What is the balance sheet used for? A balance sheet is a snapshot of a business’s financial condition at a specific moment in time. It reflects what a company owns (assets), what it owes to outside parties (liabilities), and what it owes to its owners (owners’ equity). At any point in time, the information in the balance sheet is used to answer questions such as “Is the business in a good position to expand?” or “Does the business have enough cash to ride out an anticipated lull in sales?” In addition, by analyzing how a balance sheet changes over time, financial managers can identify trends and then suggest strategies to manage a company’s accounts receivable and payable in a way that is most beneficial to the firm’s bottom line. Figure 15.13 is a summary balance sheet for Nike, Inc., as of May 2015.10 Summary financial statements present the data in a condensed format without a lot of detailed information.

Figure 15.13

Summary Balance Sheet for Nike, Inc.

What does a balance sheet track? Balance sheets are based on the fundamental accounting equation described previously:

It is important to remember that assets (the items on the left side of the balance sheet) must always equal liabilities plus owners’ equity (the items on the right side of the balance sheet). Liabilities and owners’ equity can also be thought of as claims on the company’s assets. Let’s look at each of the components of the balance sheet in more detail and then see how they all fit together to provide meaningful information.

Assets are the things a company owns, including cash, investments, buildings, furniture, and equipment. On a balance sheet, assets are organized into three categories: current, fixed, and intangible. These categories are listed on the balance sheet in order of their liquidity—the speed at which assets can be turned into cash:

• Current assets are those assets that can be turned into cash within a year. Accounts receivable, inventory, and short-term investments, such as money market accounts, are examples. As you can see in Figure 15.13, as of May 31, 2015, Nike had nearly $16 billion in current assets.

• Fixed assets are assets that have more long-term use, such as real estate, buildings, machinery, and equipment. Often, the value of a fixed asset, such as machinery or equipment, decreases over time because of usage or obsolescence. To compensate for such reduction in value over time, accountants use depreciation to spread out the costs of assets over their useful lives. Depreciation helps keep the accounting equation in balance by matching the expense of the asset with the revenue that asset is expected to generate. As of May 31, 2015, Nike had approximately $5.2 billion in fixed assets.

• Intangible assets do not have physical characteristics (you cannot touch or see them), but they have value nonetheless. Trademarks, patents, and copyrights are examples of intangible assets. So are strong brand recognition and excellent customer or employee relations, which are otherwise known as goodwill. Nike’s goodwill and intangible assets amounted to $412 million.

Liabilities are all debts and obligations owed by a business to outside creditors, suppliers, or other vendors. Liabilities are listed on the balance sheet in the order in which they will come due:

• Short-term liabilities, also known as current liabilities, are obligations a company is responsible for paying within a year or less and are listed first on the right-hand side of the balance sheet. They consist of accounts payable, accrued expenses, and short-term financing. Accounts payable are obligations a company owes to its vendors and creditors. They are similar to those bills you need to pay every month, such as cable fees, credit card payments, and cell phone charges, and other obligations that are paid less frequently, such as your taxes and insurance. Accrued expenses include payroll, commissions, and benefits that have been earned but not paid to employees. Trade credit and commercial paper make up short-term financing. Nike had approximately $6.3 billion in current liabilities.

• Long-term liabilities include debts and obligations owed by a company that are due in more than one year, such as mortgage loans for the purchase of land or buildings, long-term leases on equipment and buildings, and bonds issued for large projects. Nike’s long-term liabilities were approximately $2.5 billion.

Owners’ equity is what is left over after you have accounted for all of your assets and taken away all that you owe. For small businesses, owners’ equity is literally the amount the owners of a business can call their own. Owners’ equity increases as a business grows, assuming the business’s debt has not increased. It is often referred to as the owners’ capital account.

For larger, publicly owned companies, owners’ equity becomes a bit more complicated. Shareholders are the owners of publicly owned companies. Owners’ equity, in this case, is the value of the stock issued as part of the owners’ (shareholders’) investment in the business plus retained earnings, which are the accumulated profits a business has held onto for reinvestment in the company. The owners’ equity (stockholders’ equity) for Nike was approximately $12.7 billion.

What information is important on a balance sheet? A lot of information about a company can be determined by its balance sheet. For example, just looking at the amount of inventory a company keeps on hand can be an indicator of a company’s efficiency. Inventory is the merchandise a business owns but has not sold. Inventory on hand is necessary to satisfy customers’ needs quickly, which makes for good business. However, there are costs associated with keeping inventory, the most obvious being the money spent to purchase the merchandise. In addition to the initial cost, storing unused inventory incurs warehousing costs and ties up money that could be used elsewhere. An even worse situation can arise if the value of unused inventory decreases over time, causing a company to lose money. This is a big concern for companies like Apple, whose inventory consists of computer parts and other technology-related components that can become obsolete quickly. Inventory turnover (how quickly inventory is sold and restocked) varies greatly by industry. Some service-related companies or online businesses, like eBay or Yahoo! Inc., do not carry inventory.

Other important features to watch for on a balance sheet include how efficiently a company handles its current assets and current liabilities and whether a company is carrying too much long-term debt. These indicators will be discussed next.

How can I compare data from two different companies? Although looking at a balance sheet is a good way to determine the overall financial health of a company, the data presented on the balance sheet can be overwhelming and useless to investors if they are not organized. This is why ratio analysis is crucial when analyzing financial statements. A ratio analysis is used to compare current data to data from previous years, competitors’ data, or industry averages. Ratios eliminate the effect of size, so you can reasonably compare a large company’s performance to a smaller company’s performance. There are three main ratios one can use with information from a balance sheet to determine a company’s financial health and liquidity:

• Working capital = $\text{Current Assets}-\text{Current Liabilities}$

• Current ratio = $\text{Current Assets}÷\text{Current Liabilities}$

• Debt-to-equity ratio = $\text{Total Liabilities}÷\text{Owners}\text{'}\text{Equity}$

What measures how financially efficient a company is? One of the most important reasons one looks at a company’s balance sheet is to determine the company’s working capital. Working capital tells you what is left over if a company pays off its short-term liabilities with its short-term assets. It is a measure of a company’s short-term financial fitness as well as its efficiency. The working capital ratio is calculated as follows:

If a company has positive working capital (its current assets are greater than its current liabilities), it is able to pay off its short-term liabilities. If a company has negative working capital (its current assets are less than its current liabilities), it is currently unable to offset its short-term liabilities with its current assets. So, even after adding up all of a company’s cash, collecting all funds from accounts receivable, and selling all inventory, the company would still be unable to pay back its creditors in the short term. When a company’s current liabilities surpass its current assets, many financial difficulties can occur, with bankruptcy being the most severe. It is important to watch for changes in working capital. A decline in working capital over time can indicate that a company’s financial health is in trouble.

It is possible to have positive working capital but still be unable to handle a large, unexpected cash need. This is the situation Arnold Sawyer’s niece’s catering company faced when the company experienced a sudden spike in sales. Arnold did not know how they would get enough money to ramp up production to meet the new demand. A good financial manager and accountant must maintain a balance between having enough cash on hand and keeping it from being idle. Having a lot of cash on hand that is not actively being used is not ideal either because those monies could be used to make more money for the business, pay down its debt, or earn interest in a bank. Because of this, working capital can also be an indicator of a company’s underlying financial efficiency.

What measures whether a company can pay its bills? It is hard to compare a company’s efficiency to the rest of the industry or to its competitors, especially if companies vary significantly in size. The current ratio (sometimes called liquidity ratio) is a measurement used to determine the extent to which a company can meet its current financial obligations. The current ratio is calculated as follows:

Look back at Figure 15.13. Nike’s current ratio $(\text{\$}15,976÷\text{\$}6,334)$ equals 2.5. As an individual measure, the current ratio tells you that Nike had about two and a half as many current assets as current liabilities and could pay off its current liabilities with current assets and still have cash left over. A benchmark for a current ratio is 2:1, meaning that a company should have at least twice as many current assets as it does current liabilities. Having too high of a current ratio indicates a company may not be efficient with its cash; having too low of a current ratio may indicate a company will face potential problems paying back its creditors. What does Nike’s current ratio tell you about the company?

Can a company have too much debt? Another way to analyze the activities of a company is to use the debt-to-equity ratio. By comparing a company’s total liabilities to its total owners’ (or shareholders’) equity, the debt-to-equity ratio indicates the proportion of equity and debt the company is using to finance its assets. It can give you a general idea of a company’s financial leverage. As you may remember from the beginning of this chapter, leverage is borrowing to finance an investment. Although leverage can be beneficial by freeing up cash for additional investments, too much debt can become a problem. Companies with too much long-term debt may end up financially overburdened with interest payments. The debt-to-equity ratio is calculated as follows:

A lower debt-to-equity ratio means that a company is using less leverage and has more equity. A high debt-to-equity ratio usually means that a company has been more aggressive in financing its growth and indicates greater risk because shareholders have less of a claim on the company’s assets.

To get a better idea of how ratio analysis is used as a comparison tool, look at the data in Table 15.3. Although Nike and Under Armour are in the same industry, Nike is much bigger than Under Armour ($21.6 billion total assets compared to $2.8 billion total assets in 2015), so comparing absolute numbers is not effective. But looking at ratios makes the comparison more meaningful. How do you think the balance sheet data of the two companies compare?

Table 15.3

Comparison of Balance Sheet Data*

Ratios can be used to neutralize variances between companies of different sizes within the same industry. When comparing companies in different industries, you need to also consider industry standards. For example, as of February 2016, Target has a debt-to-equity ratio of 96.47. The debt-to-equity ratio for General Motors is 156.51. Looking at the two companies, you might think that Target has a better debt-to-equity ratio than General Motors. However, if you consider the average debt-to-equity ratios for the discount variety store industry (65.8) and the automobile industry (181.6), you have a better perspective. Compared to their industry standards, General Motors actually has a better debt-to-equity ratio than Target.

What information does an income statement show? An income statement reflects the profitability of a company by showing how much money a company takes in versus how much it spends. The difference between the two is the profit (or loss) and is referred to as the net income (or the net loss). The income statement also reveals if a firm is making abnormal or excessive expenditures or experiencing unexpected increases in the cost of the goods it sells or high product returns by customers.

What are the components of an income statement? Recall that the balance sheet relates directly to the fundamental accounting equation: $\text{Assets}-\text{Liabilities}=\text{Owners}\text{'}\text{Equity}$ Similarly, income statements also are based on an equation:

Expenses are generally broken down into cost of goods sold (how much it costs to generate the product being sold) and operating expenses (how much it costs to run the business).

Figure 15.14 shows a summary income statement for Nike. Let’s look at each of these components and then see how they all fit together on an income statement.

Figure 15.14

Summary Income Statement for Nike, Inc.

Revenue is the total income of a business. For some businesses, revenue is generated just from selling goods or performing services. If a company has several different product lines or businesses, the income statement shows each product or division in categories to distinguish how much revenue each generated. Some companies also generate revenue from investments or licensing ­arrangements. For example, Nike and Under Armour each have only one source of revenue: athletic clothing and accessories. Starbucks, on the other hand, generates its revenue from a variety of sources, including its stores, retail sales of packaged coffee and tea to grocers and other stores, and sales to food service organizations.11 As shown in Figure 15.14, Nike’s revenue for 2015 was more than $30.5 billion.

An income statement delineates several categories of expenses. The first category of expenses, cost of goods sold, comprises the expenses a company incurs to manufacture and sell a product, including the price of raw materials used in creating the good along with the labor costs used to produce and sell the items. The cost of goods sold is generally calculated by taking the beginning inventory for the year, adding any purchases to inventory, and then subtracting out the ending inventory.

There are different ways to value inventory (FIFO, LIFO, and average cost), which you’ll most likely learn about in a later accounting course. For now, it is enough know that when you are calculating a firm’s income, you need to deduct what it cost to provide the goods it sold to customers, which is the cost of goods sold. Nike’s cost of goods sold was approximately $16.5 billion.

When you subtract a firm’s cost of goods sold from its revenue, the result is its gross profit (gross margin). Gross profit tells you how much money a company makes just from the sale of its products and how efficiently its managers control the cost of the goods. In addition, analysts use gross profit to calculate one of the most fundamental performance ratios used to compare the profitability of companies: gross profit margin. In service-related companies, generally there is no cost of goods sold, so gross profit could equal net sales or revenue. After deducting the costs of goods sold from its revenues, Nike’s 2015 gross profit was approximately $14 billion.

Operating expenses are the overhead costs incurred when running a business. Operating expenses include sales, general, and administrative expenses, such as rent, salaries, wages, utilities, depreciation, and insurance. The expenses associated with the research and development of new products may also be included operating expenses. In Nike’s case, another expense is the cost of managing the risk associated with changes in foreign currency exchange rates and interest rates.

Unlike the cost of goods sold, operating expenses usually do not vary with sales or production levels and are constant, or “fixed.” Because fixed costs are hard to change in the short run (say, if there is an economic downturn), lenders and investors watch a firm’s operating expenses closely. Managers try to keep their firms’ operating expenses as low as possible but not so low that their businesses are negatively affected. The amount of profit realized from a business’s operations (operating income, or net income before taxes) is determined by subtracting the company’s operating expenses from its gross profit. Nike’s operating expenses totaled nearly $10 billion in 2015.

Is operating income adjusted further? Some people believe that operating income is a more meaningful indicator of profitability than gross profit because it reflects a firm’s ability to control its operating expenses. However, operating income is still not the “bottom line.” Any additional income the firm earns, such as earnings from its investments, must be added to its operating income; any additional expenses, such as interest payments on its outstanding debt, must be subtracted. Finally, taxes paid to local and federal governments must also be subtracted.

What is left over after doing so is the firm’s net income after taxes. It is usually stated on the last line of an income statement, which is why it is often referred to as the firm’s “bottom line.” For publicly owned companies, however, net income may be further adjusted by dividend payments to stockholders, resulting in adjusted net income. Nike’s 2015 adjusted net income was more than $3 billion.

How do I analyze an income statement? Besides looking at how effectively a company controls its expenses or how its profits compare to other firms in its industry, you should look at a firm’s income statement to get a sense of its revenue growth over time. Is the firm consistently experiencing growth or merely an unusual or temporary upward spike? Equally as important are efforts to maintain and control the firm’s expenses but not so much as to hurt its growth. Technology companies, for example, have large research-and-development expenditures, which are crucial to future growth and shouldn’t be cut back. One of the main purposes of the income statement is to report a company’s ability to generate a profit. Companies that are able to generate good profits can reinvest those profits back into the company for future growth or, for a more mature company, share the profits with its shareholders.

A number of ratios specific to the income statement can also be used to put a company’s performance into perspective relative to its industry and competitors. Specifically, the measurements that reveal this information are as follows:

• $\text{Gross profit margin}=(\text{Revenue}-\text{Cost of Goods Sold})÷\text{Revenue}$

• $\text{Operating profit margin}=\left(\text{Gross Profit}-\text{Operating Expenses}\right)÷\text{Revenue}$

• $\text{Earings per share}=\text{Net Income}÷\text{Outstanding Shares}$

Let’s look at each measurement in detail to understand the differences among them and how they are used to analyze a company’s financial health.

How can I determine a company’s overall profitability? A company’s profitability and efficiency can be determined at two levels: its profitability of production and profitability of operations. The gross profit margin determines the company’s profitability of production. It indicates how efficiently the firm is using its labor and raw materials to produce goods. The gross profit margin is calculated as follows:

The gross profit margin should also be compared to that of prior years. Over the past few years, Nike’s gross margin has basically stayed level, fluctuating between a high of 46.4 percent and a low of 43.5 percent. This indicates that this is a maturing company where rapid increases in sales as a result of new, innovative products are no longer occurring. The operating profit margin determines a company’s profitability of operations. It indicates how efficiently the firm’s business operations are generating a profit. The operating profit margin (or just operating margin) is calculated as follows:

The gross profit margin and operating margin are equally important to managers and investors. You may notice they are both ratios, and as you have learned in this chapter, ratios are best used when comparing two or more companies. So how do the income statements of Nike and Under Armour compare? Look at Table 15.4. Nike’s gross profit margin was 46 percent. Under Armour’s gross profit margin of 25 percent was not nearly as high as Nike’s, indicating that Nike was more efficient at producing its apparel than Under Armour. Additionally, Nike’s operating margin of 13.7 percent was slightly better than Under Armour’s 10.3 percent, indicating that Nike’s business operations were slightly more efficient than Under Armour’s.

Table 15.4

Comparison of Income Statement Data*

How much of a company’s profit belongs to its shareholders? The portion of a company’s profit allocated to stockholders on a per-share basis is determined by calculating the earnings per share (EPS). EPS is calculated as follows:

As with some of the other ratios, looking at the EPS in isolation does not provide a complete picture of an organization. For example, it might seem reasonable to assume that a company with a higher EPS will be the better company to invest in than one with a lower EPS. However, a highly efficient company—and potentially good investment—can have a low EPS simply because it has a large number of outstanding shares. Still, shareholders and prospective investors monitor EPS closely. Nike’s EPS for 2015 was 3.8 and has increased steadily over the past five years.

In some instances, the pressure of continually growing a firm’s net income or EPS has led managers to “cook the books” or misrepresent financial information so that the business’s bottom line appears better than it actually is. As noted previously, such fraudulent behavior has led to the downfall of companies and is the reason why SOX Act was enacted. Therefore, it is best not to rely on any one financial measure and to look at all the financial statements and other information as a whole.

What is the statement of cash flows? You have just looked at two important financial statements: the balance sheet and the income statement. The statement of cash flows (or cash flow statement) is the third important financial statement. The balance sheet is a snapshot of a company’s financial position, and the income statement reflects a company’s profitability during a specific period. A statement of cash flows reflects changes in a company’s cash positions, similar to a checkbook register. It provides aggregate data on incoming and outgoing cash transactions rather than transactions that have been recorded using accrual accounting. The statement of cash flows helps to identify whether a company is managing cash flow efficiently.

As illustrated in Figure 15.15, the statement of cash flows organized by the cash generated by three business activities: operating, investing, and financing.

Figure 15.15

Components of a Statement of Cash Flows

• Operating activities measures the cash used or provided by the company’s actual operations. This is the most important section because it shows how well a company generates cash. Unlike the other statements that show assets and revenue as accrued but not necessarily received, the operating activities section of the cash flows statement reflects what has actually been received.

• Investing activities shows how the company is building its capital through the purchase of property, plants (factories), equipment, and other investments.

• Financing activities shows the cash exchanged between a company and its owners (or shareholders) and creditors, including dividend payments and debt service.

Why is the statement of cash flows important? The statement of cash flows tells a story that the income statement does not. The income statement reports revenue receipts and expense payments. Because revenue and expenses often are accrued (earned but not paid), the income statement does not tell how efficiently managers generate and use cash. The statement of cash flows, because it focuses specifically on actual cash exchanges, provides this important information. For example, when customers make purchases on credit, the sales are recorded in the income statement as revenue and reflected as accounts receivable on the balance sheet. However, these purchases are not included in the statement of cash flows because no cash has been received at the time of purchase. Because revenue is being generated in this situation, a company may look profitable, but until accounts receivable have been collected, the company may not have enough cash to pay its bills or to meet its payroll. Similarly, if a company purchases inventory, the transaction would be recorded as a liability on the firm’s balance sheet as an accounts payable but would not be reflected on the statement of cash flows until the company actually paid the invoice with cash.

Cash flow information is useful to creditors who are interested in gauging a company’s short-term health, particularly its ability to pay its bills. In addition, it signals to investors whether the business is generating enough money to buy new inventory and make investments in the business. Accounting personnel, potential employees, or contractors may be interested in cash flow information to determine whether a company will be able to afford salaries and other labor obligations.

How is a statement of cash flows analyzed? Each section of the statement of cash flows should be looked at as well as the summary information at the bottom of the statement.

• The total cash flow from operating activities should be positive. This indicates that a business is generating cash. A negative figure indicates that the company lacks sufficient funds.

• The investing section of cash flow section shows what the company is doing with the assets used to run the business. A negative number indicates that the company is using cash to make capital expenditures and is growing. A positive number indicates that the company is receiving cash from the sale of assets, businesses, and investment securities.

• The financing section of the cash flow statement shows what the company has done over the past year to raise money. If stock has been sold or debt issued, then it could indicate that the company is raising money to finance growth. A negative figure could indicate that the company is repurchasing stock, repaying debt, or paying dividends or interest.

• The net change in cash and cash equivalents at the bottom of the statement of cash flows reflects the overall change in a company’s cash position. If it is positive, it means that a company had an overall positive cash flow. If it is negative, a company paid out more cash than it took in.

Recall the balance sheet in Figure 15.13, where the first line item under current assets is cash and cash equivalents. The difference between the cash and cash equivalent figures between periods is the same value that appears at the bottom of the cash flow statement for the same period. Figure 15.16 shows Nike’s consolidated statement of cash flows.

Figure 15.16

Summary Statement of Cash Flows for Nike, Inc.

Look at the change in the Cash Flows from Operating Activities section. Notice that Nike used cash to pay suppliers as well as to make tax payments. The company received cash from sales and other operating activities. The Cash Flows from Investing Activities section shows that Nike used cash to purchase property, plant, or equipment as well as to purchase short-term investments. Finally, the Cash Flows from Financing Activities section shows that Nike used cash to buy back some stock as well as to make dividend or interest payments. What else does Nike’s Statement of Cash Flows tell you about how the company managed its cash flow?