Companies can have innumerable variations of assets, liabilities, and capital structure. There is an expansive spectrum of combinations. On the extremes, a manufacturing firm may have multiple warehouses and machinery and be financed mostly with equity, while a financial services company may have assets consisting of complex financial instruments and equally complex financial products making up its capital structure. To make sense of all of these possibilities, accountants created a financial statement known as the balance sheet. This financial statement is an organized account of what the company owns, what the company owes, and how much of the company is owned. It is broken down into standard categories, typically organized from the most liquid items to least liquid.

Each of the items that compose a firm fits into one of the standard categories of the balance sheet, as shown in Figure 4.1. The most critical concept that accountants built into the creation of the balance sheet is the balance principle: Assets must always equal liabilities plus equity. Simply put, nothing is free. Whenever an asset is created, funds are used to do so. If there is an imbalance between assets and liabilities plus equity, it means something is unaccounted for and the analyst’s view of the company is incomplete.

An unbalanced balance sheet should never occur in past audited financial statements. This is because historical balance sheets reflect a specific moment or snapshot in time. In corporate valuation modeling, we are making predictions about the future, which could create instances of an unbalanced balance sheet. For example, we may assume the company will build a particular plant that is primarily funded by a long-term debt issuance. Multiple assumptions that vary across possible stress scenarios can easily throw off the balance of assets, liabilities, and equity. One example would be an expected decrease in the cost of the building the plant. Holding all other variables constant, we would have a situation where we issued more funds from the loan than necessary. This causes the balance principle to be violated by having liabilities and equity greater than assets. Our model needs to account for and repair any imbalance. We will see that in corporate valuation modeling we will always maintain the cardinal rule of assets equaling liabilities plus equity, but rather than wasting time balancing the balance sheet each period, we will set up our model in such a way that it does so automatically. Figure 4.2 is a graphic of this cardinal rule.

To accomplish our goal of thoroughly understanding the balance sheet and implementing it in a model, we will dedicate two additional chapters beyond this one. Since the balance sheet describes the entire underpinnings of a company, there are sections that we will want to analyze in as much detail as possible. Although this could vary among companies, the most common sections that require in-depth analysis are capital expenditures, depreciation, amortization, and long-term debt. This chapter will provide an overview and framework for the balance sheet; Chapters 5 and 6 examine the aforementioned sections in detail. As with all chapters, we will begin with theory and concept discussion, move on to Model Builder instructions, and wrap up with a Toolbox.

Be careful when distinguishing between these three. The first item, cash, is the cash necessary for the company to operate. For most nonfinancial institutions this should not be an extraordinary number. Cash projected can be valued at its face value. Rare exceptions include businesses in emerging market countries with highly devaluing currency. These businesses may keep large reserves of foreign currency or may have entered into currency swaps, which will show up on a different part of the balance sheet. Also keep in mind that cash typically earns a small amount of interest, which can be integrated into a valuation model each period.

Surplus cash is merely a concept for projection models. This is technically the “plug” on the asset side. When a model’s liabilities plus equity are greater than the assets, the remaining cash can be thought of as surplus. Think about what would cause liabilities and equity to become greater than the assets. A tangible example would be a capital expenditure that actually costs less than what was funded through debt. If the capital expenditure cost $98 million and $100 million of long-term debt was issued, there is $2 million of surplus cash. We will work with this concept in detail when we must set up an automatic balancing of the model.

The third and final cash item is marketable securities. These could be investments in money market accounts, certificates of deposit, or guaranteed investment contracts (GICs). They are typically very secure, short-term investments that are valued at their face amount. Figure 4.3 depicts the three cash items and when they occur.

Other forms of discounts can include product-placement discounts or discounts eventually passed on to customers, for which the firm is ultimately responsible. These discounts should be noted in the company’s financial statements. For corporate valuation modeling it’s important that the figures used to project accounts receivable include these discounts; otherwise, the accounts receivable value could be overstated.

Another valuation problem with accounts receivable relates to doubtful accounts or a bad loan reserve. Holders of accounts receivable are subject to an obligor’s ability and propensity to pay. When accounts receivable become very delinquent, there is an eventual expectation that they will not pay. For companies with small-to-medium accounts receivable a bad loan reserve percentage based on historical bad loans can be applied to decrease the accounts receivable figure. If accounts receivable is a core component of the business operation, then more sophisticated techniques may be appropriate. For example, a valuation that I completed involved an appliance and electronics retailer that sold three-fourths of its products on credit. These sales were booked as accounts receivable. The consumers who purchased these products were of average-to-poor credit quality, with default rates in the upper teens. Defaults followed specific timing patterns typical of consumer credit portfolios. Given the size of the credit sales as a percent of the total revenue and the high default rates, a detailed delinquency and default analysis was integrated into the valuation model.

The major valuation challenge with inventories is timing, which is captured by two different accounting methods. The first method is first-in-first-out (FIFO), which is the only method of inventory accounting that IFRS allows. When an item is sold, its value moves from the inventory account on the balance sheet to the cost of goods section of the income statement. Under FIFO, the amount by which that inventory account should be reduced is based on the cost of making the oldest of the same product in inventory.

Under the last-in-first-out (LIFO) method, the last product made in inventory represents the value that is removed from the inventory account. Often a company is constantly producing and selling products, allowing LIFO-based inventory valuation to use only the latest product costs for their products. Critics of LIFO contend that the method allows lower inventory valuation and higher cost of goods sold than in actuality. For this reason, IFRS does not allow LIFO-based valuation. In order to compare the results of two valuation models, their inventory valuation methodologies must be the same.

A key point to keep in mind is that PP&E is listed at book value. This is typically thought of as gross PP&E. Plant and equipment lose value over time due to wear and tear, otherwise known as depreciation. This depreciation is accumulated over time and netted out of gross PP&E to arrive at net PP&E. Until an asset is disposed of, its book value is listed under gross PP&E and its accumulated depreciation is netted out. Net PP&E is counted toward the value of the assets.

Notice in the previous paragraph that land was not included as an item that loses value over time. Under IFRS, land is not depreciated as part of PP&E.

Intangibles are challenging to value since they often can be unique; however, they are treated similarly to PP&E in that they can lose value over time. Patents expire, technology can be replaced, and overall intangible value erodes over time. For these reasons, intangible values are amortized over a specific useful life, similar to depreciation. Gross intangibles are kept on the balance sheet along with accumulated intangible amortization. Net intangibles are counted toward the value of the assets.

Goodwill is an exception for intangibles. IFRS 3 and SFAS 142 ended the amortization of goodwill. It is, however, periodically reviewed for impairment.

The other issue for accounts payable is that when a company becomes distressed it might try to finance its business through accounts payable, essentially taking goods and services on credit and not paying for them, nor paying an interest expense. A detrimental strategy such as this should be clear to ratings analysts, who will probably downgrade the company, making it more costly and difficult for the company to borrow. This is a red flag as it perpetuates the distress cycle and could lead to the downfall of a company.

The difference between a direct loan and a credit facility is cost and time. A direct loan may be slightly less expensive to implement, but can take longer depending on approval. This can also cause problems during distressed times as approval can be denied. Usually companies set up credit facilities, where there is a preapproved amount of credit that can be drawn down. The trade-off is cost. A credit facility will charge an undrawn amount on the credit line and then an increased amount on drawn balances. For financial modeling purposes, we would have to track both of these charges.

More importantly, for financial modeling, short-term debt often serves as the liability and equity side plug when the projection model creates more assets than liabilities and equity. Some may wonder how a situation could occur where more assets than liabilities and equity are created. A simple way to conceive of this is to imagine running a stress scenario where capital expenditures are expected to exceed base-case forecasting—a situation that occurs frequently. Usually, a set amount of long-term debt is structured for capital expenditures. In a stress situation where capital expenditures are higher than expected, gross PP&E increases. The funding of this increase on the balance sheet must come from somewhere, with short-term debt being the most likely candidate.

One needs to be very careful when using a projection model and determining the payment ability of a firm. For instance, we could look at cash on hand in a given period and compare it to the current portion of debt, but relying on cash may not be sustainable. Perhaps the company sold off an asset in a particular period that generated cash. Unless the debt is ultimately paid off, selling off assets is an unsustainable method of paying down debt. We may want to look at other sources of funds for debt payment, particularly earnings before interest, taxes, depreciation and amortization (EBITDA). This cash would be available for us to pay down interest. After taxes, dividends, and capital expenditures, we can then use the remaining cash to pay down principal. In Chapter 6, we will look at debt-repayment capacity in much more detail.

Ultimately, we are building a financial projection model for analysis. In the core model, the Balance Sheet sheet will not include the current portion of debt since we will actually try to pay debt over the course of each period. We will still be able to see repayment capacity once the debt sheet is created in Chapter 6.

For now, we should realize that long-term debt shows up on the balance sheet and is considered a liability. Repayment of that liability is a major concern for both the company and the lender. Since many focus a great deal of time on debt, the example model will have an entire sheet, called the Debt sheet, dedicated to determining the debt schedule, the repayment capacity, and the tracking of ongoing balances. The long-term borrowings section of the Balance Sheet sheet will reference the balances from the Debt sheet to obtain the correct balances of the long-term borrowings at any given time.

The most standard equity item is common stock, which is listed at issuance price. Common stock is the lowest denomination of equity and represents a fractional share in the market value of the equity in the company. Notice that it is not a fractional share in the market value of the company since debt must be netted out to understand equity value. Debt holders have priority over cash flow and therefore should be removed from the equity holder value. For instance, if the firm were being liquidated, the debt holders would be paid first and then funds would be dispersed to equity holders. Since debt holder amounts are taken away from equity holders, those amounts do not create shareholder value.

Other forms of equity include preferred stock, convertible preferred stock, and minority interest. Preferred stock is technically listed as equity, but it has many attributes of a liability. As with a liability, it typically has a fixed dividend payment based on a percentage, it can sometimes be called debt, and it can sometimes be structured so it converts to common shares. However, it is equity since it is listed as equity and has priority below debt and can sometimes be structured with a capital gains sharing mechanism (although it should never enjoy the full capital gains benefit that common shares receive).

Another type of equity is minority interest. This can often be a complex section of a balance sheet. Minority interest is determined by the percentage of interest one party has in another party. Typically, when one party has 20% or less interest in another company there is a minority interest.

If this sounds confusing, the best way to think about minority interest is to look at the situation where only two companies exist and one has a 20% interest in the other company, while the other company has an 80% interest in the first company. Let’s denote Company A as having the minority 20% interest in Company B and Company B as having an 80% interest in Company A. This situation could have been created by Company B acquiring an 80% interest in Company A, thereby causing a consolidated approach according to IFRS. A consolidated accounting approach means that all of the assets from Company A are brought onto the balance sheet of Company B. As Company B does not own all of the assets, they must report a 20% minority interest in their liabilities and equity section of the balance sheet. Other forms of interest in other companies exist, which is dictated by IFRS based on ownership percentages.

The final form of equity that is extremely important is retained earnings. When a company earns money, as reported by the income statement, it eventually flows through as net income. The company then has the choice, depending on the Board of Directors’ vote, to dividend that money out to equity holders, or to retain that money internally for use or distribution later. Any retained earnings from the past year are added to the current retained earnings to get the balance. Unless money is released as a dividend, funds are retained. Figure 4.11 shows the first of many connections between the income statement and the balance sheet.

Retained earnings are very important because they are the major link between the income statement and the balance sheet. From a financial modeling viewpoint, this link causes headaches because it is a source of circularity in the model that we must adjust for if we model the company with certain periodicities in mind. We will learn about this circularity more and see how this is efficiently calculated and automated in Chapter 7.

Another error occurs when people try to back into a figure from a growth rate. For example, say one wanted to calculate last year’s revenue given a growth rate of 10% and a current revenue estimation of 875. The common mistake is to multiply the 875 by .9. This is wrong as it will yield 787.50, which when grown by 10% equals 866.25. The proper method is to divide 875 by (1 + .1), which will yield 795.45.