FOOL SCHOOL
Valuation: Balance Sheet Basics

February 19, 2003

Cash makes the world go round. You need cash to make cash, as unfortunately no-one has yet found a tree from which we can go and pluck £20 notes at will. Companies raise cash in various different ways, either though bank loans, a myriad of novel debt offerings, venture capital funds, or through a public offering of shares. Think of how you would go about opening the corner store that you've so longed for over the years. You'll need to pack the shop full of useful products, pay yourself a probably modest wage, pay rent on the shop, set up phone lines, fit the shop out with new shelves and fridges... the list is endless. Before you receive a single penny of income, you'll have to spend a small fortune -- and this is money that you probably haven't already got.

To raise cash, your options will include the bank manager, a wealthy friend (who will naturally want some sort of return on the money he or she invests in the business) or a public flotation, although the last option would be impractical and prohibitively expensive. Large companies think in exactly the same way, although on a much bigger scale.

Companies live and die on the amount of cash they generate. For all the money they spend on acquiring new pieces of machinery or computers or spend on staff wages, if they don't receive a decent return on that investment, they will die. A company that generates above average amounts of cash will succeed in building shareholder value. That additional cash can be reinvested back into the business, can be spent on earnings enhancing acquisitions, can be paid out to shareholders as dividends or can be used for a share buyback scheme. Without any cash, a company treasurer will get to know her bank manager pretty well, but perhaps not on the friendliest of terms.

Cash earnings are very different from accounting earnings. Accountants can legitimately massage a company's profits to present a higher number, but it's much trickier to mess with the bank account balance. That's why it is always important for investors to check both the accounting profits and the cash profits. Here's an example:

Bruce's Bazaar

Bruce has raised £2,000, which he intends to use to open his new shop. On day 1, his balance sheet looks like this:

A balance sheet must always balance, because Assets (A) = Liabilities (L) + Equity (E). This equation can be rearranged if you want, for example as E = A - L. But it must always balance. Trading goes reasonably well in year 1, and Bruce's profit and loss statement looks like this:

Based on a £2,000 pound investment in the business, a return of £150 or 7.5% is nothing fantastic, but it is a reasonable start. After all, Bruce is still building up the business, and a new block of flats is scheduled to be built soon right next to his shop. He grabs a can of beer from the shop fridge, pats himself on the back, and then proceeds to spray the contents all around the shop in a fit of Grand Prix like celebration.

However, to assess how the business is really operating, we need to have a look at the other key accounting statements that make up the books and records of any company. First, the new balance sheet, as at the end of year 1:

As you can see, our balance sheet balances, because A = L + E, or 2,300 = 150 + 2,150. What is the first thing that jumps out and hits you? It's the bank balance. Bruce has spent the full £2,000 in the first year and is now faced with going back to his wealthy friend, cap in hand, asking for some more money. He needs to pay his gas bill, and buy some more stock for the shop. By looking at the cash flow statement, we can get an idea of where the money went, starting with the £150 profit he made for the year.

     Net profit                150 
     Depreciation              100 
     Increase in Debtors      (200)
     Increase in Stock      (1,800)
     Increase in Creditors     150 
     Capital spending         (400)
                            ------ 
     Decrease in cash       (2,000) 

The cash flow statement shows us where most of Bruce's £2,000 has been spent. Increasing debtors is a use of cash. Bruce has generously allowed a few of his bigger customers to shop on credit, meaning that they owe him a total of £200 for goods they've already consumed. They are his debtors. This is an inefficient use of Bruce's scarce cash resources, as he receives no interest on that money -- and he desperately needs it in order to pay the gas man.

Having £1,800 tied up in stock is an inefficient use of cash. Ideally, you want to look for a company that has as little stock as possible -- one that buys the goods it needs to supply the product to the customer only after it has received a firm order.

A high stock number can mean a number of things, none of them positive. Stock can become obsolete, pass its use-by date or perish. It may have to be sold at less than cost price or even thrown in the rubbish bin because it is now worthless. Computer product distributors have to contend with obsolete products all the time.

Bruce has managed to buy some of his stock on credit. This is a good thing, and gives Bruce some breathing space before paying for the goods. In an ideal world, a company buys on credit and sells for cash. That way, the creditors effectively fund the business, and scarce cash can be used to enhance shareholder value in the ways set out above. If you buy a crate of wine on 60 days' credit for £100 and sell it the next day for £120, you've got the use of that £120 for the next 59 days before you have to pay your creditor. If you went back and duplicated that cycle the next day, and the next, and the next, you can see how profitable you will quickly become, all funded by generous credit terms. Increasing creditors is generally a positive sign.

The final use of cash was the £400 spent on the shop fittings. This is known as capital expenditure, and it shows up as an asset in the balance sheet. You will notice, however, that it shows up in the balance sheet as a net £300. This is because £100 has been written off against the value of that asset as depreciation. This is an accounting concept whereby the value of the asset is expensed against profits over the theoretical life of the asset. It is not a cash entry. As you will see from the cash flow statement, the cash cost of buying the asset is shown as a use of funds, yet the £100 depreciation expense is added back to profits because no cash changes hands. It is an accounting entry only.

The £2,000 total cash consumed by Bruce's Bazaar leaves the company in a precarious state, despite the company making a £150 accounting profit in the year. Without resorting to borrowing yet more money, Bruce will have to sell some of that stock for cash, collect his money from his outstanding debtors and look to put off paying the gas man and any other bills until he's generated some cash with which to pay them. While this is happening, Bruce can't afford to build the business, as he's always chasing his tail. Something will have to change, or he won't be in business by the time that new block of flats is built.

Free cash flow is defined as net profits plus or minus working capital movements, plus depreciation expense, minus capital expenditure. Working capital refers to the movement in stock, debtors and creditors. If you think about it, free cash flow is the amount left over that the company can use to enhance shareholder value. In the case of Bruce's Bazaar, it generated negative free cash flow of £2,000. A company cannot survive if it doesn't generate free cash flow. The concept is important, as you will see as we move on to looking at discounted cash flow techniques in the next, and final, article of this mini-series on valuation.

More on valuation
1. Price to earnings
2. PEG
3. Price to sales
4. Dividend yield
5. Return on equity
6. Adjusting for goodwill
7. Uses of return on equity
8. Balance sheet basics
9. Discounted cash flow