Financial and Business Planning response

Figure 3-1 The Company's Business Cycle

Balance Sheet

The company's balance sheet reflects the company's overall assets and liabilities or, in other words, its financial condition at a given point of time. The balance sheet may be likened to a snapshot of the company's financial condition. It distinguishes among various types of assets and liabilities, such as cash held by the company or in its bank accounts, as opposed to inventories. The balance sheet also reflects the shareholders' equity, namely, the investment in the company made by the shareholders and the profits accumulated in the company (retained earnings). The company's total recorded assets are always equal to the sum of its liabilities plus the shareholders' equity (see Figure 3-2).

According to the reporting principles, the company is required to distinguish between current assets and liabilities which may be liquidated or are due within one year or less, and other assets and liabilities, referred to as long-term assets and liabilities, whose life span is longer than one year. Assets are presented in a declining order of liquidity, i.e., the most liquid assets appear before the less liquid assets. The first assets presented (namely, the most liquid) include cash and traded securities, and the assets presented last are the company's fixed assets, such as industrial equipment and real estate.

It is important to note that the presentation of assets and liabilities in financial statements is guided by the principle of conservativeness: Assets are recorded according to their lowest reasonable value (in other words, they are not likely to be liquidated for less), whereas liabilities are recorded according to their highest reasonable value.

The main assets and liabilities appearing on the balance sheet (see Figure 3-2), are the following:

Assets

• Cash, cash-equivalents and securities— These are the first among the company's current assets. Cash, cash-equivalents, and securities include, except for the cash in the company's bank account, all short-term deposits owned by the company and traded securities, including treasury bills. The guiding principle underlying the classification of these assets is that they entail a relatively low risk in proportion to their value at the time of liquidation, and can be liquidated quickly (usually, within less than three months).

• Accounts Receivable— Since most companies do not receive payment in cash for all of their sales, almost every company that has reached the stage of sales has an Accounts Receivable (or Receivables) item. These are short-term customer debts that the company records on its balance sheet after offsetting allowance for doubtful debts which it does not expect to collect. For example: a company by the name of Speed is owed $1,000 by its customers, but predicts that only $800 will be paid. The company will present in its balance sheet a net amount of $800 under this item, representing the portion of the debts that the company expects to collect. This amount is produced by deducting an allowance of $200 for doubtful debts from the gross debt of $1,000.

• Inventory— Inventories are assets in various stages of production that the company expects to sell as products. Inventories are divided into several types in accordance with their stage along the production process. Companies usually specify the types of inventories they have, since investors attribute a different value to different types of inventories. For instance, in most cases, an inventory of raw materials is easier to liquidate than an inventory of products in progress. A manufacturing company will generally have three types of inventories: an inventory of raw materials, an inventory of goods in process, and an inventory of finished goods. Inventories are estimated according to their cost, not according to the revenue they are expected to produce, unless such revenue is lower than the cost of production (in which case, the principle of conservativeness directs that they be recorded according to their net realizable value). The reporting of inventories in progress, as well as inventories of finished products, usually includes also allocated labor and overhead costs (such as electricity and some of the depreciation of the equipment used to manufacture them).

  When analyzing inventories, it is important to pay attention to the method of recording of the inventories, since a company selling products uses inventories of raw materials and finished products which might be recorded according to different prices. For instance, let us assume that Speed manufactures instruments that it combines with tractors that it purchases. In one month, the company purchased three identical tractors at different prices (according to the order of acquisition): $100,000, $120,000 and $115,000. At the end of the month, the company sold one set of equipment (a tractor on which the company's equipment was assembled) for $200,000. Obviously, the reported financial results reported by Speed will be affected by the choice of the tractor that constitutes a material part of the sold equipment. If the company uses an inventory method called FIFO (First In, First Out), then, assuming that Speed had no prior inventories, it will report an inventory of $235,000. $100,000 (the cost of the first tractor) will be reported as part of the cost of the equipment sold (see the next subsection for a further discussion of revenues and expenses). If the company uses the method of LIFO (Last In, First Out), then the company will report an inventory of $220,000. According to yet another method, the inventory (and the components of the cost of the goods sold) is calculated according to the average cost of the components of the sale. In our case, the inventory at the end of the period will be reported at: (100,000 + 120,000 + 115,000)*(2/3) = 223,333.33.

• Advance payments— Although companies usually try to defer payments, in many cases they pay in advance for services they will receive after the date of the balance sheet. For instance, companies often pay rent for several months in advance. The principle in the statements is to report expenses and revenues at the time of the economic occurrence of their underlying events. In other words, since the services will be received after the date of the statements, the expenses will be recorded concurrently with the receipt of the service. Therefore, the balance sheet will reflect an asset incorporating the cost for which the services or product was not yet received.

• Long-term assets— Assets that are expected to contribute to the production of revenues over a period longer than one year are referred to as long-term assets. They are divided into two main groups: tangible assets and intangible assets (intellectual property). Tangible assets include real estate, office equipment, production equipment, long-term financial assets, and stocks in other companies. These assets are usually recorded according to their historical value, i.e., according to the price of purchase, adjusted for depreciation.

  The term “depreciation” attempts to reflect the devaluation of assets over their economic life span or usage. The periodic depreciation of an asset is part of the expenses reflected in the income statement. There are various methods for calculating depreciation that are deployed in accordance with the character of the assets, the industry, and the company holding the asset. The most widely-used method is that of the “straight line”: First, the asset's economic life span is estimated, and a proportionate part of the cost is recorded every year as an expense. For instance, if a car was bought for $20,000, and its economic life span is five years, then $4,000 are recorded every year as an expense, and the asset is reported on the balance sheet with a value that decreases by such amount every year. Another common method is that of the “accelerated depreciation,” whereby the asset is depreciated more in the first years. This method reflects an accelerated depreciation in the first years of the asset's life. The value of a new car, for instance, is known to decline faster in its first few years.

  There are other depreciation methods, and in many cases the chosen method takes into account the amount of use made of the asset. For instance, consider the case of a factory where one million cars can be manufactured before it needs to be renovated. Obviously, it would be logical to express the depreciation of the factory over time as a function of the number of cars actually manufactured in it.

  Assets appear on the balance sheet according to their historical value, less depreciation and any other devaluation resulting from a decline in their market value below their cost. In fact, the net fixed assets will be equal, at the end of each period, to the net fixed assets at the end of the previous period, plus new fixed assets acquired, minus the net cost of fixed assets sold and minus periodic depreciation and any other reduction in the recorded value of the fixed assets.

  Where the statements of non-American companies are concerned, it is important to understand that in different countries the value of assets may be expressed differently, and in many cases assets may be revalued according to their market value at the time. Fixed assets may be revalued, for instance, in the United Kingdom and in the Netherlands. The principle in these countries is that assets are reflected according to the cost to the company of replacing them. In other words, if the car on Speed's balance sheet (which, for purposes of this example, will be reported according to British rules) is one year old, then, instead of reporting a depreciated value of $16,000 ($20,000 – $4,000), the cost of a similar used car on the market will be checked. If such cost is $21,000, then the car will be recorded in the balance sheet with this value. This change in value will concurrently be reflected under the item of the company's shareholders' equity. In all countries, if the market value of an asset considerably declined below its depreciated cost, and such devaluation is not expected to be remedied, then the value of the asset has to be reduced in the balance sheet by recording a loss as a result of the devaluation of the asset (since such devaluation is in lieu of future depreciation).

  Intangible assets include items such as the cost of acquired patents, trademarks and trade names, franchises, and the cost of investments in other companies above the value of their tangible assets (goodwill). These assets also appear on the balance sheet and are depreciated in accordance with their expected life span, with certain restrictions (in accordance with the accounting rules applicable in each country) with respect to the manner of recording of various assets and liabilities. For example, if Speed bought a license to use a patent that will expire in ten years in consideration for one million dollars, then it will be depreciated over ten years, unless the patent is expected to become worthless after a shorter period of time, or is expected to continue being valuable after it expires.

  Following an accounting rule change, effective from the year 2002, goodwill does not have to be depreciated if its value, as deemed by the company's management, has not declined.