As responsible investors and entrepreneurs, understanding all three financial statements will provide you with overall key insights into the financial status of a business. It’s more than just an itemized list of assets, debts, and ownership equity. More important are the ways in which companies use these to their advantage and they are hidden in plain sight. So, today I will discuss the Balance Sheet, what it actually ‘balances’ and real examples of how it works.
Table of Contents
A Fun Story About Sally and Jerry
Let’s suppose we have two different business owners that have the same yearly revenues, same fixed costs, and same profit – only one receives payments daily and other gets a bulk payment at the end of the month. Who has the better business? Let’s look at Sally’s t-shirt company v. Jerry’s Hot Dog Stand.
Sally’s T-Shirt Company
Sally owns a custom t-shirt company. She designs and purchases the shirts in bulk, and her cost is $20 per shirt. She then consigns them to a local clothing store that sells them and cuts her a check at the end of the month. The clothing store pays her $30 per shirt, and she sells 730 of them every month consistently.
Sally profits $87,600 / year. This is what her Income Statement looks like:
Jerry’s Hot Dog Stand
Jerry owns and runs a Hot Dog Stand. Every day Jerry stops by the wholesale market and picks up his supplies. He parks his stand on a corner of Central Park and sells 240 hot dogs. It costs Jerry $2 to make one hot dog, which includes a bun, beef wiener, relish, onions, etc. He sells each hot dog for $3 – a small profit, but he loves selling hotdogs and its steady work.
Jerry also profits $87,600 / year with his business. This is what his Income Statement looks like:
I know what you’re thinking – and you’re right, these are overly simplified business examples. There are other business costs associated with any business, but these are good for illustrative purposes. Let’s review their capital requirements closer.
Both businesses are identical from the Income Statement. They have the same:
They’re the same, aren’t they? NOPE – They’re not.
Here’s why: They have completely different capital requirements each month. They may have the same earnings at the end of the year for the owners, but the amount to start and operate the business are VERY different. Let’s take a closer look as to why they’re not the same.
Sally’s Capital Requirement
Sally’s t-shirt company requires capital up front each month to purchase her t-shirts. Sally has to purchase 730 t-shirts x $20 per shirt = $14,600 and have this capital up front each month. This is capital needed at the at the outset. She must have this money set aside each month to purchase her t-shirts. She must put in $14,600 to get back $21,900 ($7,300 profit) each month.
Jerry’s Capital Requirement
Jerry’s hot dog company requires capital up front each day to purchase his hot dog supplies. Jerry has to purchase 240 hot dogs x $2 = $480 and have this capital up front each day. And every day he is able to take $240 from the business.
Now you can see why Jerry has the ‘superior’ business.
This is a prime example of why you don’t only look at Income Statements to analyze a company. It is very important to look at a company’s assets vs. the amount of earnings they generate with it.
The Balance Sheet
Now let’s move onto what a balance sheet shows. The balance sheet is made up of 3 components: (i) Assets, (ii) Liabilities, and (iii) Equity. The reason it’s called a ‘balance’ sheet is the Asset section at the top will always equal the Liabilities and Equity combined. That is what it balances. Therefore:
Assets = Liabilities + Equity
Assets
The Assets (cash, inventory, and property) section tells us how much capital (money) the business has and how much it needs to function.
In the above example, Jerry and Sally only had cash, receivables, and inventory referred to as working capital assets. In the real world there are other types of assets such as: equipment, property, plant, goodwill, and other intangibles. (below you will see Property Plant and Equipment noted as PPE.
Liabilities & Equity
The Liabilities (rent, wages, utilities, taxes, and loans) & Equity sections tells us where the capital came from.
There are 3 ways in which a company can get usable capital from (i) equity, (ii) debt, and (iii) float:
- Equity comes from capital from the owners or shareholders.
- Debt comes from borrowing, a loan which usually includes an interest portion.
- Float comes from capital that is owed to various vendors (i.e., customers, suppliers, government, employees, etc.) who have essentially provided additional spending power – usually for free.
Float from Various Vendors:
- Customers – Pre-paid Orders, Insurance premiums, gift cards
- Suppliers – Accounts payable or goods the company already received but will pay for later
- Government – Taxes owed
- Employees – Payrolls to be paid in the future
The liabilities side is extremely important to pay attention to. Money from the float can accelerate a business by being able to deploy more money, which is essentially free.
Remember the example with Sally? If Sally had negotiated her t-shirt costs with her supplier to pay for them after she receives payment from the clothing store, then she could essentially run that business with $0 out of pocket money, while still bringing in the same $87,600.
Utilizing one’s float as a large company, provides tremendous amounts of leverage in the business, by providing access to additional cash. Making the best use of a company’s float can transform a company’s ability to grow.
Warren Buffett’s Perspective
Warren Buffett is a huge fan of float and discusses it in his 2009 letter to shareholders and how much of an impact it has had on his insurance business. Check it out!
Conclusion
The balance sheet contains a vast amount of information regarding a company’s financial situation. The three lessons that I want you to take away are: 1) the ability of a company to negotiate and leverage float can have a tremendous impact on growth and sustainability, 2) assets tell us how much the business has and needs in order to function; and 3) liabilities tell us where the capital in the business came from. I hope these concepts that I discussed provides you with further insight on how to better understand the balance sheet and why it’s a very important statement to review. If you wish to learn more or have particular questions about the balance sheet, please feel free to ask below.
Definitions
Capital is wealth in the form of money or other assets owned by a person or organization or available or contributed for a particular purpose such as starting a company or investing.
Working capital is the amount of an entity’s current assets minus its current liabilities.
Equity is the ownership of any asset after any liabilities associated with the asset are cleared.