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 accounting equation defines the balance sheet:
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 $50.
Owner’s equity is positioned on the right side of the ledger because it reflects value that can be drawn out of the company. Think of it this way. An owner (or a shareholder) can happily keep their money invested in the company. But, on some date, they may decide that they have another use for the funds. When this occurs, the firm will need to convert some assets to pay off that owner or shareholder.
So, a firm’s value is always expressed by the balance sheet, where assets = liabilities and owner’s equity. Here is a sample balance sheet, though it doesn’t have a right-side/left-side orientation. However, you will see that assets do equal liabilities + owner’s equity:
ZYX Retailers Balance Sheet, December 31, 2019
|Current Assets||Current Liabilities|
|Cash||$ 10,900||Accounts Payable||$ 38,500|
|Accounts Receivable||$ 40,200||Wages Payable||$ 8,800|
|Inventory||$ 98,000||Short-term Notes Payable||$ 1,100|
|Prepaid Expenses||$ 2,000||Total Current Liabilities||$ 48,400|
|Total Current Assets||$151,100|
|Fixed Assets||Long-term Liabilities|
|Buildings||$180,000||Long-term Notes Payable||$ 25,000|
|Equipment||$201,000||Total Long-term Liabilities||$ 25,000|
|Total Fixed Assets||$381,000|
|TOTAL ASSETS ($151,100 + $381,000)||$532,100||TOTAL LIABILITIES ($48,400 + $25,000)||$ 73,400|
|Total Stockholders’ Equity||$ 98,700|
|TOTAL LIABILITIES & OWNERS’ EQUITY||$532,100|
- Define asset, liability, and net worth
- Analyze the asset turnover rate
- Calculate a return on assets (ROA) for a sample retailer
- Use key ratios to inform decisions
Assets and 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.