The classified balance sheet

A balance sheet is a financial statement that displays a company’s assets,

liabilities and shareholders’ equity at a specific point in time. It can also be referred
to as a statement of net worth, or a statement of financial position. The balance
sheet provides a snapshot of what a company owns and owes, as well as the amount
invested by shareholders and helps to evaluate its capital structure – the particular
combination of debt and equity used by the company to finance its overall
operations and growth.

There are several balance sheet formats available. The more common are
the classified, common size, comparative, and vertical balance sheets.

A classified balance sheet is one with classifications (groupings or

categories) such as current assets, long-term assets, current liabilities, long-term
liabilities, and equity. It arranges the balance sheet accounts into a format that is
useful for the readers. The balance sheet adheres to the following accounting
equation, where assets on one side, and liabilities plus shareholders’ equity on the
other, balance out:

Assets = Liabilities + Shareholders’ Equity

This formula is intuitive: a company has to pay for all the things it owns
(assets) by either borrowing money (taking on liabilities) or taking it from investors
(issuing shareholders' equity). If a company keeps accurate records, the accounting
equation will always be “in balance”, meaning the left side should always equal the
right side. The balance is maintained because every business transaction affects at
least two of a company's accounts.
 Assets, liabilities and shareholders’ equity each consist of several smaller
accounts that break down the specifics of a company’s finances. These accounts
vary widely by industry, and the same terms can have different implications
depending on the nature of the business.

Assets (what the company owns)

Assets are a company’s resources – things that the company owns. Within
the assets segment, accounts are listed from top to bottom in order of their liquidity
– that is, the ease with which they can be converted into cash. They are divided into
current (short-term) assets, which can be converted to cash within a firm’s fiscal
year or less, and non-current (long-term assets), which cannot (TQ1.1).

Current assets are considered short-term assets because they generally are
converted to cash within a firm’s fiscal year, and are the resources that a company
needs to run its day-to-day operations and pay its current expenses. Current assets
are generally reported on the balance sheet at their current or market price. They
include:

 Cash and cash equivalents – the most liquid assets. They can include
Treasury bills and short-term certificates of deposit, as well as hard
currency. Companies will generally disclose what equivalents it
includes in the footnotes of the balance sheet.

 Marketable securities – equity and debt securities for which there is a

liquid market and that the company can liquidate on short notice.
  Accounts receivable – balance of money due to a firm for goods or
services delivered or used but not yet paid for by customers. This is
any amount of money owed by customers for purchases made on
credit.

 Inventory – goods available for sale, valued at the lower of the cost
or market price. This includes amounts for raw materials, work-in-
progress goods, and finished goods.

 Prepaid expenses – results from a business making advanced

payments for goods or services to be received in the future.
Companies make prepayments for goods or services such as leased
office equipment or insurance coverage that provide continual
benefits over time. According to the generally accepted accounting
principles (GAAP), expenses should be recorded in the same
accounting period as the benefit generated from the related asset.

Non-current assets are a company’s long-term investments that have a

useful life of more than one year. They cannot be converted to cash easily and are
required for the long-term needs of a business. Non-current assets are reported on
the balance sheet at the price the company paid for them, which is adjusted
for depreciation and amortization and is subject to being reevaluated whenever the
market price decreases compared to the book price. Non-current assets include:

 Tangible assets – long-term piece of property or equipment that a

firm owns and uses in its operations to generate income, such as land,
 machinery, equipment, buildings. They are also referred to as capital
assets.

 Intangible assets – include non-physical, but still valuable assets such

as intellectual property and goodwill. In general, intangible assets are
only listed on the balance sheet if they are acquired, rather than
developed in-house.

Liabilities (what the company owes to others)

Liability is a present obligation of the enterprise to outside parties, defined

by previous business transactions, events, sales, and exchange of assets or services
– anything that would provide economic benefit at a later date. Liabilities are also
known as current or non-current depending on the context. Current liabilities are
those that are due within one year and are listed in order of their due date. Long-
term liabilities are due after one year or more.

Current liabilities should be closely watched by management to make sure

that the company possesses enough liquidity from current assets to guarantee that
the debts or obligations can be met. They consist of:

 Accounts payable – represents a company’s obligation to pay off a

short-term debt to its creditors or suppliers. If it increases over a prior
period, that means the company is buying more goods or services on
credit, rather than paying in cash.

 Interest payable – interest expense that has been incurred, but has not
been paid as of the date of the balance sheet.
  Wages payable – the wages that a company’s employees have earned,
but have not yet been paid.

 Current portion of long-term debt – records the total amount of long-

term debt that must be paid within the current year.

 Customer prepayments – the advance payments a customer has made.

 Dividends payable – the amount of the after tax profit a company has
formally authorized to distribute to its shareholders, but has not yet
paid.

Long-term liabilities are an important part of a company’s long-term

financing. Companies take on long-term debt to acquire immediate capital to fund
the purchase of capital assets or invest in new capital projects. If companies are
unable to repay their long-term liabilities as they become due, then the company
will face a solvency crisis. They can include:

 Long-term debt – the total amount of long-term debt (excluding the

current portion, if that account is present under current liabilities).
This account is derived from the debt schedule, which outlines all of
the company’s outstanding debt, the interest expense, and the
principal repayment for every period.

 Pension fund liability – the money a company is required to pay into

its employees’ retirement accounts.

 Deferred tax liability – taxes that have been accrued but will not be
paid for another year.
 Knowing which liabilities have to be paid within one year is important to
lenders, financial analysts, owners, and executives of the company. This
distinction helps recognizing and deciding how to allocate financial resources. It is
used to construct financial ratios and to determine a company’s short-term liquidity
and long-term solvency. A company with significant current liabilities will have to
resolve those liabilities in the near future – and if it is not able to pay them off, it
will encounter a liquidity crisis. This can impact things like payment of dividends,
default on debt payments and payment of wages to employees. (TQ3.1)

Shareholders’ equity (the difference between assets

and liabilities)

Shareholders’ equity refers to the money attributable to a business’ owners,

meaning its shareholders. It is the amount of money a company could return to
shareholders if all its assets were converted to cash and all its debts were paid off. It
is also known as “net assets”, since it is equivalent to the total assets of a company
minus its liabilities. If shareholders’ equity is positive, a company has enough
assets to pay its liabilities; if it’s negative, a company's liabilities surpass its assets.

The content of the owner’s equity section varies with the form of business
organization. In a sole proprietorship, there is one capital account. In a partnership,
there is a capital account for each partner. Corporations divide owners’ equity into
two accounts – Common Stock (sometimes referred to as Capital Stock) and
Retained Earnings.

 Capital stock – the amount of common and preferred shares that a

company is authorized to issue, according to its corporate charter. It
 can only be issued by the company and is the maximum number of
shares that can ever be outstanding.

 Retained earnings – the net earnings that a company either reinvests

in the business or use to pay off debt. They equal net income
(revenues less expenses) or loss minus any amounts given back to
stockholders in the form of dividends. Dividends affect stockholders’
equity in the same way that owner withdrawals affect owner’s equity
in sole proprietorships and partnerships.

The balance sheet is an invaluable piece of information for investors and

analysts; however, it does have some drawbacks. It is a snapshot representing the
state of a company's finances at a moment in time. By itself, it cannot give a sense
of the trends that are playing out over a longer period. For this reason, the balance
sheet should be compared with those of previous periods. It should also be
compared with those of other businesses in the same industry since different
industries have unique approaches to financing.

A number of ratios can be derived from the balance sheet, helping investors
get a sense of how healthy a company is. These include the debt-to-equity ratio, the
acid-test ratio, along with many others.

The debt-to-equity (D/E) ratio is calculated by dividing a company’s total

liabilities by its shareholder equity. This ratio is a measure of the degree to which a
company is financing its operations through debt versus wholly-owned funds. More
specifically, it reflects the ability of shareholder equity to cover all outstanding
debts in the event of a business downturn. (TQ2.3)
 Companies raise money because they might have a short-term need to pay
bills or they might have a long-term goal and require funds to invest in their
growth. Debt and equity are the two major sources of financing. Equity financing is
the process of raising capital through the sale of shares. By selling shares, they sell
ownership in their company in return for cash, like stock financing. Debt financing
involves the borrowing of money and the most common form of debt financing is a
loan.

The biggest advantage of equity financing is that the company does not
have to pay back the money. If the business enters bankruptcy, the investors are not
creditors. They are part-owners in the company, and because of that, their money is
lost along with the company. Moreover, there are no required monthly payments;
therefore there is often more cash on hand for operating expenses. However, the
downside is quite large. In order to gain funding, the owner will have to give the
investor a percentage of his company. He will have to share his profits and consult
with his new partners any time he makes decisions affecting the company. The only
way to remove investors is to buy them out, but that will likely be more expensive
than the money they originally gave.

On other hand, there are several advantages to financing a business through

debt as well. First, the lending institution has no control over the company, and it
has no ownership. Once the loan is paid back, the relationship with the lender ends.
Next, the interest paid is tax deductible, and finally, it is easy to forecast expenses,
since loan payments do not fluctuate. However, adding a debt payment to the
company’s monthly expenses assumes that it will always have the capital inflow to
meet all expenses, including the debt ones. For small or early-stage companies, that
is often far from certain. Small business lending can be slowed substantially during
recessions. Furthermore, in tougher times for the economy, it's more difficult to
receive debt financing unless you are overwhelmingly qualified. (TQ2.1)

IKEA’s balance sheet

Intangible assets form much of Inter IKEA Group overall assets. Most Inter
IKEA Group intangible assets are so-called proprietary rights for the IKEA
trademarks, intellectual property and catalogue. Inter IKEA Group purchased these
rights for €11.8b. As a positive return is expected for a long period, these costs are
spread over a period of 45 years, which started in 2012.

Inter IKEA Group tangible assets are mainly factories and distribution
centers. Inter IKEA Group owns several offices and distribution centers, the IKEA
Delft store, the IKEA Hotel and Museum, and around 40 factories. Most of the
factories are in Europe. The majority produce IKEA furniture, and two produce
components like screws and wooden dowels used to assemble IKEA furniture.

Most Inter IKEA Group non-current liabilities, which are due over a long
period of time, consist of loans from Interogo Holding AG (a non-controlling
shareholder). Current liabilities are short-term loans, money due to suppliers and
the current portion of long-term loans from Interogo Holding AG. In addition,
equity increased with €1b during FY19 relative to FY18.

Tesla’s balance sheet

 In this case, tangible assets constitute much of Tesla’s overall assets.
Tesla’s long-term assets consist of mostly cash-generating assets such as the
operating leased vehicles and solar energy systems, which provide the company
with stable leasing revenue in the long-run. Furthermore, Tesla now has 438 Tesla
Motors Stores throughout the world and almost 100 service centers. It currently
operates 2 gigafactories in Nevada and New York and 1 factory in California.

Zooming in on the balance sheet data, we can see that Tesla had liabilities
of $10.7b due within 12 months and liabilities of $15.5b due beyond that. It had
cash of $6.27b, as well as receivables valued at $1.32b due within 12 months. So its
liabilities outweigh the sum of its cash and near-term receivables by $18.6b.
Moreover, equity increased with $1,8b during FY19 relative to FY18.

Given the statistical data, we can clearly observe the differences in the
balance sheets of both of the companies. Firstly, major part of IKEA’s total assets
consists of intangible assets, such as proprietary rights for the IKEA trademarks,
intellectual property and catalogue. However, Tesla’s overall assets involve mainly
tangible ones, such as solar energy systems and operating leased vehicles. (PQ1.1)

In the second place, Tesla’s total liabilities are greater than those of IKEA
with $10,73b. This difference may be due to the fact that Tesla’s primary business
is related to producing more expensive products than IKEA, such as electric
vehicles and energy storage systems. (PQ1.2)

However, both of the companies seem to be funded primarily by liabilities,

as both of the companies’ liabilities records tend to be greater than their equity
ones. Debt usually has a relatively lower financing cost than equity, which makes it
an attractive option for executives. (PQ2.1)
 The optimal D/E ratio varies by industry, but typically it should not be
above a level of 2.0. The D/E ratio of IKEA is calculated to be 1,94, while the
optimal for the industry in 2018 equals 0,30. The recommended D/E ratio is
particularly higher for the auto industry, and for 2018 it is evaluated to be 1,01.
However, Tesla’s D/E ratio equals 3,71, which signifies that Tesla carries a
substantial amount of debt. (PQ2.2) A company with higher D/E ratio than its
industry optimal one may have difficulties with securing additional funding from
either source. Because debt is inherently risky, lenders and investors tend to favor
businesses with lower D/E ratios. For lenders, a low ratio means a lower risk of
loan default; therefore, investing in Tesla would be riskier. (PQ2.3)