Chapter 3 - The Balance Sheet The balance sheet provides a snapshot of the firm’s

financial position on a specific date. It is defined by:Total Assets = Total Liabilities + Total Shareholder’s Equity (asset) = (sources of funding) Total assets represents the resources owned by the firm. Total liabilities represent the total amount of money the

firm owes its creditors. Total shareholders’ equity refers to the difference in

the value of the firm’s total assets and the firm’s total liabilities.

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Asset value calculation In general, GAAP requires that the firm report assets on

its balance sheet using the historical costs. Cash and assets held for sale (such as marketable

securities) are an exception to the rule. These assets are reported using the lower of their cost or current market value.

Assets whose value is expected to decline over time (such as equipment) is reported as “net equipment” which is equal to the historical cost minus accumulated depreciation.

The net value reported on balance sheet could be significantly different from the market value of the asset.

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Assets and liabilities

Current assets consists of firm’s cash plus other assets the firm expects to convert to cash within 12 months or less, such as receivables and inventory.

Fixed assets are assets that the firm does not expect to sell within one year. For example, plant and equipment, land.

Current liabilities represent the amount that the firm owes to creditors that must be repaid within a period of 12 months or less such as accounts payable, notes payable.

Long-term liabilities refer to debt with maturities longer than a year such as bank loans, bonds.

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The stockholder’s equity

Two components:1. The amount the company received from selling stock

to investors. It may be shown as common stock in the balance sheet or it may be divided into two components: par value and additional paid in capital above par. Par value is the stated or face value a firm puts on each share of stock. Paid in capital is the additional amount the firm raised when it sold the shares.

For example, DLK corporation’s par value per share is $2.00 and the firm has 30 million shares outstanding such that the par value of the firm’s common equity is $60 million. If the stocks were issued to investors for $240 million, $180 million represents paid in capital.

2. The amount of the firm’s retained earnings: the portion of net income that has been retained (i.e., not paid in dividends) from prior years operations.

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Firm Liquidity and Net Working Capital

Liquidity refers to the speed with which the asset can be converted to cash without loss of value.

For example, a firm’s bank account is perfectly liquid. Other types of assets are less liquid as they more difficult to sell and convert to cash such as PPE (property, plant and equipment).

For the overall firm, liquidity generally refers to the firm’s ability to covert its current assets (accounts receivable and inventories) into cash so that it can pay its bills (current liabilities) on time.

We can thus measure a firm’s liquidity by computing the net working capital = current assets – current liabilities.

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Firm Liquidity and Net Working Capital

If a firm’s net working capital is significantly positive, it is in a good position to pay its debts on time and is consequently very liquid.

Lenders consider the net working capital as an important indicator of firm’s ability to repay its loans.

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Checkpoint 3.2

Constructing a Balance SheetConstruct a balance sheet for Gap, Inc. (GPS) using the following list of jumbled accounts for January 31, 2009. Identify the firm’s total assets and net working capital:

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Step 4: Analyze

The firm has invested a total of $7.564M in assets, funded by $2.158M current liability, $1.019B long-term liability, and $4.387M owner equity.

The firm has $4.005M in current assets and $2.158BM in current liability, leaving the firm with a net working capital of $4.005-2.158-1.847M.

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Checkpoint 3.2: Check Yourself

Reconstruct the Gap’s balance sheet to reflect the repayment of $1 billion in short-term debt using a like amount of the firm’s cash. What is the balance for total assets and current liabilities?

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Step 1: Picture the Problem

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Current AssetsCashAccounts ReceivableInventoriesOther current assetsTotal current assets

Current LiabilitiesAccounts payableShort-term debtOther current liabilities

Total current liabilities

Long-term LiabilitiesLong-term debt

Long-term (fixed) assetsGross PPELess: Accumulated depreciationNet property, plant and equip.

Other long-term assets

Total long-term assets

Owner’s EquityPar value of common stockPaid-in-capitalRetained earningsTotal equity

Total Assets Total Liabilities and Owners’ equity

Step 2: Decide on a Solution Strategy We are given the account balances so in order to

construct the balance sheet we need to substitute the appropriate balances into the template developed in step 1.

Deduct $1B from both cash and current liability.

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Step 3: Solve CashInventoriesOther current assets

756,000,0001,506,000,000 743,000,000

Current liabilities

1,158,000,000

Total current assets

3,005,000,000 Total current liabilities

1,158,000,000

Net Property, Plant and equipment

2,993,000,000 Long-term liabilities

1,019,000,000

Other long-term assets

626,000,000 Common Equity

4,387,000,000

Total Assets $6,564,000,000

Total Liabilities and Equity

$6,564,000,000

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Step 4: Analyze We can make the following observations from

Gap’s Balance sheet: The total assets of $6,564,000,000 is financed by a

combination of current liabilities, long-term liabilities and owner’s equity. Owner’s equity accounts for $4,387,000,000 of the total.

The firm has a healthy net working capital of $1,847,000,000 (3,005,000,000 minus 1,158,000,000).

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