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302-The Balance Sheet
  Course 302:
  The Balance Sheet
  Now that you have a good idea of how profits are recorded on the income
  statement, let's adjust those green eyeshades, insert that pocket protector,
  and move on to the balance sheet. As mentioned in Lesson 107, the balance
  sheet--also known as the "statement of financial condition"--tells investors
  how much a company owns (its assets), how much it owes (its liabilities), and
  the difference between the two (its equity) at a specific point in time. Thus,
  you can think of the balance sheet as a snapshot of what a company is
  worth--according to accounting rules--on a given day.
  
  Although we're going to keep it fairly simple, this lesson will provide more
  details on the key sections of a company's balance sheet and may get a little
  technical at times. However, we think it will be well worth the time and
  effort needed to plow through it. So take a deep breath and let's dig in.
  
  
  Assets, Liabilities, and Equity--It All Equals Out
  One of the most important things to understand about the balance sheet is that
  it must always balance. Total assets will always equal total liabilities plus
  total equity. Thus, if a company's assets increase from one period to the
  next, you know for sure that the company's liabilities and equity increased by
  the same amount.
  
  Let's now take a deeper look at the various sections of the balance sheet.
  Although there are potentially many more specific line items that we could
  cover, we're going to stick with the most common, and in our opinion, the most
  important sections that investors should be aware of.
  
  
  Current Assets
  Assets are generally defined as things a company owns, which are expected to
  provide future benefits. There are two main types of assets: current assets
  and noncurrent assets. Within these two categories, there are numerous
  subcategories, or line items.

  
  Current assets are things a business owns that are likely to be used up or
  converted into cash within one business cycle--usually defined as one year.
  The most common line items in this category are cash and cash equivalents,
  short-term investments, accounts receivable, inventories, and other various
  current assets.
  
  Cash and Cash Equivalents. This line item doesn't necessarily refer to actual
  bills sitting in a cash register or vault. Generally, cash is held in
  low-risk, highly liquid investments such as money market funds. These holdings
  can be liquidated quickly with little or no price risk. This is considered
  money that can be used for any purpose the company wants.
  
  Short-Term Investments. This represents money invested in bonds or other
  securities that have less than one year to maturity and earn a higher rate of
  return than cash. These investments may take a little more effort to sell, but
  in most cases, investors can lump them with cash to figure out how much money
  a firm has on hand to meet its immediate needs.
  
  Accounts Receivable. Think of receivables as bills that a company sends its
  customers for goods or services it has provided but for which the customer has
  not yet paid but is expected to pay within the next year. In other words,
  these are sales (recorded on the income statement) that haven't been paid for
  yet with cash. Generally, accounts receivable are shown as a net amount of
  what a company expects to ultimately collect, because some customers are
  likely not to pay. The amount of receivables a company thinks it won't collect
  is typically known as an allowance for doubtful accounts. Not only do
  additions to the allowance for doubtful accounts decrease the amount of
  accounts receivable, but they also increase a company's expenses--known as bad
  debt expense.
  
  Keep an eye on accounts receivable in relation to a company's sales. If
  accounts receivable are growing much faster than sales, it generally means a
  company isn't doing an ideal job collecting the money it is owed. This could
  potentially be a sign of trouble because the company may be offering looser
  credit terms to increase its sales, but it may have difficulty ultimately
  collecting the cash it's owed. Conversely, if accounts receivable are growing
  much slower than sales, the firm's credit terms may be too stringent, at the
  expense of sales.
  
  Inventories. There are many different types of inventories, including raw
  materials, partially finished products, and finished products that are waiting
  to be sold. This line item is especially important to watch in manufacturing
  and retail firms, which are saddled with large amounts of physical inventory.
  
  The value of inventories shown on a company's balance sheet should be taken
  with a grain of salt because of the way inventories are accounted for. Similar
  to accounts receivable, changes in inventories are generally related to a
  company's sales, or more specifically, the gross profit--sales price minus the
  cost of the inventory sold--it makes from each sale. If inventory levels are
  growing much faster than a company's sales, it may be making or buying more
  goods than it can sell. That may force the company to lower its prices, which
  results in lower profits for each item sold and lower profitability for the
  company. In some cases, it may have to reduce prices to levels below the value
  of the inventory itself, resulting in losses.
  
  Additionally, inventories tie up capital. The cash that was used to create
  inventory can't be used for anything else until it's sold. Thus, another
  important thing for investors to monitor is how fast a company is able to sell
  its inventory.
  
  Other Current Assets. While there are too many to list here, this category
  includes any other assets the firm may have that are expected to turn into
  cash within the next year. However, some current assets will not turn into
  cash, the most common of which are known as prepaid expenses (yes, even though
  it's called prepaid expenses, it's actually an asset). For example, say
  Harley-Davidson HDI buys and pays up-front for an insurance policy for the
  coming year. Accounting rules say the company should record the entire payment
  as a prepaid expense (asset) as opposed to a normal expense on the income
  statement because it represents something of future worth to the company--a
  full year's worth of insurance coverage. As the year goes on, the value of the
  asset will decrease--less time remaining on the policy--and the amount of the
  decrease is recorded as an expense, a process known as amortization. Keep in
  mind that a company's prepaid expenses--which belong to a broader category
  known as capitalized costs--represent cash that was paid up-front and will
  turn into expenses instead of cash within the next year.
  
  
  Noncurrent Assets
  Noncurrent assets are cleverly defined as anything not classified as a current
  asset. The main line items in this section are long-term investments;
  property, plant, and equipment (PP&E); and goodwill and other intangible
  assets.
  
  Long-Term Investments. This is money invested in either bonds with longer
  terms than one year or the stock of other companies. These aren't as liquid as
  cash and short-term investments, and prices may fluctuate, so it's possible
  that the value shown on the balance sheet may be too high or too low. If it's
  a big enough balance, you may want to dig into the details to make sure you're
  comfortable with the kinds of risks the firm is taking with shareholders'
  money.
  
  Property, Plant, and Equipment (PP&E). These assets represent the bricks and
  mortar of a company: land, buildings, factories, furniture, equipment, and so
  forth. The PP&E amount on the balance sheet is typically reported net of
  accumulated depreciation--the total amount of depreciation recorded against
  the assets over their life. Eventually, PP&E has to be replaced, and
  depreciation is a company's best estimate of these "replacement" costs from
  wear and tear. Keep in mind that PP&E is usually not a very accurate measure
  of what a firm's bricks and mortar are really worth. Many times, buildings
  worth millions of dollars are reported at next to nothing in PP&E because of
  accumulated depreciation. Likewise, the actual value of a company's
  land--which is recorded in PP&E at its acquisition price--may be worth
  exponentially more than what is recorded.
  
  Goodwill and Other Intangible Assets. Intangibles are, just as the name
  describes, assets that can't be touched and are generally not going to turn
  into cash. The most common form of intangible assets is goodwill. Goodwill is
  formed when one company buys another and pays more than the target company is
  worth (as defined by the net worth, or equity on the target's balance sheet).
  
  You should view this line item with high levels of skepticism because most
  companies tend to pay too much when making acquisitions. Therefore, the value
  of goodwill that shows up on the balance sheet is often higher than what the
  intangible assets are really worth. Accounting rules require companies to
  value goodwill every year, and if a company lowers the value of the goodwill
  it records--a phenomenon known as impairment--it's a tacit admission that the
  company paid too much for an acquisition it made in the past.
  
  
  Current Liabilities
  Now that we're more familiar with what a company owns, let's move to the other
  side of the balance sheet, what it owes. Similar to assets, there are two main
  categories of liabilities: current liabilities and noncurrent liabilities.
  
  Obligations the firm must pay within a year are known as current liabilities.
  The main line items you should be concerned with in this category are
  short-term debt and accounts payable.
  
  Short-Term Debt. This refers to money the company has borrowed for a term of
  less than one year. It's often in the form of a line of credit that may be
  drawn down at the company's discretion. Typically, the proceeds are used for
  short-term needs. Often, the amount of long-term debt that must be paid back
  within one year is also lumped into this line item. The amount of short-term
  borrowings is an important figure, especially if a company is in financial
  distress or pays a high dividend, because the entire amount must be paid back
  relatively quickly, leaving little wiggle room.
  
  Accounts Payable. Accounts payable represents bills the company owes for goods
  or services it hasn't paid for yet. It is the opposite of accounts receivable,
  and generally speaking, investors like to see the opposite trends for the two
  line items. For example, with receivables, we'd prefer a company to collect
  what it's owed as soon as possible. However, if a company can postpone paying
  what it owes for a longer period of time--without getting in trouble--it will
  hold on to its cash for a longer period of time, a plus for cash flow.
  
  
  Noncurrent Liabilities
  Noncurrent liabilities are the flip side of noncurrent assets. These
  liabilities represent money the company owes one year or more in the future.
  Although you'll see a variety of line items in this category, the most
  important one by far is long-term debt.
  
  Long-Term Debt. This represents money the company has borrowed, typically by
  issuing bonds, that doesn't need to be paid back for several years. Too much
  long-term debt is generally risky for a company, because the interest on debt
  must be repaid no matter how the business is doing. Determining how much debt
  is too much is very firm-specific and depends on many things including the
  interest rate a company pays on its debt, and the stability of the firm's
  earnings and cash flows. One good way to determine if a company can afford the
  interest payments on its debt is to see how many times the firm's operating
  income--otherwise known as income before interest and taxes (EBIT)--will cover
  its interest expenses (interest coverage ratio).
  
  
  Equity
  As we mentioned earlier in this lesson, equity is equal to total assets minus
  total liabilities. It represents the part of the company that is owned by
  shareholders; thus, it's commonly referred to as shareholders' equity. It is
  also referred to as net assets, or net worth. Although there are several line
  items within equity, the two main categories investors should focus on are
  retained earnings and treasury stock.
  
  Retained Earnings. This line item represents the total profits the company has
  earned since it began, minus whatever has been paid to shareholders as
  dividends. Because this is a cumulative number, if a company has lost money
  over time, retained earnings can be negative and would be renamed "accumulated
  deficit."
  
  Treasury Stock. This line item shows how much of its own stock a company has
  repurchased. Because repurchasing stock is analogous to paying dividends to
  investors--and in some cases can be even more desirable--investors should take
  note of changes in this account to see how much stock a company is
  repurchasing from one period to the next.
  
  
  The Bottom Line
  You can exhale because you've made it through our tour of the balance sheet.
  Although we've admittedly left out plenty of specifics, you should know enough
  now about the income statement and balance sheet to be dangerous.
  
  In the next lesson we'll move forward to what's arguably the most important
  financial statement of all, the statement of cash flows.