Talk

Balance sheets

Overview of basic balance sheet terminology:

Revenue: Quite simply the inflow of money into a company

Expenses:
Cost of Sales/Cost of goods sold: represents the cost of creating the revenue. For a company that manufactures bread this will include the cost of wheat, yeast, labor, electricity, etc (all the raw materials and labor needed to produce the product). For a software company the cost of CD/documentation production is minimal compared to the cost of the software. However companies that employ professional services personnel to deploy the software include the cost of the personnel in the cost of goods/cost of sales entry. (note: software companies do not include the cost of developing the software. That will come later).

Gross Profit: This is the difference between revenue and cost of goods. Quite simply put this is the number you get by subtracting the cost of producing the good from the revenues. For our bread company most of the expenses are included in the cost of goods, but for our software company the cost of goods is minimal.

Selling, General and Administrative Expenses (SG&A). Also known as Operating Expenses. This includes all the expenses involved in the running of a business. This number sometimes includes Research and Development and Marketing Expenses. For our bread company this will include the secretarial and administrative expenses. The R&D entry will include the financial effort exerted in developing new types of bread.

Depreciation and Amortization: When a business buys a resource it intends to use over a period of time it does not include its expense entirely in the period it execute the purchase. For example if the bread company buys a warehouse for $2 million it will not include the cost of the warehouse in regular expense since it intends to use the warehouse for say 20 years. It will instead amortize the cost of the warehouse as $100K every year.

Non-recurring charges/gains: A one-time action will trigger a non-recurring charge sometime. For example if a company laid off employees in a quarter then the cost of their severance packages etc will figure in the one-time charge. Sometimes companies include this number in their operating expense (SG&A).

Interest Income/expense: can be the interest the company pays to service its debt. It can also be income earned from cash in hand.

Taxes: the tax liability of the company.

Net Income: The profits after all expenses have been paid out. In the case of most companies these days its negative ... sigh.

Preferred Dividends: Companies also issue different types of stocks. Preferred stocks get their dividend at a higher rate than common stock holders (usually they dont have voting rights either).

EPS: diluted vs basic. After reporting the number of shares outstanding in a company the diluted number of shares are also reported. For example software companies issue a lot of stock options. These options are not shares themselves but have the option of being converted to shares (after vesting etc). The diluted number of shares includes the number of options outstanding. The basic EPS (earnings per share) is simply the earnings / number of shares. The diluted EPS performs the calculation on the diluted number of shares and is hence lower. The diluted EPS is a good reflection of the cost of stock options.

More information:

The most essential equation in Accounting is

Assets - Liabilities = Equity

A company uses financial leverage to finance its operation. For example to increase its sales (assuming the demand exists) our bread company might desire to build a new factory. It might not possess the capital to make such an expansion. It uses financial leverage (takes on more liabilites) to make the capital commitment today. Financial leverage is:

Assets/Equity

Current Assets: are defined as those likely to be converted into cash and consumed in the next business cycle (usually defined to be one year). Current Assets include:

1. Cash. Money in the bank.
2. Marketable securities. Any investments etc that a company might have its money in for the short term.
3. Current Accounts Receivable. This is the money a company expects to receive from its customers (via collection). Usually it's a given that all the accounts receivable will be collected but this might not necessarily be the case. For example phone companies have a number of their's go to collection agencies. In that case they are unlikely to achieve full collection.
4. Inventories. Simplicistically this refers to the products manufactured but not yet sold. But can include raw materials on hand to manufacture. If a company has high inventories levels then it implies that a large percentage of its assets are locked till the goods can be sold. Another problem with large inventories is that they have to be cleared. For the bread company the inventory will rot and be useless. Retailers like the Gap have to mark down inventory and move it out in order to make room for new arrivals.

Non Current Assets:

1. Property, plant and equipment are examples. Depreciation is used to cover the lower value of equipment over time.
2. Intangible. The most notorious intangible is good will. This is the euphemism used to make accountable the extra money paid for an acquisition. For example if our bread company were to buy a pastry company as part of its acquisition and made 500K over the asking price of 1million then a goodwill of 500K has to be included into the account books.

Liabilities:

Current Liabilities: Similar to Current Assets these are the bills the company expects to pay during the following business cycle. If a business borrows money then short term debt is part of this entry. Current Accounts payable are the monies owed by this company to its suppliers. Our bread company needs to pay the wheat supplier.

Non Current Liabilities are the monies the company owes over a longer period of time.

Cash Flow Statements:

The cash flow statement is a new requirement for companies submitting their balance sheets to the SEC (since 1988). Cash flow statements are on 3 areas:

Cash flow from Operating Activities:

Net Income (Revenues - cost of sales) is calculated as discussed above
Depreciation and Amortization: Since this is a non-cash charge (i.e. this was paid off in a previous time period and does not affect the cash flow for this period it is removed from consideration) and is added. Deferred taxes are also added. Inventory/Account Receivable. When either of these two go up it implies that a company's cash is tied up in a warehouse (in the case of inventories) or in collections (in the case of accounts receivable). Both of these cases results in a lower cash flow for a company. One time charges are added back to the cash flow statement.

Net Cash from Operating Activities (or operating cash flow) is the sum/subtraction of the entries above.

Cash flow from Investing Activities:
This includes capital expenditures made by the company. In the case of our bread company it is buying a plant etc.

Investment Proceeds: the returns from any investment activities of a company. During the dot-com boom companies like Dell, Microsoft invested in start-ups with their extra cash.

Purchases or spin-offs. Costs associated with these activities are factored in.

Cash flow from Financing activities:

Dividends paid: Any dividends paid out to share holders have to be included
Issuance/re-purchase of stock: When things are going well, and the company believes that the stock price is below what the company is worth, then the company starts re-purchasing shares. This has the effect of increasing the price of the stock (higher demand) and the company increases its value. During growth period the opposite occurs. Companies conduct secondary offerings to increase the amount of free cash they have.
Payment of debt is also included.