Balance Sheet

Explanations of Numbers Suggestions and Tips

Your company's balance sheet summarizes the company's year-end financial status. Note 6 to the balance sheet
contains information on all the company's 5-year and 10-year loans outstanding.
This Help screen contains explanations of what the balance sheet numbers mean and how they are calculated. There's
a Tips and Suggestion section to guide you in using the Balance Sheet data wisely. A section describing two other
blocks of data presented just to the right of the Notes to the Balance Sheet winds up the contents of this ?/Help screen.
Understanding the Numbers in the Balance Sheet
A brief discussion and explanation of each of the balance sheet entries is presented below. The first grouping is for the
company's assets; the second is for the liabilities and stockholder equity entries.
Assets:
Cash on Hand This number represents the amount in the company's checking account at the end of the report
year.
Accounts Receivable The company does not immediately receive payment for all of the branded and private-
label pairs sold in a given year. There is an average 90-day delay in receiving the cash for pairs that have been
booked as sold. Revenues are booked when the pairs are shipped from the distribution warehouses, but, on
average, the cash received from these sales does not become available for company use until 90 days later. Thus,
accounts receivable are always 25% of the net revenues from footwear sales as reported on the company's income
statement. Note 1 to the balance sheet statement reports the size of net revenues.
Footwear Inventories This number represents the value of all branded pairs in inventory in all four regional
distribution centers at year-end, as reported on the Distribution and Warehouse Report (see the next to last line in
the Cost of Branded Pairs Sold section). The valuation of the pairs in year-end inventories includes (1) production
costs, (2) any applicable exchange rate adjustments to production costs on pairs shipped from a plant to
distribution centers in another geographic regions, (3) freight charges on pairs shipped from plants to distribution
centers, and (4) any tariffs paid on pairs shipped to distribution centers.
Net Plant Investment This number represents the undepreciated value of the company's investment in plant
capacity, as reported in more detail in the Plant Operations Report.
Work in Progress Work in progress refers to new investments in plant capacity and plant upgrades that were
ordered at the beginning of the year and that were being constructed and installed during the year. Any amounts
classified as work in progress will be added to gross investment next year and subject to depreciation at a straight
line rate of 5% annually.
Total Assets this number is the sum of all the above balance sheet entries.
Liabilities and Stockholders' Equity:
Accounts Payable The company has only one account payable at year-end; it concerns payments for
materials. Payments for materials ordered from suppliers are not due and payable for 90 days following the delivery
of those materials. So a company's actual cash outlays for materials in any one year always represents 25% of the
costs for standard and superior materials used in the prior-year and 75% of the costs for standard and superior
materials used in the current year. Thus, the accounts payable number equals 25% of the year's materials costs for
branded and private-label footwear. Note 2 to the balance sheet statement reports the company's total
expenditures for materials. Total costs for standard and superior materials for branded footwear are also shown on
the Plant Operations Report and materials costs for private-label footwear are shown on the Private-Label Sales
Report.
Overdraft Loans Payable If the company did not have sufficient monies in its checking account to cover all
required cash outlays, it is automatically issued an overdraft loan to bring its year-end checking account balance up
to 0. Any amount shown for this entry will be due and payable during the upcoming year.
1-Year Bank Loan Payable Any amount shown for this entry represents bank borrowing by company co-
managers at the end of the report year to finance company operations. The amount is scheduled for repayment in
the upcoming year. Note 4 to the balance sheet reports the interest rate on this 1-year loan.
Current Portion of Long-Term Loans As indicated in Note 5 to the balance sheet, this number represents the
annual principal payments due on 5-year and 10-years loans outstanding in the upcoming year. Note 6 to the
balance sheet shows the annual principal payments on each of the 5-year and 10-year loans outstanding; the sum
of these annual payments equals the current-portion of long-term loans.
Long-Term Bank Loans Outstanding This balance sheet entry represent the outstanding principal on all 5-
year and 10-year loans outstanding that is not due and payable in the upcoming year. Note 6 to the balance sheet
reports details of the company's long-term loans outstanding - the loan number, the year in which the loan was
taken out, the initial principal, the interest rate, the term of the loan, the outstanding principal, the annual principal
payment, and the annual interest payable. You will need to refer to Note 6 any time you and your co-managers
opt to pay off a 5-year or 10-year loan in advance decisions to prepay such loans require the entry of the
loan numbers on the Finance and Cash Flow decision screen.
Total Liabilities This entry is the sum of the preceding liability entries.
Common Stock This number represents the combined par value (at $1 per share) of all the shares of common
stock outstanding. Each new share of common stock that is issued will boost this balance sheet entry by $1. Each
share of common stock that is repurchased will reduce this balance sheet entry by $1.
Additional Capital The Additional Capital account represents the amount shareholders have paid for new
shares over and above par value of $1 per share. For example, if the company decides to raise additional capital
by issuing 1 million shares of stock and the issue price is $25 per share, then the 1 million-share stock issue will
generate $25 million in cash (1 million shares x $25 per share). In the stockholders' equity portion of the balance
sheet, the Common Stock account will increase by $1 million ($1 par value x 1 million shares issued), and the
Additional Capital account will increase by $24 million [ ($25 issue price - $1 par value) x 1 million shares issued ].

Since the Additional Capital account represents the amount shareholders have paid for new shares over and above
par value, this account is always debited for the full amount the company pays for repurchased shares in excess of
par value. For instance, if the company decides to repurchase 1 million shares of outstanding stock at a buyback
price of $38.50, then the 1 million-share stock repurchase will require $38.5 million in cash ($38.50 per share x 1
million shares retired). In the stockholders' equity section of the balance sheet, the Common Stock account will
decrease by $1 million ($1 par value x 1 million shares retired) and the Additional Capital account will decrease by
$37.5 million [ ($38.50 repurchase price - $1 par value) x 1 million shares retired ].
Retained Earnings A company's retained earnings represent additional investment in the company on the part
of shareholders. Retained earnings equals the amount of net profit that management has retained in the business
over all its years of operation. The amount retained in any one year equals total net profits less dividend payments -
in other words, any earnings not paid out to shareholders in the form of dividends are retained in the
business and represent reinvestment of earnings in the business - such reinvestment is, in effect, additional
money that shareholders have invested in company operations. It is important for you to understand that retained
earnings do not represent a stash of money that has been set away somewhere and is available for your use.
All the cash your company has in its checking account and is shown on the balance sheet as cash on hand. You
should look upon retained earnings as a "bookkeeping entry" showing how much of the company's profits that
shareholders have reinvested in the business. As such, retained earnings represent stockholders' equity
investment every bit as much as do the balance sheet entries for common stock and additional capital.
Total Shareholder Equity Total shareholder equity equals the sum of the entries for common stock, additional
capital, and retained earnings. Note that there are numbers showing shareholder equity at the beginning of the year
and the end of the year and the entries - common stock, additional capital, retained earnings - in which the changes
occurred. Recall that your company's performance is judged on Return on Average Shareholder Equity - defined as
net profit divided by the average of total shareholder equity at the beginning of the year and the end of the year.
Tips and Suggestions
It is strongly recommended that you read the notes to the company's balance sheet at least once to familiarize yourself
with their contents and the accounting procedures that are involved.
In addition, you should utilize the balance sheet for two primary purposes:
1. For information about the company's 5-year and 10-year loans. Note 6 to the balance sheet is your very best and
really only detailed source of information about the provisions of the company's 5-year and 10-year loans - the loan
number, the year in which the loan was taken out, the initial principal, the interest rate, the term of the loan, the
outstanding principal, the annual principal payment, and the annual interest payable. The loan number is needed
when you decide to pay off a particular loan in advance - the loan number must be entered on the Finance and
Cash Flow decision screen.
2. For tracking changes in shareholders' equity investment. The company's annual return on average shareholder
equity (ROE) is one of the 5 performance measures on which management is judged. ROE is defined as net profit
divided by average shareholders' equity investment in the business during the report year (see Note 10 to the
balance sheet for the formula). The company's ROE each year is calculated for you and shown in a box just below
the balance sheet entries and above the notes to the balance sheet.
The balance sheet always reports total shareholders' equity investment and allows you to see year-to-year changes
in the three components of shareholder equity:
o the Common Stock account,
o the Additional Capital account, and
o the Retained Earnings account.
The Retained Earnings account tends to rise each year, assuming the company has a positive net profit and
assuming that dividend payouts are less than 100% of net profits. Any increases in retained earnings have to be
accompanied by proportional increases in net profits or else the company's ROE declines. The company's retained
earnings decrease whenever (1) the company loses money (meaning that net profit in a given year is negative)
and/or (2) when the company's dividends payments exceed net profits (this will always occur when the company
ends up declaring a dividend per share of common stock that exceeds EPS).
One final point. The statistics in the two boxes underneath the Cash Flow Statement are always worth a look. A quick
glance will tell you whether the company's financial pulse is fine or whether there are things that need immediate
attention. A brief description of the data in these two boxes is presented below.
Data Showing Company Performance on Credit Rating Measures. Analysts at independent credit rating agencies
review the company's financial statements annually and assign the company a credit rating ranging from A+ to C-. A
company's credit rating is a function of three factors:
1. The debt-to-assets ratio (defined as all loans outstanding divided by total assets both numbers are shown on the
company's balance sheet). A debt-to-assets ratio of .33 is considered "good". As a rule of thumb, it will take a debt-
to-assets ratio close to 0.10 to achieve an A+ credit rating and a debt-asset ratio of about 0.25 to achieve an A-
credit rating (unless the interest coverage ratios are in the 5 to 10 range and the default risk ration is above 3.00).
Debt-to-asset ratios above 0.50 (or 50%) are generally alarming to creditors and signal "too much" use of debt and
creditor financing to operate the business, although such a debt level could still produce a B+ or A- credit rating if a
company can maintain with very strong interest coverage ratios (say 8.0 or higher) and default risk ratios above
3.00.
2. The interest coverage ratio (defined as annual operating profit divided by annual interest payments). Your
company's interest coverage ratio is used by credit analysts to measure the "safety margin" that creditors have in
assuring that company profits from operations are sufficiently high to cover annual interest payments. An interest
coverage ratio of 2.0 is considered "rock-bottom minimum" by credit analysts. A coverage ratio of 5.0 to 10.0 is
considered much more satisfactory for companies in the footwear industry because of earnings volatility over each
year, intense competitive pressures which can produce sudden downturns in a company's profitability, and the
relatively unproven management expertise at each company. It usually takes a double-digit times-interest-earned
ratio to secure an A- or higher credit rating, since this credit measure is strongly weighted in the credit rating
determination.
3. The default risk ratio (defined as free cash flow divided by the combined annual principal payments on all
outstanding loans; free cash flow is defined as net profit plus depreciation minus dividend payments). This credit
measure also carries a high weighting in the credit rating determination. A company with a default risk ratio below
1.0 is automatically assigned "high risk" status (because it is short of cash to meet its principal payments) and
cannot be given a credit rating higher than C+. Companies with a default risk ratio between 1.0 and 3.0 are
designated as "medium risk", and companies with a default ratio of 3.0 and higher are classified as "low risk"
because their free cash flows are 3 or more times the size of their annual principal payments).
The interest coverage ratio and the default risk ratio are the two most important measures in determining a
company's credit rating. Thus, as long as a company is financially strong in its ability to service its debt as
measured by the interest coverage ratio and the default risk ratio, then the company can maintain a higher
debt-to-assets ratio without greatly impairing its credit rating.
Data Showing Selected Financial Statistics. This section provides you with a solid indication of the strength of the
company's financial performance and financial condition, somewhat apart from its performance on the three credit rating
measures. A brief description of each of the statistics provided in this section follows:
The current ratio (defined as current assets divided by current liabilities) measures the company's ability to pay its
current liabilities as they become due. At the least, the current ratio should be a bit greater than 1.0; a current ratio
in the 1.5 to 2.5 range provides a much healthier cushion for meeting current liabilities.
Operating profit margin is defined as operating profits as a percentage of revenue. A higher operating profit
margin is a sign of competitive strength and cost competitiveness. The bigger the percentage of operating profit to
net revenues, the bigger the company's margin for covering interest payments and taxes and moving dollars to the
bottom-line.
Net profit margin is defined as net profit divided by annual footwear revenues. The bigger a company's net profit
margin, the better the company's profitability in the sense that a bigger percentage of the dollars it collects from
camera sales flow to the bottom-line. The net profit margin is sometimes called "return on sales" because it
represents the percentage of revenues that end up on the bottom line.
Dividend payout is the percentage of net profits paid out as dividends (or as dividends per share divided by
earnings per share). Generally speaking, a company's dividend payout ratio should be less than 75% of net profits
or EPS, unless the company has paid off most of its loans outstanding and has a comfortable amount of cash on
hand to fund growth and contingencies. If your company's dividend payout exceeds 100% for a year or two, then
you should consider a dividend cut until earnings improve. Dividends in excess of EPS are unsustainable and thus
are viewed with considerable skepticism by investors - as a consequence, dividend payouts in excess of 100%
have a negative impact on the company's stock price.
Free cash flow is defined as net profit + depreciation dividend payments. It is a measure of a company's
liquidity and is a component in calculating the company's default risk ratio. The bigger the free cash flow number
the better. Ideally, free cash flow will be 2-3 or more times higher than total principal payments on loans
outstanding. The bigger the company's free cash flow, the larger the debt that your company can have without
weakening the company's credit rating (assuming that your company also maintains a strong interest coverage
ratio - say, 5 to 10 times annual interest payments).
Total principal payments equals what amount of the loans previously taken out at the International Bank of
Commerce were repaid in the report year. Bear in mind that total principal payments of loans of a given size will be
smaller the longer the term of the loan. For example, a $10 million loan of 5-years duration entails annual principal
payments of $2 million whereas a 10-year loan of the same size would entail annual principal payments of $1
million.
The default risk ratio in a given year is defined as free cash flow for the year divided by total principal repayments
on loans during the report year. As indicated above, a company with a default risk ratio below 1.0 is short of cash to
meet its principal payments and cannot be given a credit rating higher than C+. If you company has a default risk
ratio between 1.0 and 3.0, it is designated as "medium risk" and had a free cash flow in the report year between 1
and 3 times annual principal payments in the report year. Ideally, your company should have a default risk ratio
above 3.0, which indicates your company's free cash flow in the report year was 3 or more times the size of your
company's annual principal payments in the report year.