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The balance sheet doesn’t get enough respect. Let’s talk about what it is to start off. The balance sheet is like a net worth statement. It lists all your assets, identifies your liabilities, which you can think of as money owed to others, and whatever is left over is the value of the owner’s interest in the business, or what you might think of as net worth. It’s called a balance sheet because it balances. Assets reported MUST equal liabilities plus equity. This is accomplished through the feat of double-entry bookkeeping. An Italian monk came up with this system, which if you have business degree and had to endure first year accounting, you may recall is premised on debits and credits. There is no such thing as a one sided journal entry. You will often think something should be recorded as a revenue or an expense or as an asset or a liability, but that is only one side of the entry. There has to be other accounts on either on the income statement or balance sheet that offset. Many an entrepreneur has picked up a spreadsheet and projected how much they are going to make by forecasting revenues and expenses. However, what they often miss is the sources of cash and what will the balance sheet look like along the way. That is the learning objective of the next few lessons. In this lesson, we are going to look at the asset side of the balance sheet.
You may hear someone talking about such and such company has a strong or a weak balance sheet. But what exactly do they mean by this? A strong balance sheet is one with lots of “good” assets and low amounts of “bad” debt. A good asset is one that is cash or can be readily converted to cash fairly easily. So for instance, amounts due from customers, finished goods inventory, capital assets like real estate and equipment, marketable securities like stocks and bonds –these are all good types of assets that can be sold for cash or can be pledged to a lender as security to obtain a loan at a relatively low interest rate. Because these assets can be converted to cash easily, that’s the characteristics that primarily drives an asset’s “goodness.”
So if those are good assets, what are the “bad” assets. Bad assets are those that aren’t readily convertible to cash. For example, raw materials are often a bad asset because raw materials alone aren’t readily financeable and need to be converted into a finished good before they can be sold. Intangible assets like customer lists and goodwill are equally difficult to liquidate and only have value as long as the business is making money. When a business stops making money, these sorts of assets are worthless. Investments in private companies, sometimes referred to as associates, are hard to liquidate or sell because they don’t have an ready market or an objective value.
Goodwill deserves special mention because most users of financial information tend to ignore goodwill, mostly out of a lack of understanding of what it represents. Let me tell you what it is and how it originates. Goodwill on a balance sheet can only arise in one way, that is when one business acquires another business and pays more than what the underlying assets acquired are worth. So if in this case, we bought $128 of assets, and we could attribute $118 to specific assets acquired (working capital, capital assets and the like), the leftover $10 gets allocated to goodwill.
You might wonder why a company would pay more than what the underlying assets acquired are worth? Well, they do this because the cash generating potential of the business acquired is greater than the composite value of the individual assets. In essence, the value of the business with all these assets is worth more than the sum of its parts. That in essence represents the value of goodwill –the excess cash generating potential of assets acquired. You might wonder what the opposite of goodwill is. That would be a situation where you acquire assets that individually have more value than the amount you paid. This is a called a bargain purchase. That difference between what you paid and the value of the assets acquired, gets recognized as a gain on the income statement.
Internal goodwill or inherent goodwill represents the excess cash generating potential of your business. If your business is successful, it’s likely that your business is worth more than the value of the assets recorded on the balance sheet. However, internally generated goodwill is never recorded on the balance sheet. Accountants are only going to allow you to record assets on the balance sheet that result from an arm’s length transaction, such as the acquisition of a business from an independent third party. So in practice, you need to get used to identifying the quality of the assets that a company shows on the balance sheet and making some mental math adjustments to determine the value of the “good” assets.
You will notice that I’ve divided the assets into two sections. At the top we have current assets, current in the sense that they either are cash or convertible to cash within one year. The section below that is reserved for capital assets or assets that have extended economic lives beyond one year. Current assets are most often composed of what we call “working capital.” Working capital is the investment required to offer customers credit, raw materials to meet production requirements, and finished goods inventory to meet customer demand. The working capital investment consumes cash! This is very important to keep in mind. So many companies ignore this distinction between cash and working capital. As a result, poorly managed companies carry excessive inventories and are less diligent in managing their customer receivables. When you are carrying more working capital, you are trading this off against carrying more cash.
If you don’t have cash, this is when companies will often negotiate a line of credit with their bank using their working capital assets as collateral to give them cash. There is nothing wrong with this, but realize that a line of credit comes with a cost. Working capital assets are typically valued at their book value or the transactional value. The cost to produce or procure inventory or the value of a sale in the case of a receivable from a customer, represent the transactional value. However, if there are investments in marketable securities like bonds or shares –these are typically valued at their fair market value or the amount you can sell these assets into a liquid market like a stock exchange.
The other category of assets are capital assets. These are the investment in long lived assets which might be property, plant and equipment or intangible assets like patents, formulations, and goodwill. Just like working capital, these assets require cash to acquire. Generally speaking, capital assets get initially recorded at the cost to acquire these assets. However, unlike working capital assets, capital assets are regularly adjusted downward for the passage of time through those depreciation and amortization charges we discussed in the lesson on the income statement. So, if you have a capital asset that the business acquired for $100 and that asset was believed to have an economic life of 10 years, you would depreciate that assets by $10 a year. That $10 gets reported as an expense on the income statement and here, on the balance sheet, you see the value of that asset being reduced by $10 each year. So, at the end of the current year, the net book value of the capital asset is now $90. Test your understanding. Is the $10 depreciation charge on the income statement a cash or a non-cash expense? Yes, it’s a non-cash expense. The whole $100 was set up as a capital asset at the date of acquisition on the balance sheet.
Thereafter, it’s an accounting entry to reduce that asset through depreciation, which if you follow it all the way through, will reduce your equity on the balance sheet. Next question…does the value of the capital asset you see on the balance sheet represent the value of the asset if you were to go sell that asset today? Very rarely is the answer. The net book value is an accounting value, which is a notional number that balances the books. So often, you will need additional information to assess the true value of the capital assets of a business. This information might be from a market appraisal for instance. We will teach you the basics of business valuation in our crash course on corporate finance principles.
Businesses are continuously investing in capital assets. As you are thinking about these sorts of capital investments, bear in mind there are two types of capital expenditures or “capex” to think about. Maintenance capex is capital spending required to sustain your existing operating capacity. Say you need to replace the roof or replace a vehicle in the fleet. There is no incremental return to the business by making this type of capital investment. However, these types of expenditures happen all the time, often when our existing assets capital assets, or some major component thereon, reach the end of their useful lives. A new roof will last another 25 years, so it get recapitalized to the balance sheet and depreciated over this period.
On the other hand, growth capex is spending on new projects that are expected to yield a return. For example to purchase a new piece of equipment with more capacity, more efficient operating costs, or opening up new branches. These are the good types of capital expenditures because they should in theory grow either sales or reduce costs thereby improving the bottom line. My favorite types of businesses are those that require low levels of working capital and maintenance capex. Weak businesses have just the opposite, high levels of working capital and high amounts of maintenance capex. So that’s the asset side of the story, in our next lesson, we will teach you about the liability side of the balance sheet.69
In this lesson, we are going to discuss the liability side of the balance sheet. Think of liabilities as amounts owed to others and most often are used to finance the asset side of the balance sheet or the operating expenditures on the income statement. So, where can you get the money to pay for the bills of the business?First of all –suppliers. The advantage of supplier credit is that it’s free credit. You often get 30 days, sometimes longer without any financing cost from the supplier who provides you the goods or the services without paying cash up front. Credit cards are interest free sources of financing provided the business pays the balance by the date allowed. If the business misses that payment or only pays the minimum amount, note that all purchases will accrue interest at often extremely high interest rates of 20-30%. Do not finance any business with credit cards.
By securing payment terms with a supplier, you reduce the amount of financing required. The business also saves on interest costs. But to get suppliers to provide the business credit, the business will often be asked to fill out a credit application and provide references. One credit terms are established with a supplier, the business makes the payments to suppliers at the last possible moment under the terms. However, it’s common practice for businesses to even pay beyond that date. This is a practice known as stretching payables. It would be nice if everyone paid according to the credit terms, but as you know from your own customers, stretching payments is common practice in today’s business world. 71
Few entrepreneurs think of the strategic importance of how they treat the financial aspects of their supplier relationships. Stretching payments should only be done in situations where it doesn’t impact the relationship or out of necessity. Sometimes when dealing with large companies, there isn’t a personal relationship at stake which allows the business to stretch payments. For key suppliers of strategic importance, treating them well and sticking to the terms of the agreement is important. It makes them more responsive to your needs. It fosters a relationship of cooperation. We have one partner that we work with to deliver webinars and they have a practice of paying us within a couple of minutes of submitting an invoice to us. We are happy to go the extra mile for this partner because they pay attention to details like that. This is a practice that we’ve adopted as well with those special suppliers. The downside of abusing supplier relationships is they reduce your credit limit or cut you off altogether. When this happens, you get a double whammy –you lose the credit and you end up often paying for goods and services even before they are delivered, which is even more detrimental to your cash flow.
Many vendors will provide customers with 15 to 60 days of credit without any interest charge as a form of sales incentive. Often, your company will do the same. One commonly overlooked opportunity is to negotiate purchase discounts for early payment of invoices. For examples, the terms may be “2/10, net 30,” which means a 2% discount if the invoice is paid within 10 days of receipt, with the balance due in 30 days. While 30 days of free credit is nice, often taking advantage of the discount is financially prudent. Reducing your expenses improves your operating margin by 2% for that expenses. In this case, the return on taking advantage of that particular discount would be almost 38%. Even if you didn’t have the cash on hand to pay early, you might be better off telling management to draw on its line of credit and realize the discount (and pay the interest cost, which will most assuredly be less than 38%), than it is to utilize the additional 20 days of free credit provided by the supplier.
Let’s break up the liability and side of the balance sheet a little further along the lines we did the asset side. Liabilities can be broken out between current and long term. Current liabilities are those due within one year, whereas long term are those that extend longer than one year. Current liabilities include supplier payables as discussed, but you will also notice the word “accruals” or more precisely “accrued liabilities.” An accrued liability is a liability that is an estimate of an amount owing, but is not yet payable. So for example, we may have received a raw material from a supplier, but the supplier has yet to send the business an invoice for the delivery. Or perhaps employees are paid every second week and the month end straddles a pay period. In this case, we estimate the wages earned in the month and set up an accrued liability for this amount. This enables the matching principle we discussed back on the income statement.
Now, let’s talk about debt because that is money borrowed from banks or lender. When we used debt, we are using other people’s money to fund the business. Many people hold one of two beliefs when it comes to debt. 1. The first belief is that debt is evil and show be avoided at all costs. We’ve seen those news stories of banks foreclosing on houses and businesses forced to close because they couldn’t pay back the lender for the money borrowed. This is a very real possibility when debt is mismanaged, so for some entrepreneurs, like myself, I tend to avoid debt.2. The opposite belief held is that with interest rates so low, it’s like free money and should be borrowed as much as possible. The rationale when managers borrow cash is that they can accelerate growth of the business using the borrowed funds. They can invest in assets, acquire competitors, hire more people, accelerate sales and marketing campaigns faster than they would had the been constrained by the amount of equity made available by the owners. Both ends of the spectrum are flawed. The right answer is that using a safe level of debt is an integral part of managing the business.
The more money you can use from other people, the less money you have to use from the shareholder or parent company. This is called “financial leverage.” Adding a safe amount of debt is, generally speaking, an acceptable and prudent way to improve the return of shareholders, though on the surface, you might not recognize it. The additional interest costs the business will pay on borrowed money will cause lower net earnings. However, when you flip over and compare that against the smaller amount of equity investment by the shareholder, this results in a higher return on investment for the shareholder in percentage (return) terms. Leverage accomplishes just that, increasing returns by using debt. This sounds good in theory, but in practice, it’s more complicated than just adding more debt. So, let us tell you how you should think about debt in your role.
First of all, you need to consider the costs of setting up and carrying debt on the balance sheet. The obvious cost is the interest rate and associated repayments required. When you have good assets available to offer as security, as we learned in previous lesson, the interest cost can be very affordable –say from 2-7%. If you were the shareholder, would you expect a 2% return on your investment? Absolutely not, because shareholders hold a residual interest in the business. A residual interest means that if anything goes wrong and the company is liquidated, the shareholder always gets paid last and thus takes on more risk than lenders. When the business lack good assets or the business doesn’t generate consistent levels of earnings, taking on more debt is riskier and more difficult to do. In these situations, if the business is able to access debt at all, it will see debt instruments such as second mortgages or unsecured debentures. The interest cost for lower quality debt instruments will be significantly higher –typically 10-18%.
Finally, the interest cost is but just one cost of using debt in a business. Issuance costs to set up loans can be significant and include advisor fees, lawyers, commitment fees, stand by fees on any utilized portions of the credit facility, administrative fees, monitoring fees, appraisals, among others. So make sure you understand the full cost of debt before agreeing to it. A general rule of thumb is that issuance costs run 2.5% of the proceeds raised. But, I’ve seen situations where the interest rate doubled because of some of the hidden costs of financing, so don’t just fixate on the interest rate. It’s but one component.
As noted, the dark side of debt is that if the business fails to meet the terms of the credit facility in any way, then it gives the lender an option to take control of your business by calling the loan. Credit facilities and loans are always governed by a credit agreement. Inside a credit agreement there are covenants that the business must maintain. A positive covenant is something the business promises to do –for example to provide regular financial statements. A negative covenant is something that the business promises to NOT do –for example to allow the debt to EBITDA to exceed say 3:1. Any time a covenant is violated, it gives the lender certain rights. Those rights range from triggering a cure period, a timeline during which the business must cure the deficiency, to an outright demand for the repayment in full of the loan. The latter is what ultimately leads to headlines of foreclosure, receiverships, and bankruptcies.
So getting back to our initial assessment of the balance sheet, how do you evaluate financial leverage? In other words, how do you know when there is too much debt? Generally speaking, you want to see a nice healthy balance of equity. Equity is a like a sponge, it absorbs negative surprises when they happen. When you compare the amount of debt relative to the amount of equity, you don’t want to see a large ratio here. For example, in the first column, we compared debt to equity and see only a 12% ratio. We included the amounts payable to suppliers which arguably you might exclude. The only way you could lose control of this business is if you didn’t pay your suppliers and your suppliers petitioned the courts putting you into receivership. In the second column, you see that we introduced some debt. Our total debt to equity ratio is now 117%. This many seem like a big jump, but it really depends on the nature of the business. A business that is very stable, say a nursing home, where earnings and cash flows are very predictable may be able to sustain a debt to equity ratio of 3:1 or more. However, a business that is highly cyclical and generates unpredictable cash flows, can withstand far less debt, so this ratio should be much lower.
Keep in mind why we use debt in financing a business. Debt is always cheaper than equity. When you use debt, you aren’t using equity to capitalize the business, that’s the OPM –other people’s money leverage effect. When the business does well, you can grow the business and the returns faster than had no debt been used. However, when a business fails to be profitable, debt can get the company into trouble if it is unable to service the debt payments. I once had a fellow director that described this phenomena of debt leverage as the pillow and the sword. Debt being an instrument of leverage, it represents the sword that can cut both ways. Whereas, equity is that spongy pillow I spoke of that can absorb financial under performance. So the question you have to ask yourself as an executive or director is which do you prefer to sleep with each night when you go to bed –the pillow or the sword? If you’ve ever been in an overleveraged situation in your life, you know exactly what I’m talking about. You can lose a lot of sleep.
In our last lesson, we mentioned the shareholder holds the residual interest, which is the riskiest position to hold in any company. In this lesson, we are going to talk about understanding equity. Equity represents the “permanent capital” of the business. Using a little bit of algebra, Assets minus Liabilities equals Equity, this is your so called residual interest.
The equity for an incorporated company is comprised of:
1. Common stock, preferred stock, or capital stock –the amount of money invested by the owners.
2. Retained earnings –which is the accumulation of earnings less dividends since the inception of the business. In other words, you take all the net incomes earned and subtract all the dividends withdrawn and that gives you the balance of retained earnings. If this balance is negative, then we call this a deficit.
Retained earnings is how the income statement flushes its way through the balance sheet. Non-profit businesses are a little different and often don’t have capital stock. A non-profit will also refer to retained earnings as either a surplus or deficit.
So to summarize how you think of the movement of equity accounts remember that equity is the value of amounts contributed by owners, less the value of amounts withdrawn by owners plus/minus the net income earned by the business Equals the balance of shareholders’ equity. Note that this is just a mathematical representation of the accounting value of the residual interest and it should equal Assets –Liabilities if you’ve followed double entry bookkeeping.
But does this “accounting value” of equity represent the true financial value of the owner’s interest in the business? Think about that for a moment. In most cases, the answer is a resounding “No.” If the business is to be sold or there is a question around the value of the shares for the next capital raise, you will need to get a better indication of what this equity is truly worth.
For a company that is listed on a stock exchange, the value of equity is easy to determine. You can go online anytime, type in the company’s ticker symbol (short hand way to identify the company) to any one of hundreds of websites and get a stock quote like the one presented here for our steel fabrication company. In the left hand column, we have the trading statistics for the shares of the company. For this company, the last trade for one share of the company was done at $16/share. In the right hand column, you see the “market cap,” which is short for market capitalization. This is the total market value of shareholders’ equity. There is your answer. The sum of capital stock plus retained earnings is worth the market capitalization amount. The market cap may be higher or lower than the book value or the accounting of the equity accounts reported on the balance sheet.
Your next question may logically be, what if the business is not listed and there is no market cap readily available. How do you value it then?
The real answer for you is to consult a professional. Business valuators are used for all sorts of purposes that relate to any situation where you need to value either an asset or the equity of the business. Business valuators may be appraisers, investment bankers, or Chartered Business Valuators, which can be very expensive. But let me give you the crash course in business valuation so that you can at least have a conversation with them or you can do some quick and dirty analysis of your own.
The value of any business interest is the GREATER of the value for which assets can be sold and liabilities liquidated OR the value of the sale of the business as a going concern –in other words as a viable business. The larger of the two numbers gives you VALUE OF EQUITY.
The asset’s market value may differ from the accounting book value for any variety of reasons –for example –real estate may have appreciated in value. This would be an unrecorded asset on the books. Going the other way, if the company is in distress, often selling off intangibles and goodwill is nearly impossible, so these may get subtracted from the value of the owners’ residual interest.
The easiest way to determine the market value of equity is to review each line of the balance sheet and adjust to an estimate of what you think each asset and liability is worth if sold off individually. The sum of these adjustments gets added or subtracted from the book value of equity to arrive at the fair value of equity. I’m leaving taxes aside, that’s a refining point that is best left to the finance staff to figure out.
The going concern value looks at how much income the business is generating, both currently and expected in the future. This income stream gets valued based on what it’s worth to a potential buyer. Using this approach to valuing a business, think of the business like a bond, you invest ‘x’ dollars to receive ‘y’ interest every year the bond is outstanding. In essence, equity is worth the stream of cash flow attributed to it in the future. Valuators will use a variety of techniques but they all attempt to triangulate on the same number. The simplest for you to understand and apply is the EBITDA multiple. We talked about EBITDA and multiples back in the analysis of the income statement. EBITDA is a proxy for operating cash flow. Different industries have different rules of thumb. So for instance, say that your industry has a rule of thumb that a business in your industry can be bought and sold for an average multiple of 8x EBITDA. If you know your EBITDA, you know the value of your business. As shown here, EBITDA of $19 x 8 multiple gives you a total value of $152. Note that this is the total value of the assets of the business, so to calculate the equity value, remember your accounting equation.
Assets less Liabilities = Equity. When the going concern value is greater than the asset value, this is the market value of shareholder’s equity. When the asset value is greater, then this is the market value of shareholder’s equity.
If the going concern value is in excess of the value calculated using the asset approach, this would be an indication of inherent goodwill. Remember our discussion on goodwill and what it represents? It represents the excess cash flow generating potential of the business. So, now you are ready to negotiate your next acquisition or divesture using those simple rules of thumb. You can get the finance guys and the lawyers to tighten up the deals afterwards.
Now that you have a much better understanding of debt and equity, let’s talk financing strategy for a moment before we finish up our discussion of the right side of the balance sheet. Most businesses need capital to exist. The exceptions are few. In fact, unless you can convince your customers to pay you upfront for your goods or services before you build them, procure them, or deliver them, then your business needs capital.
Let’s look at all the various potential uses of capital:
1. Capital can be used to fund ongoing operations: I’ve never met an employee who doesn’t like to get paidand suppliers are of similar ilk.
2. Capital can be used to fund capital expenditures to build and maintain plant and equipment.
3. Capital is required for Mergers & Acquisitions: M&A activities allow a company to purchase incremental or adjacent businesses to accelerate growth.
The first three uses tend to be obvious. If I poll a classroom of participants, everyone tends to come up with those three. But the next four tend to be less obvious, can you think of other uses of capital?
4. Capital can be used to fund working capital, everything from purchasing raw materials, assembling finished goods, and selling goods to customers on credit as an incentive to purchase. This might seem obvious, but in practice, I’ve come across countless business cases that have neglected to consider the required investment in working capital.
5. Capital can be replaced in refinancing opportunities: The idea here is to replace higher cost sources of capital with lower cost sources of capital.
6. Recapitalizing the business to facilitate a transfe
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