the plaintiff in one of the biggest lawsuits in history in the late 90s, and who knows? There might again come a time when people become too dumb to change out the browser that comes with their operating system.
Subtract liabilities from assets, and we get shareholder’s equity. It’s the total of the company’s stock, plus its paid-in capital (which is stock sold to investors directly from the company, rather than in the stock market.) It also includes retained deficit, which is the losses the company suffered and didn’t distribute to its shareholders – a piece of minutiae you don’t need to concern yourself with.
Today’s homework assignment? Figure out your own assets and liabilities. No one reading this post will bother to, of course, but if you do you’ll know your net worth. And be in a far better position to further increase those assets while reducing the liabilities.
*We’re not going to call it The Home Depot when there are 2000 of them.