Understanding the Balance Sheet

Understanding the Balance Sheet




The purpose of the balance sheet. The balance sheet’s purpose is to provide a detailed listing of the company’s assets and limitations. It is not unlike a personal credit report. If you think about your own financial net worth, you probably have a number of assets such as a home, a means, a stock portfolio, cash in a savings account, and so forth. You also likely have a list of limitations or debts, such as a mortgage, a car loan, electric or telephone bills that have not however been paid, etc. This concept is directly similar to a company, and the balance sheet lists out all of these.

Like the income statement, an investor needs to be aware of the possible accounting assumptions made for the balance sheet. clearly, some line items are unambiguous. For example, the worth of cash in the bank is a pretty straightforward value. However, the worth of a 5 year old computer, or an undeveloped piece of land, are less concrete. For most of these kinds of items, a company will book their value at in any case was paid for it. While items that depreciate, like computers, are usually de-valued over a period of time, that piece of land will likely appreciate over time, and the current value may not be reflected on the balance sheet. This can make the company more valuable than it appears (some value investors refer to these as “asset plays”).

For financial companies, a ton of assumptions are made on the balance sheet. The actual value of a loan is very difficult to calculate due to variable interest rates, risk of default, risk of early payment, etc. Take that reality and multiply it by the millions of loans a large bank has noticeable, and you begin to see why investing in edges is such a difficult and risky endeavor. However, since the Magic Formula throws out financial stocks, we won’t discuss that in much detail here.

One other thing to be generally aware of is that both assets and limitations are categorized as either “current” or “long-term”. The line items falling into the “current” category are assets that the company expects to be converted into cash within the next 12 months, or limitations that are expected to be paid off over the next 12 months. “Long-term” assets and limitations have a longer time horizon for being liquidated or covered, respectively.

To understand the balance sheet, will continue with our past example, Intel (INTC). Here is it’s year end 2007 balance sheet. All values are in millions of dollars, and items in parenthesis represent limitations. The balance sheet often has line items that are specific to a line of business or a company, so some of these you won’t generally see, while others are pretty shared.

Cash & Equivalents: 7,307

Short-term Investments: 5,490

Total Cash Equivalents: 12,797

Accounts Receivable: 2,576

Inventories: 3,370

Trading Assets: 2,566

Deferred Tax Assets: 1,186

Other Current Assets: 1,390

Total Current Assets: 23,885

character, Plant, Equipment, Net: 16,918

Goodwill: 3,916

Marketable Equity Securities: 987

Other Long-term Investments: 4,398

Other Assets: 5,547

Total Assets: 55,651

Accounts Payable: (2,361)

Accrued Compensation and Benefits: (2,417)

Accrued Advertising: (749)

Deferred Income on Shipments: (625)

Other Accrued limitations: (1,938)

Income Taxes Payable: (339)

Short-term Debt: (142)

Total Current limitations: (8,571)

Long-term Debt: (1,980)

Long-term Income Taxes Payable: (785)

Deferred Tax limitations: (411)

Other Long-term limitations: (1,142)

Total limitations: (12,889)

Total Equity: 42,762

Debt-to-Equity Ratio: 4.96%

Current Ratio: 279%

A fleeting explanation of each line item:

Cash & Equivalents. Just what it sounds like. This is very liquid cash in a bank account, or an investment that can be sold quickly at a known price.

Short-term Investments. Often classified with cash. Examples of these would be a CD or bond with a maturity under 12 months.

Total Cash Equivalents. Simply the above two additional together. For examination purposes, these assets can be liquidated at the stated value at any time.

Accounts Receivable. Amount owed to the company for products, but not however received. An example of this would be when a computer maker like Dell (DELL) buys Intel parts on credit but has not however paid off the balance. Intel is owed this balance, and it is booked here.

Inventories. Value of processors, chipsets, and memory that have been manufactured but not however sold to customers. This is an important number to watch for a company like Intel, because the value of this inventory declines rapidly as newer chips are rolled out.

Trading Assets. This is a line item you don’t generally see. In this case, they represent short-term debt instruments (bonds) that Intel has invested some of it’s cash in to earn a higher return.

Deferred Tax Assets. An accounting unexpected. Remember in the income statement article that we mentioned that tax provisions were an assumption of how much the company would owe in taxes? Often those assumptions turn out to be a bit off, and the company either owes more or less taxes than it set aside. Since these are assets, at some point in the past Intel overestimated it’s tax liability, and is carrying the difference on the balance sheet. This account can be used to make up the difference on the downside in the future (which Intel expects to do, as it’s listed as a current asset to be used in the next 12 months).

Other Current Assets. A catch-all line item. For most companies, you need to go into the footnotes to get the details here. This is especially important if it’s a large value, as all kinds of dirty secrets can be hidden in the “other” line items. For Intel, the bulk of this number (over $1 billion) was due to a pre-payment on a stock buyback authorization, which was neatly offset by a $1 billion accrued liability.

Total Current Assets. All of the above additional together. These are the assets Intel expects to transform to cash within the next 12 months.

character, Plant, Equipment – Net. The value of all of Intel’s factories, administrative buildings, computers, chipmaking equipment, and so on. Sometimes the balance sheet will show an “at-cost” figure and then “accumulated depreciation”. Whenever a company buys equipment, it will set up a depreciation schedule and degrade the value in set intervals. The net figure is “at-cost” minus “accumulated depreciation”.

Goodwill. When a company (acquirer) purchases another company (acquiree), the amount paid over the Total Equity of the acquiree is carried as goodwill on the balance sheet of the acquirer. The idea is that this premium represents the intangible assets and future earnings strength of the acquiree. This is an accounting phantom – this number has no tangible value and is often written down (impaired) if the acquired assets prove not to be as valuable as expected. Since it is essentially a made-up asset, strategies like the Magic Formula disregard it totally and assign it no worth.

Marketable Equity Securities. Some cash high companies like Intel will invest a portion in equities, much like you or I would invest our excess cash in a stock portfolio. Intel holds stock in companies like VMWare (VMW) and Micron (MU), both of whom are part of joint ventures with Intel. It is fairly scarce to see public companies keep up a meaningful amount of equity assets on the open market.

Other Long-term Investments. These represent minority stakes in other companies that were not purchased on the open market. In 2007, this value mainly represented Intel’s minority stake in NOR flash maker Numonyx and WiMAX maker Clearwire.

Other Assets. Another “other” category that you need to dig into the footnotes to understand. For Intel, these include other non-marketable equity investments, derivatives for managing foreign exchange risk, estimated value of intangible assets, and direct investments in joint ventures (IM Flash Technologies with Micron, for example).

Total Assets. The cumulative value of all current and long-term assets.

Accounts Payable. Money that Intel owes to suppliers but has not however paid in cash.

Accrued Compensation and Benefits. This is money Intel owes it’s employees for hours worked, earned but unpaid bonuses, and benefits such as unused paid time off.

Accrued Advertising. Most companies lump their advertising contract obligations in with accounts payable, but Intel has a separate line item specifically for it. This is money the company owes advertising outlets but has not paid off in cash.

Deferred Income on Shipments. This is money that has been paid to Intel by customers, but that Intel has not however shipped. It is carried as a liability to represent the obligation Intel has to truly ship the product that has been paid for! This concept can be applied for any company’s “deferred income” limitations.

Other Accrued limitations. Another catch-all “other” line item. Most of it is the aforementioned prepaid proportion buyback. Hedging portions of the derivative contracts and equity holdings are included here, but there are not many hard details on these in the 10-K (annual SEC filing).

Income Taxes Payable. Estimated tax limitations that Intel will have to pay within the next year.

Short-term Debt. Usually a bank credit line that needs to be paid off in a short amount of time (not unlike a credit card). Many companies also have a “Current Portion of Long-term Debt” line item which reflects how much of their long-term bonds are maturing within the next 12 months.

Total Current limitations. A sum of all the above limitations. These are all due to be paid off in within the next year.

Long-term Debt. The total confront amount of noticeable long-term bonds issued by the company, plus the expected interest due to be paid on them.

Long-term Income Taxes Payable. This differs from deferred tax items in that Intel has already been charged with this amount of tax.

Deferred Tax limitations. See above “Deferred Tax Assets”. The same idea, except for this line item, Intel underestimated the tax they would have to pay.

Other Long-term limitations. however another “other” category! Intel lumps a lot of things in here, mainly uncertain tax limitations and interest payment obligations.

Total limitations. All current and long-term limitations summed up.

Total Equity. Calculated as (Total Assets – Total limitations). This is Intel’s “net worth” – the amount of assets left over for shared shareholders like us after all limitations are paid off. Theoretically, this is the liquidation value of the company.

Debt-to-Equity Ratio. Calculated as ((Short-term Debt + Long-term Debt) / Total Equity). This is a financial health statistic. We don’t want to see a high percentage of debt to equity, because this debt has to be serviced by profits and that takes out our cut as shareholders. In some situations, the debt interest requirements can be higher than profits, or already worse, debt coming due in the next 12 months may not be able to be paid off with cash flow and cash reserves, leading to possible bankruptcy. As a rule of thumb, MagicDiligence looks for a number here less than 70%, although it varies by business. Intel’s is under 5%, so debt burden is not a concern here.

Current Ratio. Calculated as (Current Assets / Current limitations). This is another financial health measure that tests the “liquidity” of a company, or it’s ability to cover it’s short term limitations. The higher the better here. Any number under 100% should be scrutinized, as this could average that the company will not be able to pay it’s limitations in the near term. 125% is a decent number to look for, but riskier companies should be required to have a higher figure (175% or better). Intel’s 279% figure is noticeable.

That was a long one! But the balance sheet is extremely important in calculating how financially sound a company is. It also shows you how much capital the company needs to generate it’s profits, which is basic to calculate return on capital. We’ll discuss both of these in our red and green flag articles that show how to use the information discussed above. In the third part of this series, we will take a look at the cash flow statement.




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