This is the third of four articles on Making Money. Making Money Part One: Don’t Let Work Get in the Way argued that ‘Cost of Goods Sold’ activities should come first. Making Money Part Two: Net Profit described ways to use income statements to make more money. This article will explore how you can use your balance statement to make more money.
Israeli physicist and business guru Eliyahu M. Goldratt is our guiding author for this series. He defined the goal of making money as follows: “This is the goal: To make money by increasing net profit, while simultaneously increasing return on investment, and simultaneously increasing cash flow.”
Return on Investment
Calculating return on investment is one of, if not the primary, purpose of the balance sheet. Every manager receives (or should be receiving) regular balance sheets. Most managers understand how to read a balance sheet, but fewer understand how a balance sheet can be deceptive. Return on Investment is measured in the equity category, but the equity total is directly affected by all other line items.
Balance Sheets are a weight scale, tallying on the left side all things owned (assets) and tallying on the right side who owns them (liabilities and equity). Balance sheets are also organized top to bottom, with current assets above fixed assets, current liabilities above long term liabilities, and long term liabilities above equity ownership. In addition to recognizing the total mirrored in Total Assets and Total Liabilities and Equity, a quick glance at a balance sheet should include recognition of the following.
- Total Current Assets
- Total Current Liabilities
- Net Fixed Assets
- Total Long-Term Debt
- Total Equity
Balance sheets may have less leeway for deception than income statements, but both assets and liabilities can be misstated. A good rule of thumb is that risk of deception increases with longevity. While current assets can be misstated through either error or fraudulence only, fixed assets can be more easily misstated. The difference between current and long term is even more severe with liabilities. Current liabilities are difficult to misstate, but long term liabilities are easily misrepresented. An error in any of these categories create errors in the Total Equity line.
The rest of this article identifies potential deception in Current Assets, Fixed Assets, and Long Term Liabilities.
Current assets include Cash, Marketable Securities, Accounts Receivable, and Inventory. While cash deception means theft and fraud, the same is not always true of the others.
Marketable securities are generally short-term, high-quality securities like Treasury bills and certificates of deposit (CDs). As long as that is the case, marketable securities are difficult to misstate. Be wary of any balance sheet that includes lower grade securities. Deception in this area would be unusual, but inclusion of even moderately risky securities (or worse junk bonds) as a marketable security should be cause for alarm.
Accounts receivable consists of 30 to 60 day rolling debt offered to clients. Of course, the value of that debt is only as good as the clients. A company has great leeway in deciding when to accept delayed payment from its clients, and lower standards are associated with lower collection of payment. Accounting principles require that management make a good faith estimate of the percentage debt that will remain uncollected using a contra-asset account. Good faith estimates can be deceptive both when they lack good faith and when they lack good estimation.
Inventory management can be complex, and deception can be difficult to avoid. Problems can include spoilage, shrinkage (theft), or even salability. Inventory that cannot be sold should be marked down, but that may not always show up on the balance sheet.
Problems with fixed assets are more severe for three reasons. First, fixed assets are generally more expensive so deceptive errors are more costly. Second, valuation of fixed assets is more difficult and arbitrary giving more leeway for error. Third, asset requirements vary widely across sectors and industries, limiting the effectiveness of standardization.
Since we’re unable to consider each industry individually, we’ll use three perspectives to consider the problem of asset valuation. We talk about them in terms of depreciation. At very minimum, understanding of a balance sheet requires knowing which depreciation method is used.
Valuation of assets begins with recognition of what the asset cost us to buy. The problem with this is that the original purchase price may be entirely meaningless, even for an asset in perfect condition. The original purchase cost may have been a great deal, understating the balance sheet value of the asset. The original purchase may also have been a bad deal, overstating the balance sheet value of the asset.
More significantly, the replacement cost of the asset may have gone up or down. If that is the case, what we originally paid for the asset means nothing. Related to replacement cost is resale value. If an asset is resalable, then its liquidation value is real. If an asset is not resalable, then its liquidation value may even be negative if we have to hire someone to throw it away. This is called straight-line depreciation, in which the attempt is estimation of salvage value.
Even when appropriate, this valuation method is complicated, qualitative, subjective, and arbitrary. Trusting balance sheet numbers without understanding the process used in the valuation process may easily be misleading.
If managers assume an asset will not be salvaged, sold, replaced, or change in value, then the current value of an asset can be estimated using declining-balance depreciation. In the declining-balance method, the purchase price of an asset is decreased by a percentage each year. Since assets are most useful when they are new, the percentage per year may not be even. Knowing that a balance sheet is built using declining-balance is not enough; it is also necessary to know the percentage per year.
It is important to remember that in this method, consideration of salvage, resale, and replacement have been entirely abandoned. If and when one of those becomes necessary, the change will not be predicted by the balance sheet. Awareness of the context in which the balance sheet exists is essential and cannot be replaced.
The most important dimension of an asset is also the most difficult to analyze. Any businessperson quickly learns that an asset is only as valuable as the revenue it will generate. Correct understanding of an asset depends on correct understanding of the entire business, including market trends, the competition, employment, operations, product development, and managerial effectiveness.
The most important lesson from assets is that understanding of the underlying business is essential to understanding a balance sheet.
Long Term Liabilities
Long term liabilities can seem as straightforward as current liabilities, but there are at least three problems that make that untrue. First, creative financial vehicles can blur the line between debt and equity. Second, accounting rules can keep some liabilities off the balance sheet entirely. Third, variable-rate liabilities may be dangerously fluid.
Where understanding assets requires comprehension of the business, understanding long term liabilities requires comprehension of financial products.
Creative Financial Vehicles
Long term liabilities usually have custom-created agreements, and those agreements can include legal requirements that are not at all represented in a balance sheet. Convertible Notes innately obscure the balance sheet, as their option to convert to equity can dilute shareholder value. Bank Covenants can do the same. Any financial vehicle can include a creative term that affects the balance sheet, but few of those terms will be quantitatively represented in the summary.
Leases of plants, equipment, and materials show up correctly in the balance sheet as long as they are leased under the terms of a capital lease. However, anything leased under the terms of an operating lease can be excluded from the balance sheet. Adding the operating lease into the long term liabilities is necessary to avoid deception.
Variable Interest Rate
Simple but important, long term liabilities are frequently negotiated with variable interest. Tomorrow’s balance sheet can be drastically different from today’s balance sheet when interest rates shift.
Financial analysis is the science and art of using data to maximize earnings, especially accounting data. Assisting you in making more money by helping you avoid lying to yourself is what we do best. You don’t need a full time CFO. You just need us. We are your part-time, outsourced CFO.
Look for Part Four on Statement of Cash Flows.