Turning Gadflies into Allie
February 4, 2008
Multinational companies are the driving force behind globalization, but they are also the source of many of its most painful consequences, including currency crises, cross-border pollution, and overfishing. These remain unsolved due to two kinds of failures. For one, such issues are, by their nature, beyond the scope of individual governments to avoid or resolve. For the other, transnational organizations, such as the World Bank, the International Monetary Fund, and the World Trade Organization, have proved unequal to the task.
The Income Statement
September 17, 2007
The balance sheet is a snapshot of a business as of a given moment in time. The income statement isn’t. Rather, it’s a summary of everything that happened during a given period of time. The combined income statement in Table 4.2 shows what happened for two periods, the period from January 1, 2002, through December 31, 2002, and the period from January 1, 2003, through December 31, 2003. The moment in time of the balance sheet will always correspond to the last day of the period covered by the income statement.
We won’t need to go into every item on the income statement; most are self-explanatory. Let’s highlight some items that should raise red flags.
Sales Revenue
According to the income statement, Houston Sash & Door sold windows and doors totaling $1,881,117 during the period that began on January 1, 2003, and ended on December 31, 2003. Right? Not exactly.
The accountant who prepared the income statement wasn’t kind enough to break out for us the gross amount of sales and deduct from that number the sales returns the business experienced. Houston Sash & Door might actually have sold $2,381,177 worth of windows and doors, of which $500,000 worth was returned and not paid for. If a business has a high level of returns, it may mean that a high level of inferior goods has been shipped. If this is true, it may mean that lawsuits can be expected from customers who bought and paid for goods and now aren’t satisfied or, worse, have been injured by the goods or have had their businesses harmed by them. If you find an unusually high level of returns (which you can’t find from this income statement), keep digging.
Don’t forget what we learned about accounts receivable. In order to prettify the financial statements, the seller may have artificially increased sales by granting easy credit to unqualified customers. These sales show up as sales revenues on the income statement, as well as accounts receivable on the balance sheet, whether or not any of these sales ultimately bring in any cash.
Professional Services
This refers to legal and accounting fees the business incurred during the period. Compare 2002 with 2003. They were minuscule in 2002 and in excess of $58,000 in 2003. If the large increase represented accounting fees, it probably means that the business experienced an IRS audit. At the present time it may be impossible to determine whether the audit resulted favorably or whether a big tax bill is coming. Not only that, the IRS may have audited only one prior year. If the accountant took the same aggressive position with respect to a certain item(s) on the tax returns for other years, you may be faced with an audit for those years as well. If the large increase in professional services was due to legal fees, it probably means the business was involved in a lawsuit. Keep digging.
Net Income
We’ll see that the real income a business earns for its owners is different from the bottom-line figure that appears on the income statement. The net income Houston Sash & Door shows for the year ending December 31, 2003, is $280,397. But this doesn’t mean there’s $280,397 in cash available for the owner. There may be more! After all, we arrived at net income by deducting an amount for depreciation. But you don’t have to spend any money to get the depreciation deduction the way you do to get a deduction for office supplies, utilities, and the like. The point here is that there is a critical difference between a business’s net income and its cash flow. More on that later.
Accounts Payable, Notes Payable, Long-Term Debt, And Paid-in Capital
September 15, 2007
Accounts Payable
Just as Houston Sash & Door grants its customers credit, the people who supply Houston Sash & Door with lumber and other materials sell these items on credit. When such a credit transaction occurs, it generates an account payable.
When we examine Houston Sash & Door’s accounts payable account on December 31, 2003, we note that the $65,703 it owed is rather insignificant compared to its almost $2 million in sales and is less than half of its payables as of December 31, 2002. How do we explain this? It may be that Houston, fortified with lots of cash, took advantage of cash payment discounts offered by suppliers. It also may be that business was slow toward year-end (the business may be seasonal in nature) and fewer items were purchased. There’s one circumstance, however, where low (or no) accounts payable are a problem: When the business’s credit is so bad that no one will sell to it on credit and all purchases must be made COD!
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The Balance Sheet : Plant and Equipment
September 14, 2007
The big-ticket items appear here. These are the fixed assets, which are not likely to be converted into cash during the business’s operating cycle. The plant and equipment account includes all the hard assets not sold to customers, such as office furniture, machinery, cars and trucks, and equipment. It includes those items that are expected to be around for more than a year and are depreciated, rather than expensed, items. Had Houston Sash & Door owned any real estate, there would also be a real estate account.
We’ve stated that the balance sheet tells us what the business paid for the assets, not what they’re worth now or what it would cost to replace them. Not only that, the total plant and equipment entry is net of accumulated depreciation. On December 31, 2003, the total cost of all the items that appear in the equipment, furniture, and fixtures ledgers was $60,868. Since then the owners of the business have taken $31,592 in depreciation deductions, so that the adjusted book value of this account is $29,276.
The Balance Sheet : LIFO and FIFO
September 14, 2007
We said that the balance sheet records only what was paid for assets, not what they’re worth. One of the trickiest aspects of the balance sheet for a nonaccountant is the problem of what actually was paid for the inventory. Here’s the problem: Houston Sash & Door buys inventory (raw lumber) throughout the year. Also throughout the year Houston Sash & Door converts the lumber to finished products and sells them. Let’s assume that the cost of the lumber keeps rising during the year (a pretty good assumption in inflationary times).
The Balance Sheet : Inventory
September 11, 2007
If the business you’re contemplating buying is a service business, you won’t have inventory to worry about, but if you’re thinking of buying a business that manufactures and/or distributes products, you’ll be faced with the problem of valuing and dealing with the seller’s inventory.
On December 31, 2003, Houston Sash & Door had $203,841 in its inventory account. Does this mean that the inventory is worth $203,841, or that it could be sold for $203,841? Neither. Since the balance sheet records only what was paid for assets, it provides us with hardly a clue about what inventory is worth or what it can be sold for, if at all! Houston’s inventory may be worth far more than $203,841, far less, or zero. How is this possible? Very often, inventory decreases in value as it sits on the shelves.
The Balance Sheet : Notes Receivable
September 10, 2007
Houston Sash & Door’s balance sheet has two entries for notes receivable. One represents an amount creditors incurred in the normal course of business with Houston Sash & Door. The other, Note Receivable-Officer, represents a debt Houston owes the business. This is the one to which you should give special attention.
Is there an enforceable promissory note backing up the debt? Since Houston was dealing with a company he owns himself, there may not be. Since the receivable appears as a current asset, it should be payable within a year. Is it? Most important, how are you going to deal with his personal debt to the business when you buy the business? Will you require that it be paid at the closing? Will you insist on withholding part of the purchase price, in order to assure that the debt is paid when it comes due? Whatever you do, don’t forget about this important item.
Pay close attention to the other notes receivable entry. Just because a note is included as a current asset doesn’t mean it can be collected within a year. A note receivable may have started out in life as an account receivable. When the debtor couldn’t pay, the creditor did the next best thing: The creditor had the debtor sign a short-term promissory note. But since the debtor couldn’t pay the debt when it was a receivable, there’s no assurance the debtor will be able to pay the promissory note, either.
The Balance Sheet : Accounts Receivable
September 7, 2007
On December 31, 2003, Houston Sash & Door was owed $230,962 by its customers (net of reserve). The company generated these receivables by making sales on credit. As soon as a sale was made, a receivable was entered in the company’s accounts receivable ledger. The $230,962 figure represents the total amount of credit sales that hadn’t yet been paid on December 31, 2003. Does this mean that within the coming year the business can expect to receive exactly $230,962 from its customers? Not quite. Every business has a certain percentage of accounts receivable that go bad.
The Balance Sheet : Cash
September 3, 2007
Cash is the first item that usually appears under current assets, which are, generally speaking, the most liquid assets, that is, those assets most easily converted into cash. The current assets part of the balance sheet lists the assets in descending order of liquidity. Since there’s nothing more easily converted into cash then cash itself, it’s listed first. As a rule of thumb, accountants will place an asset in the current assets category if the asset is expected to be reduced to cash during the business’s operating cycle, which is the time it takes for cash to go through the business and come back as cash, as follows: starting with cash, to the purchase of raw materials, to the manufacture of finished goods, to the sale of the goods (i.e., the inventory), to the conversion of inventory to accounts receivable, and the conversion of accounts receivable back to cash when the accounts are paid.
Analyzing the Financial Statements: The Balance Sheet
September 2, 2007
You should know what a balance sheet is and what it isn’t. Every balance sheet ever prepared for any business is perfectly balanced! This is not the result of accountants being mathematical wizards. Rather, it’s because a balance sheet represents an equation, and the left side of an equation always equals the right side.
The equation is:
Assets = liabilities + net worth
Stated differently:
Assets - liabilities = net worth
Not only is every balance sheet an equation, it’s an equation as of a given moment in time. Let’s take a look at the balance sheet in Table 4.1. It reveals the following:
Assets ($822,658) = liabilities ($131,243) + net worth ($691,415)
