Developing a Basic Financial Model – Part II: The Balance Sheet

Excel is probably the most popular spreadsheet in use today, and certainly a mainstay of investment banks, private equity firms and hedge funds. It offers a tremendous amount of flexibility to develop a wide array of financial computations, ranging from simple, static calculations to complex, dynamic analyses. In order to effectively develop financial models for use in valuation analyses or forecasting, it is important to understand how companies show their information. This article continues the overview of the link between the basic components of a full financial spreadsheet by discussing the balance sheet and its related components. Because these financial statements are based on accounting rules, there will be some accounting theory used in this article but only very high level, basic elements to allow the reader to follow along.

The Balance Sheet

The balance sheet provides a snapshot at a particular moment in time of a company's assets, liabilities and equity. For public company's trading on an exchange in the United States, the Securities and Exchange Commission requires data to be filed on a quarterly basis. Other global exchanges require semiannual filings for public companies. Most businesses worldwide would have an accounting system to track balance sheet information on a much more regular basis (likely daily) for monthly reporting purposes.

A balance sheet is an indication of an entity's health and the simple accounting relationship is:

Assets = Liabilities + Equity.

Given the formula, assets are often referred to as being on the left side of the balance sheet with liabilities and equity representing the left side (one reason for this may be the fact that when a full balance sheet is presented on one page, the assets are first, and thus, on the left side of the page).

Assets. An asset is something of value to the company and comprises items that will, in theory, provide cash to the business. Typical assets listed on a balance sheet include cash and short-term investments, accounts receivables, inventories, prepaid expenses, and property, plant and equipment ("P,P&E"). If you are a manufacturing business, you likely use your P,P&E to make products to sell, which means that buy raw materials from suppliers and buildup your inventory balance, and one a product is finalized and sold, you have an increase in accounts receivable. Once you collect on the accounts receivable (the customer pays you for the product you made), you have an increase in cash. While other types of businesses may have more or less of specific assets, the fundamental flow described above can be applied across many industries. Items like cash and accounts receivable reside in a category called current assets, whereas P,P&E is considered a long-term asset.

Liabilities. A liability is something that a company incurs as a means of operating the basic business. Typical liabilities listed include accounts payable, accrued expenses, taxes payable, current portion of long-term debt, long-term debt and other long-term liabilities. To continue with the prior manufacturing example, when that company purchases raw materials from suppliers, many times the business will get terms, or a payment plan for such raw materials. For example, it is common to allow a purchaser 30 days by which to pay for materials purchased. A supplier may incentivize the buyer by offering a discount to the total purchase if paid within 10 days, and expects full payment by the 30th day from the purchase. These purchases show up on the manufacturer's books as accounts payable or obligations to a supplier or suppliers. Items including taxes payable and accounts payable reside in a category call current liabilities, with other liabilities being considered long-term. A major long-term liability is debt. Now, debt can be long-term or short-term (the current portion of long-term debt is contained in current liabilities), with short-term debt often a credit line from a bank or bridge financing from a third party institution. Many companies, including cable, telecom, auto manufacturing and retail, finance their long-term plans through the issuance of debt. When companies do this, the debt appears on the left side of the balance sheet.

Equity. The equity account (also called shareholders' equity, stockholders' equity or members' equity) is the numerical difference between assets and liabilities when everything is properly accounted. The equity account changes when a company generates net income, pays a dividend or raises capital. The equity account is important because other individuals or companies who are looking to buy businesses often look to the equity account as a sign of the overall health of a company and its historical performance. For example, the retained earnings ("RE") category is a component of the equity account and is a culmination of the historical net income and dividend payments. If you are analyzing a business and you see that RE is $10,000,000 and last year's net income was $1,000,000, you might infer that this business has been steadily profitable for the past 10 years ($10,000,000/$1,000,000). If, on the other hand, the prior year's net income was $10,000,000, there is either a case of a newly started business or some uncertainly about year-over-year performance, and this might be a warning flag. In the most obvious case, if the prior year's net income was a loss of $20,000,000, in the absence of a turnaround in the business, next year's retained earnings may go negative, indicating a deficit. This deficit indicates that the book value of the liabilities is greater than the book value of the assets, and that is indeed a warning sign. In this instance, a company would like have to raise additional outside equity, which would increase the overall equity account and possibly offset the deficit of the RE account.

In summary, this section attempted to outline some very basic items related to a balance sheet to setup the next article with will cover the cash flow statement. It is the cash flow statement that tracks the changes in balance sheet items and ties together the income statement and balance sheet. In addition, there are theories that can be more easily explained when the concepts of how the three statements work together are established. For now, just understand that the accounting rules for balance sheet information is designed to gauge the health and viability of a business and shed light on the ability to generate profits in the future.