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Implications of Balance Sheet Utilization



Implications of Balance Sheet UtilizationIn the business world (even governments), balance sheet utilization is often mismanaged. Some of the problems faced by executives in the pursuit of financial gain and representatives furthering flawed public policy will now be examined. This post emphasize in discussion of balance sheet utilizations and its implications. Some specific issues addressed through the post are as follows: Using Equity As Currency; Accretive Versus Dilutive Equity Transactions; Impact Of Inflation On The Balance Sheet; The Impact Of Currency Fluctuations On A Balance Sheet.



Using Equity As Currency

Sometimes companies seek to preserve cash by utilizing pieces of ownership to motivate employees, acquire assets, or purchase other businesses. By doing so, the company dilutes existing ownership stakes by the amount of new equity that is issued in these transactions.

Presumably, having a stake in the success of the business will motivate employees to perform better. Whether this is true or not is subject to debate, but the practice often allows organizations to reduce the amount of required cash to retain top talent. The amount expensed for such issuance is based on the number of shares issued and the trading price of those shares at the time of issuance.

Another use of equity is for the acquisition of another business. Sometimes this is accomplished by a private business issuing a portion of its shares, membership interests, or partnership interests to another company’s owners in exchange for ownership interests of the business being purchased; other times, just the assets of the target company are acquired.

Solely buying a company’s assets carries much less risk than a stock purchase. When a company’s stock is purchased, the assets as well as liabilities come along with the deal. To the extent that the new owner is clearly informed about all of the liabilities that are obligations of the business, the transaction is fair to both parties.

Buying stock allows the purchaser to acquire a bigger company due to the effective leverage utilized in the purchase. Only the equity needs to be bought, and the assets are effectively financed by the existing liabilities on the balance sheet of the business being purchased.

There is always a risk that the liabilities are greater than anticipated, however. Imagine that fraud has hidden the true obligations of the company being acquired. After the deal is done, the purchaser may feel buyer’s remorse in part due to claims surfacing that were unanticipated. Such claims may originate through vendor invoices that were never recorded, taxes that were never paid, or litigation related to the company’s past practices.

A good example is the taint experienced by companies that acquired asbestos manufacturing businesses years ago. Even though those claims arose long after the deals were closed, class action lawsuits cost the acquiring companies billions of dollars of medical expenses, higher insurance premiums, settlement costs, and of course, legal fees.

Because the dangers (and corresponding liabilities) associated with the asbestos in the insulation products that were produced was not yet known, the companies that bought the equity of other businesses in this field were blindsided.

The purchase of assets, on the other hand, is safer. When bought properly, assets come unencumbered by liabilities. Does an asset purchase completely protect a buyer from a later lawsuit? Of course not. But one’s defenses are much, much stronger.

Equity holders are by definition subordinate, or junior in right of payment, to liability holders (creditors) in a business. And while new owners may insist on indemnification, or protection from sellers, for potential but undisclosed prior liabilities, chasing them later is a difficult and costly process.

Whether a public company buys assets or equity of another business, many transactions are effected utilizing the stock of the buyer to compensate the owners of the selling business for the ownership of the company being acquired. For the buyer, the amount of ownership in its business that is issued to the selling shareholders determines whether or not the potential acquisition makes economic sense.


Accretive Versus Dilutive Equity Transactions

In any business decision utilizing company resources, management must ascertain whether or not an asset purchase makes the most sense for its owners. This is true on a micro or macro level. A corner Laundromat, for example, may have $1,000 to spend on either a snack machine or another dryer. General Electric may, for example, have had the wherewithal to purchase a company like Telemundo, the Spanish-speaking network to complement its National Broadcast Company (NBC) investment (prior to selling NBC to Comcast). Or GE might instead invest in a power plant on a barge off the coast of Nigeria or develop a new health-care technology.

No business has unlimited resources, and those managers who allocate company assets are to be held responsible for the decisions they make. Each transaction directly affects individual shareholders.

If you own 10 percent of a company that earns $1 million per year, your share of the business income will be $100,000 annually. If the management enters into an agreement that results in your $100,000 increasing to $150,000 each year, you as an owner will be thrilled!

Such a transaction is considered accretive, because it increases earnings per share. On the other hand, if management makes a deal that reduces your income to $50,000 next year, you won’t be quite so pleased. A transaction that reduces earnings per share is considered dilutive to shareholders.

Imagine that the ABC Corporation is a publicly traded C corporation. ABC has one million shares outstanding that trade on the New York Stock Exchange at $20 each. ABC’s market capitalization is then said to be $20 million. This is calculated simply as 1,000,000 shares outstanding times the $20 price per share. ABC Corporation earns $1 million per year and therefore has earnings per share of $1.00.

Again, the math is straightforward: $1,000,000 of profit divided by 1,000,000 shares outstanding equals $1.00 per share. XYZ Company, a private company with no public float or shares available for purchase on a stock exchange, also earns $1 million per year. XYZ is for sale for $10 million. ABC Corporation agrees to buy XYZ for the full asking price of $10 million utilizing shares of ABC stock.

In order to come up with the purchase price, ABC issues 500,000 shares of stock, worth $20 apiece, to the owners of XYZ Company. This is calculated as 500,000 shares times $20 per share equals the $10,000,000 sought by the XYZ shareholders.

Was this a good decision by the managers of ABC Corporation? The answer lies in whether or not the transaction was accretive or dilutive to ABC shareholders.

Let’s look at the pro forma results (i.e., assuming that the transaction had already occurred). ABC Corporation’s earnings have now increased from $1 million prior to the transaction to $2 million annually due to XYZ’s additional $1 million of net income that now benefits ABC. ABC Corporation has more shares outstanding, though, and consequently has more hands to share in the increased earnings.

ABC had one million shares prior to the deal getting consummated, but now it has another 500,000, with a new total of 1.5 million shares outstanding. Dividing the new total earnings of $2,000,000 by the revised shareholder base of 1,500,000 shares equals $1.33 per share. In short, the transaction has increased ABC’s earnings per share by one-third, from $1.00 to $1.33; it is therefore accretive and desirable.

Good job, ABC management!

Different types of buyers may offer better value for equity holders of companies for sale. Obviously, if you own some or all of a business and you wish to liquidate your interests, you would like to get as much as possible for your investment. Consider the varying categories of business purchasers in the marketplace and their differing interests.

Let’s look at a local, singular grocery store for sale. It generates a certain amount of revenue and profit and seeks a reasonable asking price, as its owners are looking to move on to other ventures or to retire.

Clearly, any company buyer seeks to get more money in the future than it invests today. Financial investors that buy equity in businesses include individuals, pension funds, insurance companies, hedge funds, and mutual funds.

These institutions make investments on their own behalf or for others. Their objective is to realize a profit through appreciation in the value of the shares or other assets they buy. The financial investor may consider purchasing a small grocery store as an investment.

In doing so, based on current income levels, the return on investment might be 20 percent. (The purchase price in this case is expected to be five times net income, so the return is one-fifth of the purchase price, or 20 percent.)

Strategic investors include vendors, customers, or competitors. Just like financial investors, strategic investors look to make a profit on investments on behalf of their owners.

A strategic investor, a large grocery store chain, is also considering the acquisition of the small, private grocery store. The large chain has advantages over the financial investor, however. Because it already buys from suppliers a lot of similar inventory (e.g., fruit and vegetables, meat and poultry, paper products, dairy products, canned goods, and other stocked items), it is able to extract concessions from vendors that result in lower prices and better payment terms.

The grocery store chain also has another store in the area, so its existing advertising coverage will allow it to eliminate the advertising expense for the smaller store after purchase.

The larger competitor has an existing accounting department that can handle this function for the acquired store going forward, eliminating salaries for bookkeepers at the small store.  And because less competition will exist in the area, the large grocery store chain may be able to raise prices at both stores. This combination of beneficial factors in a purchase by a strategic investor is called “synergy.”

Due to the synergies associated with the deal, the strategic investor in this case, the large grocery store chain, might realize a 40 percent return on its investment (through an effective doubling of net income) if the price were the same as that proposed by the financial investor. Alternatively, the chain might pay a premium to the financial investor’s maximum purchase price and still derive a superior rate of return.

For these reasons, companies are generally better off looking for strategic buyers when looking to sell their business so that their owners realize maximum benefit.


Impact Of Inflation On The Balance Sheet

Sometimes people view inflation as an evil process that depletes the value of hard earned savings. This is not always the case. Inflation is, quite simply, the decline in the purchasing power of the U.S. dollar (or whatever currency is utilized by the business). The type of assets held by an individual or business as well as the corresponding leverage employed will determine how favorable or unfavorable the impact inflation will have. Certain assets lose value as domestic inflation rises.

Examples are cash (in U.S. dollars) and accounts receivable. If a business holds U.S. dollars and the dollar weakens, more of the cash will need to be utilized to purchase the same amount of goods. Accounts receivable, similarly, lose value, as the cash to which they convert has reduced purchasing power upon receipt.

Other assets may increase in value with inflation. A company may own real estate or foreign currency, both of which would likely grow in value denominated in U.S. dollars. To exaggerate the point, imagine that an owned building is worth $1 million. Now let’s drop the value of the U.S. dollar by 50 percent. Now it takes twice as many dollars to buy the building, which is currently worth $2 million. In short, hard assets offer greater protection from a falling local currency.

Imagine that the $1 million building is purchased with a $1 million loan, or mortgage. Should the U.S. dollar decline in value through inflation by 50 percent, the business now would have an asset worth $2 million but still owe only $1 million. One million dollars of value has been created through inflation. Yes, the $1 million is worth half of what it once was, because of the dollar’s reduced purchasing power. But there is still $500,000 of pre-inflation dollar purchasing power that has materialized through sharp inflation. This is because liabilities do not rise with inflation (although interest rates often go up, making adjustable loans more expensive).

So, if a company has significant debts along with substantial tangible long-term assets, its balance sheet is well poised to handle an inflationary period. Of course, the impact on inflation must also be considered on the income statement. To the extent that inflation hurts business profits, the balance sheet will suffer as well over time due to lower retained earnings.

The main determinant on the positive or adverse effect that inflation has on the income statement is whether the price received for goods or services sold rises faster or slower than a company’s expenses. For example, if a restaurant is unable to raise prices in a competitive environment (like my favorite bastion of capitalism, the mall food court) and its costs for food inventory go up, its gross margins will be squeezed and its profitability will decline.

Airlines are highly dependent on the price of jet fuel, which sometimes reaches 40 percent of their operating expenses. When the price of oil and jet fuel rise, airlines generally see profits fall because the industry has so many competitors and travelers tend to be very price sensitive through the utilization of the Internet for fare shopping. Some astute airlines have locked in long-term supply contracts for jet fuel during lower oil price environments. These businesses have been able to better weather the storm when jet fuel prices have skyrocketed, and some weaker competitors have been forced to enter bankruptcy to reorganize or liquidate.

Having hard assets like real estate utilizing liabilities that don’t increase in dollar terms during an inflationary period is one way to protect oneself from inflation. If you are concerned about the potential for the United States to default on its enormous debt, don’t be.

That’s because the U.S. government has the ability to print unlimited dollars to meet its obligations. The effect of such a process would be to render the dollar “diluted,” much like having lots of extra shares issued in a company. Borrowing money now at long-term fixed rates to purchase tangible assets like real estate or commodities offers maximum equity value protection if you expect the dollar to fall (as I do).

Investing in (loaning money for the purchase of) long-term U.S. government securities (bonds) that are not inflation protected or keeping cash may seem safe but still may result in a decline in the value of one’s nest egg.


The Impact Of Currency Fluctuations On A Balance Sheet

To the extent a business pays its expenses domestically in local currency and generates sales in the same country receiving the same currency as payment, the fluctuation of the U.S. dollar against the euro or the Japanese yen will have no direct impact on the company’s financial statements. However, if your balance sheet assets and liabilities are listed in U.S. dollars and your company owns foreign assets or is obligated to repay debts in other currencies, foreign exchange rates may have a dramatic impact.

Let’s say that banks in Japan are willing to lend money at 1 percent interest—this is not far from the truth. Your American business agrees to accept the loan but must repay it in Japanese yen. It should be easy to convert the money to U.S. dollars and generate a return on the money in excess of the 1 percent interest expense. This real strategy is called the “carry trade.” Simply putting the cash into a domestic certificate of deposit should yield at least double the cost of capital, generating a profit. However, there is a risk that the dollar weakens in value relative to the yen, resulting in losses.

Imagine that the dollar buys 100 yen when the loan is issued. Let’s say that the debt is 100 million yen, which gets immediately converted into 1 million dollars. Subsequently, the dollar’s purchasing power declines (due to, say, a perception of increasing Japanese government financial strength and a limited yen supply versus the American government’s declining fiscal prowess and growing number of dollars issued).

Now the dollar may be traded for only 80 yen. In other words, you now need more dollars to pay off the obligation. Specifically, you’ll now need $1.25 million to pay off the 100 million yen liability. The converse works as well. A strengthening dollar will make the debt easier to repay.

Companies with international operations constantly evaluate (and hopefully manage) the risks associated with currency fluctuation in the jurisdictions where they operate. Some large financial institutions offer businesses hedging contracts called “swaps.” These are effectively insurance contracts that require premiums but compensate the holders if commodities, or in this case, currency exchange rates, change in value.

If customers pay an American business in euros and the euro strengthens against the U.S. dollar, the company effectively benefits from a price increase proportional to the percentage increase. For example, a euro-denominated contract that is modestly profitable when a euro buys $1.25 will see a 20 percent effective price increase if costs remain flat and the euro purchases $1.50 when received. Since dollar expenses don’t necessarily rise when this occurs, the extra 20 percent of revenue flows down to the operating profit line of the company. Of course, if the same business must pay expenses in euros as well, much of the benefit is eaten up with higher costs.

Exporters love a weak domestic currency. It makes it easier for their foreign customers to afford their products. For companies that purchase their goods abroad through importation, the opposite is true.

A strong U.S. dollar, for example, makes it easier for American companies (and consumers for that matter) to afford foreign goods and services. According to the Financial Times, China has been criticized for intentionally keeping the Yuan artificially cheap; its value is fixed by the People’s Republic against the dollar. Doing so benefits the many exporters in the Asian nation.

This is one reason, I believe, why U.S. citizens purchase so many Chinese-made goods—they’re cheap relative to other things that may be purchased with a U.S. dollar. But their frequent purchase has led to hundreds of billions of dollars leaving the United States and caused an enormous trade deficit. China has used much of this inflow to lend money to the United States. In fact, the United States now owes China over trillion!

1 Comment

1 Comment

  1. iris

    Nov 22, 2010 at 12:35 am

    I need know what income tax information should be disclose in the balance sheet and income statement by FASB 109?

    Thank you!

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