Series 65

Quantitative Methods of Evaluating Businesses and Investments - Balance Sheet

The Balance Sheet
The balance sheet is simply a picture of a company's assets and liabilities at a specific point in time. It is similar to a net worth statement for an individual, except that the "net worth" is referred to as "shareholders' equity."

For a business, the following formula applies:

Shareholders\' Equity = Total Assets - Total Liabilities

Assets fall into three categories:
  • Current - includes cash, marketable securities, accounts receivable and inventories

  • Fixed - refers to items owned and used by the company, such as real estate, equipment and furniture. The value used on the balance sheet is the original cost minus depreciation taken in previous years.

  • Intangibles- these are the non-physical components of the business's value, such as patents, copyrights, trademarks, franchises and goodwill.
Liabilities are defined as either current or long term.
  • Current liabilities - amounts that must be paid within a year and include:
    • Accounts payable
    • Notes payable
    • Taxes payable
    • Interest payable
    • Dividends payable

  • Long-term liabilities - amounts that become payable more than one year into the future and generally includebonds and long-term bank loans.
The key calculation derived from a company's balance sheet is working capital, which is obtained by subtracting current liabilities from current assets:

Working Capital = Current Assets - Current Liabilities

Look Out!
Working capital is not affected when a company buys securities with cash, since current assets include both cash and securities. A typical exam question will offer that scenario and then ask which balance sheet items are affected. Working capital will be an incorrect answer.

Shareholders' Equity
includes three components:
  • Common and preferred stock - on the balance sheet, only the par value of both classes of stock is used, not the market value. (Par value is a dollar amount assigned to a security when first issued. For stocks, par value usually is a small amount that bears no relationship to its market price.) This par value is multiplied by the number of outstanding shares.

  • Capital surplus- this refers to the premium that shareholders pay in excess of the par value, usually when stock is issued by a company. Also called paid-in surplus.

  • Retained earnings - these are the net profits the company retains for future use rather than pay out as dividends.
Exam Tips and Tricks
You can expect only one or two questions on financial
statements, such as:
  1. XYZ Corporation buys furniture for a new addition onto its headquarters. Which of these items on its balance sheet will be affected?
    1. Current Assets
    2. Current Liabilities
    3. Net Worth
    4. Working Capital
    1. I and III
    2. I and IV
    3. II and III
    4. All of the above

The correct answer is "b", since cash (a current asset) will decrease, this also decreases working capital. Furthermore, furniture is a fixed asset, not a current asset; and net worth is only affected by profit, loss or dividend payout.

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