Anatomy of a Balance Sheet

The FINANCIAL COUNSELOR

This department is designed to help readers to a better understanding of the general business conditions which affect their investments. It is obviously impossible to give advice as to specific investments.

by HOWARD DOUGLAS DOZIER

A CORPORATION is a fictitious person, a creature of the State, existing only in contemplation of the law. It can do that which its charter grants it permission to do, and only that. Among the charter powers granted is always that of contracting debts. A corporation is unique in this respect: when its debts are all paid, if it is solvent, it has nothing left but its charter; it then owns no property.

The equilibrium between what a corporation owns and what it owes can be illustrated by this skeleton of a balance sheet: —

Owned

Fixed capital $10,000,000

Current assets 2,000,000

Deferred assets 500,000

Good will 1,000,000

Total $13,500,000

Owed

Bonds $3,000,000

Common stock 6,000,000

Current hills payable 250,000

Accruals 250,000

Reserves 1,000,000

Surplus 3,000,000

Total $13,500,000

The balance sheet is one of the two principal statements upon which the investor must depend for information about the company whose securities he contemplates buying. The other is the income account. This paper deals with the anatomy of the balance sheet; a later one will discuss the income account.

Now for the dissection, first of a corporation’s ‘ownings,’ and then of its ‘owings.’ What it owns, as shown on the assets side of its balance sheet, may be classified under the four general headings of fixed capital, current capital, deferred assets, and intangible assets. Most corporations use three of these designations in listing their assets, and some use all four.

Fixed capital or fixed assets consist of plant and equipment, land and buildings, and other like holdings. A statement of their value may be what a corporation says all of these are worth, or what they were worth, depending upon whether deduction has been made to the extent of the wear, rot, rust, decay, and out-ofdateness. If no such deduction has been made, then the corporation owes an amount sufficient to pay for this shrinkage.

Current assets are another classification of owned property. This term is applied to a company s cash, accounts receivable, and to those other assets which it can convert quickly into cash, or which mature within a comparatively short period of time, say one year. If the investor could get a look into the strong box he would find among the current assets promissory notes maturing within ninety days, bonds and other securities marketable presumably at any time or falling due shortly, deposits in banks, and cash in the till. How many of these assets it is wise for a company to keep on hand depends upon how many of its bills are just around the corner.

Fixed and current assets are all but self-explanatory. Deferred assets, however, are not so obvious. Though more difficult to understand, they are no less real than those falling under other classifications. Let us take, for example, fire insurance or the purchase of a bond at a discount. Fire insurance is generally purchased for three-year periods. At the end of the first year the company still owns two years of this particular service. This unused protection has value precisely as unused coal in the bin has value. Any inventory of what a company owns at that time should include the value of this unused service. Or again, a company which buys a ten-year bond for $100 at a price of $90 stands to make a profit of $10 during the period, if it keeps the bond. At the instant of purchase none of the profit has been earned, but some of it has been by the end of a year. The fact that the profit cannot be realized in cash does not destroy its existence. Each year brings the company nearer the realization of the $100 and the collection of its $10 profit. The fact that the corporation amasses a little of this profit, each year necessitates that the value of if at any time be included among the assets as of that time. The name which has come to be applied to all such unrealized claims as these is deferred assets.

Then there is that intangible something called good will, which many companies attribute value to and list among their ownings. This has been defined as the habit which people have of going back to trade where they have been trading. Even cattle like to go again to drink out of the same water hole. This custom of going back to the same place to trade is responsible for some revenues — how many nobody knows — and more revenues usually mean more operating profits. These in turn mean greater safety to bondholders and surer and larger dividends to stockholders. Inasmuch as it is customary to attribute value to that which produces income, and inasmuch as habits acquired by the public or induced in it by the expenditure of good money do this, many corporations list good will among their assets and place a monetary value upon it. This is frequently justifiable, but the difficulty so far as the prospective investor is concerned is that the value placed upon it is somebody’s guess.

Even at best, whatever value is placed upon it is precarious and may be illusory. It is the substance of things hoped for; it is like the Mowers of the field which to-day are, but to-morrow are withered and gone. The conservative investor, therefore, will be wise if he is wary of those securities whose issuers set too much store by the good will they claim to enjoy.

Now let us move on to the liability side of the balance sheet. It is obvious, of course, that the company owes those who have let it have money when it was launched or those who have furnished funds to keep it going. Among the former are to be found the bondholders and the stockholders of all classes, and among the latter the banks from which it has borrowed and the merchants from whom it has bought on open account.

The corporation owes other debts less easily identified. So-called accruals are an example of these, Let us take tax accruals. Taxes grow daily, but are paid only annually or semiannually. Conceivably a company could pay its taxes daily or weekly as it does its wages, but that is impracticable. Nevertheless, when night comes it owes the municipality, the State, or the Federal Government something on this account. Figuratively it appoints its bookkeeper as custodian of tax money, and figuratively he takes his place in the pay queue once a month and is handed an envelope filled with tax money What he accumulates from month to month is what the company owes on taxes but is not permitted by the tax gatherer to pay.

Now the bookkeeper does not want to keep the money idle in the safe, so he puts it in the bank or perhaps buys short-time government bonds which will fall due and will be paid about the time be will have to meet taxes. These securities he puts in the strong box with other assets, and that is how some of the current assets came to be in the possession of the company.

Then again the company, for reasons which seemed to it sufficient, may have bought for $110 a bond which will mature in ten years at $100. A loss of $10 will be sustained if the company keeps the bond. The bookkeeper finances this outgo in the same manner as he did taxes. But since his company does not have to suffer the loss until the end of the period, he can put what shows up in the bond premium envelope monthly into a longer maturity bond than it would have been wise to do in the case of his tax money. This method of keeping accounts is adopted in order to meet debts continuously, although it is in fact impossible to pay them so in actual practice.

The debt load is thus evenly distributed over the company’s earning power. What a company owns and what it owes ebb and flow together, and if it always has cash and readily salable assets enough to pay its current bills promptly its cash position is said to be excellent. It is not hard up for money.

Then there are the reserves on the owed side of the account. The way the depreciation reserve comes into being is illustrative of the history of all the rest. Each minute, a company’s. plant and equipment wear, however little, and they are going out of date, although imperceptibly. They have deteriorated, nevertheless, and the company owes for this shrinkage. It cannot pay it by the minute or even daily, but it can periodically lay away funds with the bookkeeper equal to the estimated decline in value. The bookkeeper, in his turn, cannot keep any particular portion of tbe property intact, but he can put other kinds into the hands of the corporation to offset this wasting process. He may buy bonds or he may renew the plant with the money he receives on account of depreciation, and when he lists his company’s ownings these appear. They compensate for the value which has faded out of the plant and equipment at some other place.

Among the last items which appear in the balance sheet is surplus. This is a special debt due owners for having had nerve enough to undertake the business and stay with it. This special debt, of course, is due them after the corporation has made provision for settlement with them for the money which they putin, presumably, in return for their stock.

When everybody else is paid, what is left is a debt to the owners — namely, the stockholders.

In conclusion it ought to be remarked that a careful analysis of the balance sheet is the initial step toward the commOn objective of all conservative investors — namely, an appraisal of the quantity and quality of the income to be expected from an enterprise and available to those who purchase its securities. The balance sheet gauges possibilities; the income account reveals actualities.

An understanding of both is the beginning of financial wisdom. Such an understanding converts financial fundamentalism into financial self-reliance. It is hardly too much to say that one’s personal investments should lie well within the field of his own knowledge. Keeping them within this field will not keep him from widening the field, but it is pretty sure to keep him from losing his money while he is doing his widening.