Guides, Resources & Education

Basic Accounting Guide for U.S. Companies – Part 2/3

Find out how to read a U.S. public company’s balance sheet in Part 2/3 of the Basic Accounting Guide.

Learn how to analyse the financial statements of public U.S. companies, item by item.

The Balance Sheet

The purpose of the balance sheet is to indicate the solvency, ‘book value’, and financial strength of a company. It defines what the company owns (assets) and what it owes (liabilities). Let’s look at Coca-Cola’s balance sheet for the fiscal year ending December 31st, 2020.

Source: The Coca-Cola Company Investor Relations Annual Report 2020

Before delving into each item, let me clarify a few things. The balance sheet is essentially split into two halves, the first of which details assets, and the second of which describes liabilities. An asset is something that has economic value which is expected to produce a benefit in the future. In contrast, a liability is anything that is owed – such as debt. Balance sheets are further divided into: Current Assets/Liabilities and Non-Current Assets/Liabilities. ‘Current’ means less than 12 months whereas ‘Non-Current’ means more than 12 months in duration. These rules are important to remember and will be further explained shortly.

Let’s look at Current Assets, which refers to any assets that can be turned into cash (liquidated) within 12 months. Several items fall under this heading. Cash and Cash Equivalents, Short-term Investments, and Marketable Securities all refer to cash and highly liquid, safe investments such as U.S. treasury bills, money-market funds, and certificates of deposit (short-term bank loans). Such investments are made by companies to earn a small return during periods when cash is not required. Trade Accounts Receivable is any money that the firm is still owed in exchange for goods and services it has provided. Inventories, as you may have guessed, refers to any raw materials, work-in-progress, and finished products that the company has ready for sale. Inventory obviously varies between companies and it makes sense to analyse its nature. Let me elaborate on this. On one hand, a grocery chain will have a lot of food on its books that can spoil easily, so you should be wary of taking its worth at face value. On the other hand, a mining company may hold precious metals on its balance sheet, which tend to retain their value. This is why it is important to determine the extent to which Inventories are actually a valuable asset rather than a pure accounting term. We can view the exact composition of Inventories by navigating to the footnotes:

Source: The Coca-Cola Company Investor Relations Annual Report 2020

Prepaid Expenses are advance payments made for goods and services to be received in the future. In the line below Prepaid Expenses, the Current Assets are totalled. Although not labelled as such, anything below this line refers to Non-Current Assets that would take longer than 12 months to convert into cash. Equity Method Investments refers to the value of any significant stake (part ownership) that Coca-Cola holds in other companies. To qualify as an Equity Method Investment, this stake must be no less than 20% and no more than 50% – a level of ownership that is regarded as ‘significant’ but not ‘controlling’ (less than 51%). In addition to the ‘book value’ of the investment (what it is worth on paper), the proportional share of net income produced by the investee is also regularly added to the investor’s balance sheet under Equity Method Investments (or deducted in the case of a loss). Other Investments and Other Assets are defined in the footnotes.

Deferred Tax Assets are any advance tax payments that the company can redeem as tax relief in the future. Property, Plant, And Equipment (PPE) envelops assets such as land, buildings, and machinery. The word ‘net’ is given in the same line to indicate that the value of the PPE has been adjusted for depreciation – an accounting process which spreads out the cost of purchasing tangible assets like machinery over time. This is done because these assets provide a benefit for the company (increasing revenue and profits). Depreciation is a non-cash charge (a theoretical expense) which technically ‘reduces’ earnings, in turn lowering tax expenses. Trademarks With Indefinite Lives refers to the value of Coca-Cola’s trademarks, such as logos, slogans, and designs. They are a type of intellectual property which legally differentiate Coca-Cola’s products from those of its competitors (e.g. PepsiCo). Goodwill is perhaps the single most useless item on a balance sheet. Let me define what it means. When one company buys another, the acquirer (buyer) typically pays more than the acquiree is worth in terms of tangible (physical) net assets (total assets – debt). This ‘extra payment’ is commonly made to compensate the acquiree’s shareholders for the value of intangible assets like good customer relations, intellectual property, proprietary technology, or to simply sweeten the deal.

Goodwill = Acquisition price – (Acquiree’s Assets – Liabilities)

Goodwill is reported as an intangible Non-Current Asset on the acquirer’s balance sheet. However, it is difficult to accurately value Goodwill because of its intangible nature – it could be more valuable, fairly valued, or less valuable. If Goodwill loses value for whatever reason, it is said to be impaired. Other Intangible Items refers to just that – a variety of small items that are too insignificant to record individually.

The first item under Current Liabilities is Accounts Payable and Accrued Expenses, which refers to any money due to suppliers or vendors for goods and services provided that haven’t been paid for yet. These invoices are essentially a type of non-interest bearing short-term debt and they are the polar opposite of Accounts Receivable. Loans and Notes Payable refers to real short-term, interest-bearing debt due within the next 12 months to creditors such as banks. Similarly, Current Maturities of Long-term Debt describes the portion of (previously) long-term debt that is due to be repaid in the next 12 months. The final item under Current Liabilities is Accrued Income Taxes, which denotes any tax that is due to be paid to the government within the next 12 months.

Let’s move onto the final section of the balance sheet: Non-Current Liabilities. Long-term Debt refers to any interest-bearing debts such as corporate bonds that have a maturity exceeding one year. As a general rule, both short-term and long-term debt have pros and cons. The pros are that taking on debt allows a company to increase its financial firepower – it can access capital now to make investments that produce benefits later – and to reduce its taxes because interest payments are considered a tax deductible business expense. However, the obvious drawbacks of debt are that the interest payments are an ongoing expense which drags on profitability and the company must be ready to repay the debt principal (the amount borrowed) by the maturity date. If the company is unable to do this, it may go bankrupt, leading investors to lose their entire inlay. With these factors in mind and due to its importance, it is worth analysing the composition of Long-term Debt in the footnotes. Doing so would indicate the exact type of Long-term Debt, the interest rates, principal amounts, and the maturity dates. Needless to say, if a company is in poor state of solvency and has a significant amount of debt due shortly, it would be worth thinking twice about investing. Other Liabilities could include operating leases for real estate or machinery, and pension plan obligations, which are again broken down in the footnotes. Other Liabilities should not be disregarded because they are often similar to debt instruments: unless obligatory payments are made, the company could suffer setbacks such as legal troubles or withdrawal of access to a certain service. Deferred Tax Liabilities are the exact opposite to Deferred Tax Assets – they are tax payments that will come due at some point past 12 months.

We do not need to concern ourselves with the exact specifics comprising Shareholders’ Equity (SE), which is referred to as Equity Attributable to Shareowners of The Coca-Cola Company in the above balance sheet. Essentially, SE refers to the claim that shareholders have to the company’s assets after all debt has been paid, so it can be described using the formula below:

Shareholders’ Equity = Total Assets – Total Liabilities

SE is commonly referred to as ‘book value’ and it is a rudimentary indicator of solvency. For example, if this value is negative, we know that the company does not have enough assets to cover its liabilities, which indicates poor solvency, and vice-versa. SE is not the same as liquidation value – the value of the company should it be ‘stripped for parts’, which may occur in the event of bankruptcy. This is because liquidation value is predominantly comprised of the worth of tangible and liquid assets, excluding components with more elusive value such as Inventories and Goodwill. In an upcoming article I will discuss financial ratios, multiples, and what makes a good balance sheet.

Click here to learn how to read a cash flow statement

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Johan Lunau – 17/06/21

3 comments on “Basic Accounting Guide for U.S. Companies – Part 2/3

  1. Pingback: Basic Accounting Guide for U.S. Companies – Part 3/3 – Lucid Finance

  2. Pingback: A Guide To Value Investing For Novice Investors – Lucid Finance

  3. Pingback: Quantitative Value Strategies: Graham’s Net-Nets – Lucid Finance

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