Introduction to Balance Sheets

What you’ll learn to do: Explain how a balance sheet is used to evaluate an asset management path

The balance sheet shows a financial picture of what a business is worth at a particular point in time—usually the end of a month. It is not the same thing as an income statement, which provides a snapshot of a company’s financial performance over a specified period of time. Instead, the balance sheet shows the culmination of financial performance, including how much the company owns (assets), how much the company owes (liabilities), and the value of the firm (owner’s equity or assets – liabilities)

The Balance Sheet

The accounting equation defines the balance sheet:

[latex]\text{assets} = \text{liabilities}+\text{owner's equity}[/latex]

Think of it this way. There are two sides to a ledger, which must remain balanced or completely equal to one another.

On the left side of the ledger are the company’s assets, including cash, accounts receivable (outstanding bills that customers will pay), inventory, facilities, and equipment. These reflect elements of the asset management path, the economic resources owned by a company, such as inventory, buildings, and plant and equipment, in addition to cash and accounts receivables.

On the right side of the edger are the company’s liabilities or things that it owes, encompassing accounts payable (bills it needs to pay for its vendors), wages payable (salaries and benefits that are owed to employees), long-term notes (outstanding loans against which the company is making payments), and more.

These are neither good nor bad; they just are. Because we’re looking at the business at a moment in time, we see activity of the firm. Some of that activity means that they have outstanding liabilities or money they owe creditors. For example, if we looked at the balance sheet on payday, wages payable would be $0.00 because wages had been paid and the next pay period had not yet begun.

But, if this is true, if liabilities and assets can change depending upon the time period, how can we be sure that the left side of the ledger (assets) will always balance with the right side of the ledger (liabilities)? Easy: owners’ equity.

Owner’s equity simply means the value the owners could extract from the company. Think about it this way. If a firm had $100 in assets and $50 in liabilities, what amount could the owners extract from the business if they closed it today? Well, they would use the $100 in assets to cover the $50 in liabilities, leaving $50 in owner’s equity. Then, they’d share the $50 as the proceeds of having managed and run the business.

But, what if part of the liabilities had been $10 of wages payable and they were paid? How would that change the balance sheet? Well, likely this would mean cash, an asset used to pay wages, decreased by $10 and wages payable, a liability, decreased by $10. So, assets would equal $90, liabilities would equal $40 and owner’s equity would still be $50.

Owner’s equity is positioned on the right side of the ledger because it reflects value that can be drawn out of the company. Think of it this way. An owner (or a shareholder) can happily keep their money invested in the company. But, on some date, they may decide that they have another use for the funds. When this occurs, the firm will need to convert some assets to pay off that owner or shareholder.

So, a firm’s value is always expressed by the balance sheet, where assets = liabilities and owner’s equity. Here is a sample balance sheet, though it doesn’t have a right-side/left-side orientation. However, you will see that assets do equal liabilities + owner’s equity:

Assets & Liabilities

As you learned earlier, assets are resources owned by a company that can be expressed in monetary terms. Assets can be categorized as current assets or fixed assets. Current assets are assets owned by a company that will be consumed or converted to cash within one year. These can be:

• Cash: money held in checking or savings account. Also referred to as liquid funds.
• Accounts Receivable: money owed to the business by customers, to be collected in the near future, such as buy now, pay later
• Prepaid Expenses: purchases made by the company, paid in advance, that are assets until they expire or are consumed

Fixed assets, also referred to as plant and equipment, are assets owned by the company that will last longer than one year and are used in the operation of the business, such as buildings, vehicles, land, and machinery.

Liabilities are debts or obligations of the company: money owed to suppliers. Current liabilities are debts or obligations that are due within one year. For instance, accounts payable, which is the amount the company owes to suppliers for items or services purchased, and salaries payable, which are the payroll dollars owed to employees for work performed but not yet paid.

Long-term liabilities are debts or obligations that the company owes but does not have to pay within one year, like mortgage notes payable (the amount the company owes on a building; usually the building is considered collateral).

Owner’s equity, also known as stockholders’ equity, represents the rights or interests of those that have invested in the company. In a corporation it is referred to as shareholders’ equity. Common stock is the amount of initial and subsequent investment of corporation owners by the purchase of shares of stock. Retained earnings are the earnings (profits) that the company is keeping (retaining) in the company.

Net worth is the value of the company. Assets minus liabilities equals net worth.

Asset Turnover Rate

Asset turnover, or turnover rate, is a ratio of how many times during a selling season assets are turned over, or used. In other words, it calculates how many sales dollars are generated for each dollar invested in assets. The formula is revenue / net assets.

Think about how this might apply within a retail context. Imagine you’re the front-end manager at your local supermarket, with responsibilities including the coffee shop and floral department. Looking at the income statement for successive periods, you can see that asset turnover is slowing. You know that your buying has been steady, so this must mean that net sales are being affected.

As you walk the area, you notice that you still have mugs with hearts on them and vases that say “I love you Mom” on display—still at full retail price.  This looks like stuff from Valentine’s and Mother’s Day. Remnant inventory is a concern—if they don’t sell, there will be less money to pay for planned purchases. What can you do to help the situation?

Markdown the slow selling “old merchandise” in order to stimulate sales and move the merchandise. It may not sell very well, but it will sell a lot better than leaving it fully priced. Of course, this can have a slightly negative impact on gross margin, but it will increase sales. Ultimately, this will make it possible to order new merchandise that will stimulate interest and sales. If possible, it might also be possible to work with the vendor to return the unsold, aging merchandise or to share the costs of markdowns.

Return on Assets

One way a firm can reflect its efficiency is return on assets (ROA). ROA refers to how much income is produced by its use of assets. Again, for a retail business, assets are inventory available for sale and the dollars generated by sales. Generally, return on assets is calculated as ROA = net profit / total assets. But, it can also be calculated by multiplying the operating profit margin × asset turnover.

Of course, it’s important to understand that retailers manage their operations to meet their own financial goals. Thus, factors that influence operating profit margin and asset turnover may vary between retailers. For example, consider Daisy Donuts and Jasmine Jewelers, which are neighbors in the same strip mall, but have much different financial goals. As such, they have much different operating profit margin and asset turnover, despite ROAs of 15%.

• Daisy Donuts
  • Asset turnover: 5.0, given donuts are perishable and are priced to sell quickly to avoid spoilage
  • Operating profit margin: 3%.
• Jasmine Jewelers
  • Asset turnover: 1.0, given jewelry is expensive and a considered purchase
  • Operating profit margin: 15%.

As you can see, both outlets have the same ROA, but the components that make up that ROA are vastly different, reflective of each retailer’s financial objectives.

Key Ratios

Additional key ratios important in helping a retailer judge performance and financial well-being include inventory turnover, current ratio, quick ratio, and return on investment.

Inventory turnover is a measure of the productivity of inventory. The formula to calculate inventory turnover is inventory turnover = cost of goods sold / average inventory at cost.

Current ratio is a measure of financial strength, reflecting the firm’s ability to pay short and long-term obligations. The formula considers the company’s current total assets (both liquid and fixed) relative to its current total liabilities. The formula to calculate the current ratio is current ratio = current assets / current liabilities.

Quick ratio is another measure of financial strength. However, inventory is NOT counted among current assets because the quick ratio seeks to describe a firm’s ability to pay short and long-term obligations, but does not regard inventory as sufficiently liquid. Instead, it considers only assets that can be converted to cash within 90 days like cash, cash equivalents, marketable securities like stocks and bonds and accounts receivable. The formula for the quick ratio is quick ratio = (current assets – inventory) / current liabilities.

Return on investment (ROI), also known as return on net worth (RONW), is a performance measure used to assess the efficiency of an investment—how well it generates profit compared to another investment. The formula for ROI is ROI  = net profit / investment cost.

Although we’ve examined them previously, we include both gross margin percentage (gross margin / net sales) and net profit margin (net profit / net sales) here because they, like the others, are part of the strategic profit model.