ENGG 401 X2ENGG 401 X2Fundamentals of Engineering ManagementFundamentals of Engineering Management

Spring 2008Spring 2008

Chapter 4:Chapter 4:

The Balance SheetThe Balance Sheet

Dave LudwickDave Ludwick

Dept. of Mechanical EngineeringDept. of Mechanical Engineering

University of AlbertaUniversity of Albertahttp://members.shaw.ca/dave_ludwick/

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

Balance SheetsBalance Sheets

• A balance sheetbalance sheet is a snapshot of a business’s financial position at a point in timepoint in time (usually the last day of the accounting period).– Also called a Statement ofStatement of Financial PoFinancial Positionsition

• The balance sheet balances a business’s assets against its liabilities, and owner’s equity:

Assets = Liabilities + Equity

• Assets include current assetscurrent assets and fixed assetsfixed assets.• Liabilities include current liabilitiescurrent liabilities and long-term long-term

liabilitiesliabilities.• Owner’s equity includes sharesshares and retained earningsretained earnings.

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

Balance Sheets (2)Balance Sheets (2)

• Assets:– If the asset is useful (helps to earn revenue), it is recorded at book

value (the lesser of original cost minus depreciation or market value).

• If market value is higher, it is nevernever recognized in advance of being realized.

– If it is useless or worn out, it is written off.• depreciation and writedowns

– Accounting is always conservative.• In times of high inflation, book values deviate from real values

– Some long-term assets are intangibleintangible.• Something that can’t be seen or touched but has value to a company

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

A sample Balance SheetA sample Balance Sheet

Balance Sheet

Current Assets

Cash 10000

Current Liabilities

Accounts Payable 5000

Accounts Receivable 20000 Wages Payable 25000

Notes Receivable 15000 Utilities Payable 2000

Marketable Securities 25000 Long-Term Debt

Inventory 120000 Notes Payable 20000

Capital Assets Bonds Payable 600000

Equipment 250000 Owner’s Equity

Buildings 500000 Common Stock 300000

Goodwill 60000 Retained Earnings 48000

Total Assets 1000000

Total Liabilities + OE 1000000

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

Sample Balance Sheet #1Sample Balance Sheet #1

Source:

http://www.investopedia.com/

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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Sample Balance Sheet #1 (2)Sample Balance Sheet #1 (2)

Source:

http://www.investopedia.com/

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

Sample Balance Sheet #2Sample Balance Sheet #2

Source:

http://www.toolkit.cch.com/

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

Balance Sheets: General ObservationsBalance Sheets: General Observations

• All finance statements are created at the end of or after the accounting period– Typically this is once per year but can be monthly, quarterly, semi-

annually

• List assets in ascending order of liquidity.– Cash at top, then receivables, and so on.

• Prepaid expenses are bills paid annually but tracked monthly or quarterly (ex: rent, insurance).

• Fixed assets usually list the purchase value as well as an accumulated depreciation as a reduction.– This gives the ability to have a sense of the “age” of the assets.

• Capital shares (cash injection) are distinguished from retained earnings (cash retention).

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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ENGG 401 X2 – Fundamentals of Engineering Management

Goodwill and IntangiblesGoodwill and Intangibles

• GoodwillGoodwill is the premium you paid to purchase a company.– Equivalent to the purchase price minus the book value of the

business.– Goodwill can be depreciated, just like any other asset.– But you can’t just say you have Goodwill. The only time Goodwill is

created is when one company buys another for more than its net assets (Net Assets = Total Assets – Total Liabilities)

• Intangible assets can be depreciated as well.– e.g., patents have a finite lifetime

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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Credit IssuesCredit Issues

• Receivables occur when you sell your product or service on credit -> effectively the company provides a short-term loan– Customers agree to pay you within a defined period of time (30 Days)

• Liabilities represent value that you have, in effect, borrowed from others.– Just like you can sell on credit to your customers, so too can you buy

on credit from your suppliers

• Creditworthiness is a key issue throughout:– You check the credit rating of your customers.– Your suppliers check your credit rating.– Your short term lender focuses on the quality of your current assets.– Your long term lender usually has the right to take over assets that

“securitize” the loan.– Certain government charges transfer to board members.

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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Working CapitalWorking Capital

• Working capitalWorking capital is the difference between current assets and current liabilities.– The extra cost of being in business over and above fixed assets.– A good measure of a company's efficiency and its financial health.

• Working capital ratioWorking capital ratio is current assets divided by current liabilities.

• Adequacy of working capital is one key test for the provision of a short term credit line by a bank.– A positive working capital means you can pay off your short-term

liabilities.– A negative working capital means you can’t meet your short-term

liabilities with your current assets.

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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Working Capital (2)Working Capital (2)

• Working capital generally increases with sales level.– Typically, inventory, payables and receivables are proportional to

sales.– Failure to recognize this has sunk many a business.

• Inventory and receivables are often measured in terms of days.– As a ratio of daily sales– Often in the 30 to 60 days range

• More businesses fail for a lack of available cash than for a lack of profit.– Businesses need to make sure they collect on their receivables– Businesses need to ensure they turnover (sell) their inventory

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Example: Working Capital DeficiencyExample: Working Capital Deficiency

• Imagine a start-up “magic box” business with the following characteristics:– Your “rich uncle” gave you $500k to see what you could do.– You and some friends spent two years and $400k doing the

software.– Your losses to date from two years of prototyping are $95k. – Your sales strategy is a CM of 50%.– Material is 90% of COGS, contract labour is 10%.– You are selling $25k/mo of boxes to larger companies, who are

testing the product. You are at break even.– One company gives you an order for $1,000,000!!

• Can you survive the order?

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Example: Working Capital Deficiency (2)Example: Working Capital Deficiency (2)

• The sequence:– You order the material at time zero, terms net 30.– You receive the material a month later.– You pay for the material on time.– You hire the labour force in month two to finish the product.– You ship the product at the start of month three, terms net 30. You

book the earnings at this time.– Your large customer takes 60 days to pay, due to testing of the first

large shipment.

• Follow the balance sheet and “think like a banker”.

Dave Ludwick, Dept. of Mech. Eng.The Balance Sheet

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Example: Goodco versus BadcoExample: Goodco versus Badco

• Goodco and Badco have the same income statement for a one year period:

Retained Earnings, start 125

Net Earnings for the year 46Less: Dividend Paid 16

Retained Earnings, end 155

Revenue 650Warranty/ Bad Debt 6Net Revenue 644

COGS 320Contribution Margin 324CM, % 49.8%

SG&AAll admin except dep. 220

Depreciation 70

Operating Income 34

Other Income 12

Net Income 46

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Example: Goodco versus Badco (2)Example: Goodco versus Badco (2)

• Goodco and Badco have very different balance sheets this year.

Goodco BadcoAssetsCurrent Cash 22 22

Receivables 120 120Inventory 88 88Prepaids 28 28

Total current 258 258

Fixed Cost 760 760Less depreciation 210 210

Net 550 550

Total assets 808 808

Goodco BadcoLiabilitiesCurrent ST Credit 24 174

Accounts Payable 48 48Accrued Expenses 9 9

Taxes Payable 2 2Cur. Port. of LT Debt 20 20

Total current 103 253

Long Term Debt 175 225

Shareholders' EquityCapital Shares 375 175

Retained Earnings 155 155

Total Liabilities plus Equity 808 808