Prentice Hall's one-day MBA in finance & accounting (12 page)

69

A S S E T S A N D S O U R C E S O F C A P I T A L

• Acquiring and holding products before they are sold to customers causes a business to record
inventories.

• The costs of some operating expenses are paid before the cost is recorded as an expense, which causes a business to record
prepaid expenses.

• Investments in long-term operating resources, called
property, plant, and equipment
(or, more informally,
fixed
assets
), cause a business to record depreciation expense that is included in operating expenses.

• Inventory purchases on credit cause a business to record
accounts payable.

• Many expenses are recorded before they are paid, which causes a business to record its unpaid expense amounts in either an
accounts payable
account or an
accrued expenses
payable
account. These two payables are called
operating
liabilities.

Accounts Receivable

No dollar amounts (also called
balances
) are shown for the assets and operating liabilities in Figure 5.3. The amounts depend on the policies and practices of the business. The amount of the accounts receivable asset depends on the credit terms offered to the company’s customers, whether most of the customers pay their bills on time, and how many customers are delinquent. For example, assume the business offers its customers one-month credit, which most take, but the company’s actual collection experience is closer to five weeks, on average, because some customers pay late. In this situation the balance of its accounts receivable would be about five weeks of annual sales revenue, or approximately $5 million at the end of the year ($52 million annual sales revenue ×

5/52 = approximately $5 million accounts receivable).

Inventories

The amount of the company’s inventories asset depends on the company’s holding period—the time from acquisition of products until the products are sold and delivered to customers. Suppose that, on average, across all products sold, the business holds products in inventory about 12 weeks. In this
70

B U I L D I N G A B A L A N C E S H E E T

situation the company’s year-end inventory would be about $7.2 million ($31.2 annual cost-of-goods-sold expense ×

12/52 = approximately $7.2 million). At the end of the year, recent acquisitions of inventory had not been paid for because the company buys on credit from the sources of products.

See the line of connection in Figure 5.3 from the inventories asset to accounts payable. Assume, for instance, that about one-third of its ending inventories had not been paid for. As a result, the year-end accounts payable would be about $2.4 million from inventory purchases on credit. The total amount of accounts payable also includes the amount of unpaid expenses of the business at the end of the year for which the business has been billed by its vendors.

Operating Liabilities

For most businesses, a sizable amount of operating expenses recorded during the latter part of a year are not paid by the end of the year. At the end of the year the business has unpaid bills from its utility company for gas and electricity, from its lawyers for work done during recent weeks, from the telephone company, from maintenance and repair vendors, and so on. A business records the amounts it has been billed for (received an invoice for) in the accounts payable operating liability account. A business also has a second and equally important type of operating liability. A business has many expenses that accumulate, or accrue over time, for which it does not receive bills, and to record these “creeping” expenses a business uses a second type of operating liability account that is discussed next.

In my experience, business managers and investors do not appreciate the rather large size of accruals for various operating expenses. Many operating expenses are not on a pay-as-you-go basis. For example, accumulated vacation and sick leave benefits are not paid until the employees actually take their vacations and sick days. At year-end, the company calculates profit-sharing bonuses and other profit-sharing amounts, which are recorded as expense in the period just ended, even though they will not be paid until some time later. Product warranty and guarantee costs should be accrued and charged to expense so that these follow-up costs are recognized in the
71

A S S E T S A N D S O U R C E S O F C A P I T A L

same year that sales revenue is recorded—to get a correct matching of sales revenue and expenses to measure profit. In summary, a surprising number of expense accruals are recorded.

Expense accruals are recorded in a separate account, labeled
accrued expenses payable
in Figure 5.3, because they are quite different than accounts payable. For one thing, an account payable is based on an actual invoice received by the vendor, whereas accruals have no such hard copy that serves as evidence of the liability. Accruals depend much more on good faith estimates of the accountants and others making these calculations. Suppose the business in the example knows from experience that the balance of this operating liability tends to be about five weeks of its annual total operating expenses.

This ratio of accrued expenses payable to annual operating expenses is based on the types of accruals that the company records, such as accrued vacation and sick pay for employees, accrued property taxes, accrued warranty and guarantee costs on products, and so on. The five weeks reflects the average time between when these expenses are recorded and when they are actually paid, which can be quite a long time for some items but rather short for others. Thus, the year-end balance of the company’s accrued expenses payable liability account is about $1.6 million ($16.9 million annual operating expenses × 5/52 = approximately $1.6 million).

Prepaid Expenses, Fixed Assets,

and Depreciation Expense

Chapter 2 explains the accrual basis of profit accounting and cash flow from profit. One key point to keep in mind in comparing profit and cash flow is that a business has to prepay some of its operating expenses. I won’t repeat that discussion here; I’ll simply piggyback on the discussion and point out that a business has an asset account called
prepaid expenses,
which holds the prepaid cost amounts that have not been charged off to expense by the end of the year. Usually, the amount of the prepaid expenses asset account is relatively small—although, if the ending balance were large compared with a company’s annual operating expenses, this strange
72

B U I L D I N G A B A L A N C E S H E E T

state of affairs definitely should be investigated. A business manager should notice an unusually large balance in the prepaid expenses and demand an explanation.

One of the operating expenses of a business is depreciation.

This is a very unique expense, especially from the cash flow point of view (as Chapter 2 discusses at some length). I do not separate depreciation expense in Figure 5.3, although I do show a line of connection from the company’s fixed assets account (property, plant, and equipment) to operating expenses. As I explain in Chapter 2, the original cost of fixed assets is spread over the years of their use according to an allocation method.

What about Cash?

A business has one other asset not shown in Figure 5.3 or mentioned so far—cash. Every business needs a working cash balance. Recall that in the example the company’s annual sales revenue is $52 million, or $1 million per week on average. But the actual cash collections in a given week could be considerably less or much more than the $1 million average.

A business can’t live hand to mouth and wait for actual cash collections to arrive before it writes checks. Employees have to be paid on time, of course, and a business can’t ask its creditors to wait for payment until it collects enough money from its customers.

In short, a business maintains a minimum cash balance as a safety buffer. Many businesses keep rather large cash balances, part of which usually is invested in safe, short-term marketable debt securities on which the business earns interest income. The average cash balance of a business relative to its annual sales revenue may be very low or fairly high. Cash balance policies vary widely from business to business. If I had to guess the cash balance of the business in the example, I would put it at around two or three weeks of annual sales revenue, or about $2 to $3 million. But I wouldn’t be surprised if its cash balance were outside this range.

There’s no doubt that every business needs to keep enough cash in its checking account (or on hand in currency and coin for cash-based businesses such as grocery stores and gambling casinos). But precisely how much? Every business manager
73

A S S E T S A N D S O U R C E S O F C A P I T A L

would worry if cash were too low to meet the next payroll.

Some liabilities can be put off for days or even weeks, but employees have to be paid on time. Beyond a minimum, rock-

bottom cash balance amount to meet the payroll and to pro-

vide at least a bare-bones margin of safety, it is not clear how much additional cash balance a business should carry, just as some people may have only $5 or $10 in walking-around money and others could reach in their wallet and pull out $500.

Unnecessary excess cash balances should be avoided. Excess cash is an unproductive asset that doesn’t pay its way toward meeting the company’s cost of capital (i.e., the interest on debt capital and the net income that should be earned on equity capital). For another thing, excess cash balances can cause managers to become lax in controlling expenses. Money in the bank, waiting only for a check to be written, is often an incentive to make unnecessary expenditures, not scrutinizing them as closely as needed. Also, excess cash balances can lead to greater opportunities for fraud and embezzlement.

Yet having a large cash balance is a tremendous advantage in some situations. The business may be able to drive a hard bargain with a major vendor by paying cash up front rather than asking for the normal credit terms. There are many such reasons for holding a cash balance over and above what’s really needed to meet payroll and to provide for a TEAMFLY

safety buffer for the normal lags and leads in the cash receipts and cash disbursements of the company. Frankly, if this were my business I would want at least a three weeks’

cash balance.

An executive of a leading company said he kept the com-

pany’s cash balance “lean and mean” to keep its managers on their toes. There’s probably a lot of truth in this. But if too much time and effort goes into managing day-to-day cash flow, then the more important strategic factors may not be managed well.

Figure 5.3 does not present a complete picture of the com-

pany’s financial condition. Cash is missing, as just discussed, and the sources of the company’s capital are not shown. It’s time to fill in the remaining pieces of the statement of finan-

cial condition of the business, otherwise known as the
balance
sheet.

74

Team-Fly®

B U I L D I N G A B A L A N C E S H E E T

BALANCE SHEET TETHERED WITH INCOME

STATEMENT

Figure 5.4 presents the income statement and balance sheet (statement of financial condition) for the business example.

The income statement includes interest expense, income tax expense, and net income (which are discussed earlier in the chapter). The balance sheet includes the sources of capital that the business has tapped to invest in its assets—interest-bearing debt and owners’ equity. The balance sheet is presented according to the discussion earlier in the chapter. In particular, note that the total amount of operating liabilities (the sum of accounts payable and accrued expenses payable) is deducted from total assets to determine the capital invested in assets.

Note:
Amounts are in millions of dollars.

Income Statement

Balance Sheet

Assets

Cash

$ 3.0

Accounts receivable

$ 5.0

Inventories

$ 7.2

Prepaid expenses

$ 1.0

Property, plant, and

Sales revenue

$52.0

equipment

$17.5

Cost-of-goods-sold expense

$31.2

Accumulated depreciation ($ 7.7) $ 9.8

Gross margin

$20.8

Total assets

$26.0

Operating expenses

$16.9

Earnings before interest

Operating Liabilities

and income tax

$ 3.9

Interest expense

$ 0.6

Accounts payable

$ 3.4

Earnings before income tax $ 3.3

Accrued expenses payable $ 1.6

$ 5.0

Income tax expense

$ 1.1

Capital invested in assets

$21.0

Net income

$ 2.2

Sources of Capital

Interest-bearing debt

$ 7.5

Owners’ equity

$13.5

Total sources of capital

$21.0

FIGURE 5.4
Balance sheet and income statement.

75

A S S E T S A N D S O U R C E S O F C A P I T A L

Figure 5.4 displays lines of connection, or tether lines, from sales revenue and expenses in the income statement to their corresponding assets and operating liabilities in the balance sheet. These lines are not actually shown in financial reports, of course. I include them in Figure 5.4 to stress that the profit-making activities of a business drive a good part of its balance sheet. Also, you might note the line from net income to owners’ equity; net income increases the owners’ equity. All or part of annual net income may be distributed in cash to its shareowners, which is recorded as a decrease in the business’s owners’ equity.

s

END POINT

A business needs assets to make profit. Therefore a business must raise capital for the money to invest in its assets. The seed capital comes from shareowners; they may invest additional money in the business from time to time after the business gets off the ground. Most businesses borrow money on the basis of interest-bearing debt instruments such as notes payable. Profitable businesses retain part or all of their annual earnings to supplement the money invested in the business by their shareowners.