Analyzing a Balance Sheet

Introduction

How many times have you flipped to the back of a company's annual report and found
yourself blankly staring at the pages of numbers and tables? You know that these should
be important to your investing decision, but you're not quite sure what they mean or where
to begin.

In Lesson 3, we're going to take our first major step towards changing that. Smart
investors have always known that financial statements are the keys to every company.
They can warn of potential problems, and when used correctly, help determine what a
business is really "worth". An investor who understands financial statements will never
have to ask "is this company a good investment?".

For every business, there are three important financial statements you must look at; the
Balance Sheet, the Income Statement, and the Cash Flow Statement. The balance sheet
tells investors how much money the company has, how much it owes, and what is left for
the stockholders. The cash flow statement is like a business' checking account; it shows
you where the money is spent. The income statement is a record of the company's
profitability. It tells you how much money a corporation made (or lost).

In this lesson, we are going to learn to analyze a balance sheet. There are two segments:
in the first, we will go through a typical balance sheet and explain what each of the items
means. In the second, we will actually look at the balance sheets of several American
corporations and perform basic financial calculations on them.

Grab a cup of coffee, a nearby calculator and let's begin!

How to Get a Copy of a Company's Balance Sheet

Since you can't do your analysis without a balance sheet, you're going to have to get your
hands on one. How do you get a company's financial statements? Generally, you should
look in one of three places.

1.) The Annual Report: The annual report is a document released by companies at the
end of their fiscal year which includes almost everything an investor needs to know about
the business. It generally contains pictures of facilities, branch offices, employees, and
products [all of which are completely unimportant to making your investing decision.] They
are normally followed by a letter from the CEO and other senior management which
discusses the past as well as upcoming year. Tucked away in the back of most annual
reports is a collection of financial documents. Most of the time you can go onto a
company's website and find the Investor Relations link. From there, you should be able to
either download the annual report in PDF form or find information on how to contact
shareholder services and request a copy in the mail.

2.) The 10K: This is a document filed with the SEC which contains a detailed explanation of
a business. It is reported annually and contains the same financial statements the annual
report does, in a more detailed form. The benefit of the 10K is that it allows you to find out
additional information such as the amount of stock options awarded to executives at the
company, as well as a more in-depth discussion of the nature of the business and
marketplace. Sometimes you will find that a company has no financial statements in the
10K, but instead has written, "incorporated herein by reference" This means that the
financial statements can be found elsewhere [such as in the annual report or another
publication]. Even if this is the case, it is still worth it to get a copy. You can find this by
contacting the company, visiting their website, or going to FreeEdgar (freeedgar.com) or
SEC.gov.

3.) The 10q: The is similar to the 10k, but is filed quarterly [four times a year - normally
the end of January, June, September, and December]. If the company is planning on
changing its dividend policy, or something equally as important, they may bury it in the
10q. These documents are critical and can be obtained in the same way as the annual
report and 10k.

You will want to get a copy of all three documents for the past year or two from the
company you are interested in investing in. Most of them can be found at
http://finance.yahoo.com - type in the ticker symbol of the company you want to research
and then click the "financials" link. This will bring up a copy of the latest quarterly financial
statements. (For all good purposes, I would recommend you first analyze the annual
balance sheet, which can be found by clicking "annual data" in the upper right hand
corner.) Another excellent source of financial statements is The Street. As always, it is
best to get the information directly from the company.

What is a Balance Sheet?

Pretend that you are going to apply for a loan to put a swimming pool into your backyard.
You go to the bank asking to borrow money, and the banker insists that you give him a list
of your current finances. After going home and looking over your statements, you pull out a
blank sheet of paper and write down everything you have that is of value [your checking
and savings account, mutual funds, house, and cars]. Then, at the bottom of the sheet
your write down all of your debt [the mortgage, car payments, and your student loan]. You
subtract everything you owe by all the stuff you have and come up with your net worth.

Congratulations, you just created a balance sheet.

Just as the bank asked you to put together a balance sheet to evaluate your credit-
worthiness, the government requires companies to put them together several times a year
for their shareholders. This allows current and potential investors to get a snapshot of a
company's finances. Among other things, the balance sheet will show you the value of the
stuff the company owns [right down to the telephones sitting on the desk of their
employees], the amount of debt, how much inventory is in the corporate warehouse, and
how much money the business has to work with in the short term. It is generally the first
report you want to look at when valuing a company.

Before you can analyze a balance sheet, you have to know how it is set-up.

Note: Unlike other financial statements, the balance sheet cannot cover a range of dates. In other words, it may be good
"as of December 31, 2002", but can't cover from December 1 - December 31. This is because a balance sheet lists items
such as cash on hand and inventory, which change daily.

Assets, Liabilities and Shareholder Equity

Every balance sheet is divided into three main parts - assets, liabilities, and shareholder
equity.

• Assets are anything that have value. Your house, car, checking account, and the
antique china set your grandma gave you are all assets. Companies figure up the
dollar value of everything they own and put it under the asset side of the balance
sheet.

• Liabilities are the opposite of assets. They are anything that costs a company
money. Liabilities include monthly rent payments, utility bills, the mortgage on the
building, corporate credit card debt, and any bonds the company has issued.

• Shareholder equity is the difference between assets and liability; it tells you the
"book value", or what is left for the stockholders after all the debt has been paid.

Every balance sheet must "balance". The total value of all assets must be equal to the
combined value of the all liabilities and shareholder equity (i.e., if a lemonade stand had
$10 in assets and $3 in liabilities, the shareholder equity would be $7. The assets are $10,
the liabilities + shareholder equity = $10 [$3 + $7]).

What Does a Balance Sheet Look Like?

Below is an example of what a typical balance sheet looks like.

Coca-Cola Company
Consolidated Balance Sheet - January 31, 2001
Assets
Current Assets Dec. 31, 2000 Dec. 31, 1999
Cash and Cash Equivalents $1,819,000,000 $1,611,000,000
Short Term Investments $73,000,000 $201,000,000
Receivables $1,757,000,000 $1,798,000,000
Inventories $1,066,000,000 $1,076,000,000
Prepaid expenses and other $1,905,000,000 $1,794,000,000
Total Current Assets $6,620,000,000 $6,480,000,000

Long Term Assets

Long Term Investments $8,129,000,000 $8,916,000,000
Property, Plant and Equipment $4,168,000,000 $4,267,000,000
Goodwill $1,917,000,000 $1,960,000,000
Intangible Assets N/A N/A
Accumulated Depreciation (or
N/A N/A
Amortization)
Other Assets N/A N/A
Deferred Long Term Asset Charges N/A N/A
Total Assets $20,834,000,000 $21,623,000,000
Liabilities
Current Liabilities
Accounts Payable $9,300,000,000 $4,483,000,000
Short Term Debt $21,000,000 $5,373,000,000
Other Current Liabilities N/A N/A
Total Current Liabilities $9,321,000,000 $9,856,000,000

Long-Term Liabilities
Long Term Debt $835,000,000 $854,000,000
Other Liabilities $1,004,000,000 $902,000,000
Deferred Long Term Liability Charges $358,000,000 $498,000,000
Minority Interest N/A N/A
Total Liabilities $11,518,000,000 $12,110,000,000

Shareholder's Equity
Misc. Stock Option Warrants N/A N/A
Redeemable Preferred N/A N/A
Preferred Stock N/A N/A
Common Stock $870,000,000 $867,000,000
Retained Earnings $21,265,000,000 $20,773,000,000
Treasury Stock ($13,293,000,000)($13,160,000,000)
Capital Surplus $3,196,000,000 $2,584,000,000
Other Stockholder Equity ($2,722,000,000) ($1,551,000,000)
Total Stock Holder Equity $9,316,000,000 $9,513,000,000
Net Assets $7,399,000,000 $7,553,000,000

Current Assets

The first thing listed under the asset column on the balance sheet is something called
"current assets". This is where companies list all of the stuff that can be converted into
cash in a short period of time [usually a year or less]. Because these assets are easily
turned into cash, they are sometimes referred to as "liquid". They normally consist of:

Cash and Cash Equivalents

Cash and Cash Equivalents is the amount of money the company has in bank accounts,
savings bonds, certificates of deposit, and money market funds. It tells you how much
money is available to the business immediately. How much should a company keep on the
balance sheet? Generally speaking, the more cash on hand the better. Not only does a
decent cash hoard give management the ability to pay dividends and repurchase shares, but
it can provide extra wiggle-room when times get bad.
There are some cases where cash on the balance sheet isn't necessarily a good thing. If a
company is not able to generate enough profits internally, they may turn to a bank and
borrow money. The money sitting on the balance sheet as cash may actually be borrowed
money. To find out, you are going to have to look at the amount of debt a company has
(we will be discussing this later on in the lesson). The moral: You probably won't be able to
tell if a company is weak based on cash alone; the amount of debt is far more important.

Short Term Investments

These are investments that the company plans to sell shortly or can be sold to provide
cash. Short term investments aren't as readily available as money in a checking account,
but they provide added cushion if some immediate need were to arise. Short Term
Investments become important when a company has so much cash sitting around that it
has no qualms about tying some of it up in slightly longer-term investment vehicles (such
as bonds which have maturities of less than one year). This allows the business to earn a
slightly higher interest rate than if they stuck the cash in a corporate savings account.

Perhaps the most legendary cash hoard in the business world right now is Microsoft's - the
company has $5.25 billion in cash and $32.973 billion in short term investments.

Receivables

Also sometimes known as "Account Receivables", this is money that is owed to a company
by its customers.

Here's how it works: Let's say Wal-Mart wants to order a new DVD which is being released
by Warner Brothers. Wal-Mart orders 500,000 copies for its stores. Warner Brothers
receives the order, and within a week, ships the DVDs to one of Wal-Mart's warehouses.
Included in the shipment is a bill (let's say WB charged Wal-Mart $5 per DVD for half a
million copies - that's $2.5 million). Warner Brothers has already sent the movies to Wal-
Mart, even though Wal-Mart hasn't paid a penny. In essence, Wal-Mart is buying on credit
and promising to pay WB's the $2.5 million.

The $2.5 million would go on Warner Brother's balance sheet as receivables.

Generally a company that sells a product on credit sets a term. The term is the number of
days customers must pay their bill before they are charged a late fee or turned over to a
collection agency (most terms are, 30, 60 or 90 days). If Warner Brothers sold the DVDs to
Wal-Mart on a 30 day term, Wal-Mart must pay its bill during that time.

While accounts receivable are good, they can bring serious problems to a business if they
aren't handled properly. What if Wal-Mart went bankrupt or simply didn't pay Warner
Brothers? WB would then be forced to write down its receivables on the balance sheet by
$2.5 million. This is what is called a delinquent account. Normally, companies build up
something called a reserve to prepare for situations such as this. Reserves are set amounts
of money that are taken out of the profits each year and put into an account specifically
designed to act as a buffer against possible loses the company may incur. (Reserves are
touched on in Part 29). When customers don't pay their bills, companies can take money
out of the reserve they had built up to pay back suppliers.

Receivable Turns
Common sense tells you the faster a company collects its receivables, the better. The
sooner customers pay their bills, the sooner a company can put the cash in the bank, pay
down debt, or start making new products. There is also a smaller chance of losing money
to delinquent accounts. Fortunately, there is a way to calculate the number of days it takes
for a business to collect its receivables. The formula looks like this:

Credit Sales (found on the income statement - not the balance sheet)
-------------------------(divided by)---------------------------
Average Receivables

Let's look at an example.

H.F. Beverages
Balance Sheet
(Excerpt)
2000 1999
Receivables $1,183,363 $1,178,423

Income Statement
(Excerpt)
Credit
$15,608,300
Sales

H.F. Beverages* is a major manufacturer of soft drinks and juice beverages. It sells to
supermarkets and convenience stores across the country on a 30 day term. To see if
customers are paying on time, we need to look for the income statement. It is normally
found within a page or two of the balance sheet in the annual report or 10K. With the
income statement in front of you, look for an item called "Credit Sales" (if you can't find it,
there is an item called "Total Sales" which is acceptable but not as accurate).

In 2000, H.F. Beverages reported credit sales of $15,608,300. If we look at the excerpt
from its balance sheet (above), we will see that in 2000, it had $1,183,363 in receivables
and in 1999, $1,178,423. We need to find out the average amount of receivables H.F. had
in 2000, so we would take $1,1873,363 + $1,178,423 and divide it by 2. The answer is
$1,180,893.

Plug the two numbers into the formula.

Credit Sales = $15,608,300

------------(divided by)--------------
Average Receivables = $1,180,893

The answer, called "Receivable Turns" by financial analysts, is 13.2173. This means that
H.F. Beverages collects its accounts receivable 13.2173 times per year. Once you calculate
this number, finding out the number of days it takes for customers to pay their bills is
simple. Since there are 365 days in a year and the company gets 13.2173 turns per year,
take 365 ÷ 13.2173. The answer is the number of days it takes the average customer to
pay (in H.F.'s case, we come up with 27.61).

This means the company is doing a good job managing its accounts receivable because
customers aren't exceeding the 30 day policy. Had the answer been greater than 30, you
would have been wise to try to find out why there were so many late payments, which could
be a sign of trouble. (Keep in mind you will need to read through the company's reports to
find out what its collection deadline is. Not all companies require their customers to pay
within 30 days).

*A Fictional Company for illustration only

Inventories

When looking at a company's current assets, you need to pay special attention to
inventory. Inventory consists of merchandise a business owns but has not sold. It is
classified as a current assets because investors assume that inventory can be sold in the
near future, turning it into cash.

To come up with a balance sheet amount, companies must estimate the value of their
inventory. For instance, if Nintendo had 5,000 units of its new video game system, the
Game Cube, sitting in a warehouse in Japan, and expected to sell them to retailers for $300
each, they would be able to put $1,500,000 on their balance sheet as the value of their
current inventory (5000 units x $300 each = $1.5 million).

This presents an interesting problem. When inventory piles up, it faces two major risks.
The first is the risk of obsolesce. In another year, few stores will probably be willing to buy
the Game Cube video game system for $300 simply because a newer, faster, and better
system may have come along. Although the inventory is carried on the balance sheet at
$1.5 million, it may actually lose value as time passes. When you hear that a company has
taken an inventory write-off charge, it means that management essentially decided the
products that were sitting in storage or on the store shelves weren't worth the values they
were stated at on the balance sheet. To correct this, the company will reduce the carrying
value of its inventory.

If a year passes and Nintendo still has 3000 of the 5000 units in storage, the executives
may decide to lower their prices hoping to sell the remaining inventory. If they lower the
Game Cube's price to $200 each, they would have 3000 units at $200. Before, those 3000
units were stated at a value of $900,000 on the balance sheet. Now, because they are
selling for less, the same units are only worth $600,000. The risk of obsolesce is especially
present in technology companies or manufacturers of heavy machinery.

Another inventory risk is spoilage. Spoilage occurs when a product actually goes bad. This
is a serious concern for companies that make or sell perishable goods. If a grocery store
owner overstocks on ice cream, and two months later, half of the ice cream has gone bad
because it has not been purchased, the grocer has no choice but to throw it out. The
estimated value of the spoiled ice cream must be taken off the grocery store's balance
sheet.

The moral of the story: the faster a company sells its inventory, the smaller the risk of
value loss.

Inventory Turn

Before you invest, you are going to have to make an informed decision about how much you
think the inventory is really worth. A major part of this decision should be based on how
fast the inventory is "turned" (or sold). Two competing companies may each have $20
million sitting in inventory, but if one can sell it all every 30 days, and the other takes 41
days, you have less of a risk of inventory loss with the 30 day company.

Finding out how fast a company turns its inventory is simple. Here's the formula:

Current Year's Cost of Goods Sold or Cost of Revenues (found on the income statement -
not the balance sheet)
----------------------------------------(Divided By)------------------------------------------
The average inventory for the period

Let's look at a real-world example:

Coca-Cola
Balance Sheet
(Excerpt)
2000 1999
Inventories $1,066,000,000 $1,076,000,000

Income
Statement
(Excerpt)
Cost of
$6,204,000,000
Goods Sold

The cost of goods sold is $6,204,000,000. The average inventory value between 1999 and
2000 is $1,071,000,000 (average the values from 1999 and 2000). Plug them into the
formula.

Current Year's Cost of Goods Sold = $6,204,000,000

----------------------(divided by)----------------------
Average Inventories = $1,071,000,000

The answer is the number of inventory turns - in Coca-Cola's case, 5.7927. What this
means is that Coca Cola sells all of its inventory 5.79 times each year. Is this good? To
answer this question, you must find out the average turn of Coke's competitors and
compare. If you do the research, you find out that the average turnover of a company in
Coke's industry is 8.4. Why is Coca-Cola's turn rate lower? Should it affect your investing
decision? The only way you can answer these kinds of questions is if you truly understand
the business you are analyzing. This is why it is important that you read the entire annual
report, 10k and 10q of the companies you have taken an interest in. Although Coke's turn
rate is lower, further analysis of the balance sheet will reveal that it is 4 to 5x financially
stronger than its industry averages. With such outstanding economics, you probably don't
need to worry about inventory losing value.

Let's take the inventory analysis a step further. Once you have the inventory turn rate,
calculating the number of days it takes for a business to clear its inventory only takes a few
seconds. Since there 365 days in a year and the Coca Cola clears its inventory 5.7927
times per year, take 365 ÷ 5.7927. The answer (63.03) is the number of days it takes for
Coke to go through its inventory. This is a great trick to use at cocktail parties; grab a copy
of an annual report, scribble the formula down and announce loudly that "Wow! This
company takes 63 days to sell through its inventory!" People will instantly think you are an
investing genius.

The number of days a company should be able to sell through its inventory varies greatly by
industry. Retail stores and grocery chains are going to have a much higher inventory turn
rate since they are selling products that generally range between $1 and $50. Companies
that manufacture heavy machinery such as airplanes, are going to have a much lower turn
over rate since each of their products may sell for millions of dollars. Hardware companies
may only turn their inventory 3 or 4 times a year, while a department store may do twice
that, turning at 6 or 7. If you want to compare the inventory turnover rate of a company to
its competitors, you can go to MSN Money Central.

Inventory in Relation to Current Assets

When analyzing a balance sheet, you also want to look at the percentage of current assets
inventory represents. If 70% of a company's current assets are tied up in inventory and the
business does not have a relatively low turn rate (less than 30 days), it may be a signal that
something is seriously wrong and an inventory write-down is unavoidable.

1
It is acceptable to use the total sales instead of the cost of sales. The cost of sales is a more accurate reflection of
inventory turn and should be used for the truest results. When comparing the company to others in its industry, make
sure you use the same number. You cannot value one company using cost of sales, and another using total sales.

McDonald's vs. Wendy's: An Example

It's easy to see how a higher inventory turn than competitors translates into superior
business performance. McDonalds is unquestionably the largest and most successful fast
food restaurant in the world. Let's compare it to one of its main competitors, Wendy's.

McDonalds
2000 1999
Inventories $99,300,000 $82,700,000
Cost of
$8,750,100,000
Revenue

Wendy's
2000 1999
Inventories $40,086,000 $40,271,000
Cost of
$1,610,075,000
Revenue

Use the inventory turn formula [cost of sales or cost of revenue divided by the average
inventory values] to come up with the number of inventory turns for each business.
Between 1999 and 2000, McDonalds had an inventory turn rate of 96.1549 [incredible for
even a high-turn industry such as fast food]. This means that every 3.79 days, McDonald's
goes through its entire inventory. Wendy's, on the other hand, has a turn rate of 40.073
and clears its inventory every 9.10 days.

This difference in efficiency can make a tremendous impact on the bottom line. By tying up
as little capital as possible in inventory, McDonalds can use the cash on hand to open more
stores, increase its advertising budget, or buy back shares. It eases the strain on cash flow
considerably, allowing management much more flexibility in planning for the long term.

The Final Word on Inventory

The bottom line: investors want as little money as possible tied up in inventory. It is fine to
have a lot of inventory on the balance sheet if it is being sold at a fast enough rate there is
little risk of becoming obsolete or spoiled. Great companies have excellent inventory
handling systems so they only order products when they are needed - they never buy too
much or too little of something. Businesses that have too much inventory sitting on the
shelves or in a warehouse are not being as productive as they could be: had management
been wiser, the money could have been kept as cash and used for something more
productive.

*Note: These financials were taken from Yahoo! finance on 02/09/02

Prepaid Expenses

In the course of every day operations, businesses will have to pay for goods or services
before they actually receive the product. If a jewelry store moved into your neighborhood
mall, it would most likely have to sign a rent agreement and pay six to twelve months' rent
in advance. If the monthly rent was $1,000 and the business prepaid for an entire year,
they would put $12,000 on the balance sheet under Prepaid Expenses ($1,000 monthly rent
x 12 months = $12,000). Each month, they would deduct 1/12 from the prepaid expenses
until the end of the year, at which point, the amount would be $0.

Sometimes companies decide to prepay taxes, salaries, utility bills, rent, or the interest on
their debt. These would all be pooled together and put on the balance sheet under this
heading.

By their very nature, Prepaid Expenses are a small part of the balance sheet. They are
relatively unimportant in your analysis and shouldn't be given too much attention.

Notes Receivable

Notes Receivable are debts owed to the company which are payable within one year.

Other Current Assets

Other current assets are non-cash assets that are owed to the company within one year.

Non Standard Items

Sometimes companies put items on their balance sheet which aren't standard. If you find
yourself analyzing a balance sheet and an oddball term shows up, search for it at
investorwords or investopedia. If that still doesn't work, you can call your broker or a local
banker, all of whom should be happy to give you an explanation of a term.

I would recommend you get a copy of Barron's "Dictionary of Finance and Investing Terms"
( ). They are relatively inexpensive ($10 or $11), and define over 4,000
terms. This can be a huge asset regardless of the financial statement you are looking at.
You may also find the "Dictionary of Business Terms" useful as well. It has 7,500 entries
covering almost every business definition you could possibly ask for ( ).
While neither is required to do balance sheet analysis, they can be a big help.

Current Liabilities

Current liabilities are the debts a company owes which must be paid within one year. They
are the opposite of current assets. Current liabilities includes things such as short term
loans, accounts payable, dividends and interest payable, bonds payable, consumer deposits,
and reserves for Federal taxes.

Let's take a look at some of the most common and important ones.

Accounts Payable

Accounts payable is the opposite of accounts receivable. It arises when a company receives
a product or service before it pays for it.

Accrued Benefits / Payroll

This is money owed to employees as salary and bonus that the company has not yet paid.

Short Term and Current Long Term Debt

These items are sometimes referred to as notes payable. They are the most important item
under current liabilities. Most of the time, they represent a company's bank loans.
Borrowing money in itself is not necessarily a sign of financial weakness; an intelligent
department store executive may work out short term loans at Christmas so she can stock
up on merchandise before the Holiday rush. If demand is high, the store would sell all of its
inventory, pay back the short term loans, and pocket the difference. This is known as
utilizing leverage. The department store used borrowed money to make a profit.

So how can you ever hope to tell if a company is wisely borrowing money (such as our
department store), or recklessly going into debt? Look at the amount of notes payable on
the balance sheet (if they aren't classified under 'notes payable', combine the company's
short term obligations and long term current debt.) If the amount of cash and cash
equivalents is much larger than the notes payable, you shouldn't have any reason to be
concerned.

If, on the other hand, the notes payable has a higher value than the cash, short term
investments, and accounts receivable combined, you should be seriously concerned. Unless
the company operates in a business where inventory can quickly be turned into cash, this is
a serious sign of financial weakness.

Other Current Liabilities

Depending on the company, you will see various other current liabilities listed. Sometimes
they will be lumped together under the title "other current liabilities." Normally, you can
find a detailed listing of what these "other" liabilities are buried somewhere in the annual
report or 10k. Often, you can figure out the meaning of the entry by its name. If a
business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly
confident the amount listed is what will be paid out to the company's bond holders in the
short term.

Consumer Deposits

If you are looking at the balance sheet of a bank, you will want to pay close attention to an
entry under the current liabilities called "Consumer Deposits". Often, they will be will
lumped under other current liabilities. This is the amount that customers have deposited in
the bank. Since, theoretically, all of the account holders could withdrawal all of their funds
at the same time, the bank must list the deposits as a current liability.

Working Capital

The number one reason most people look at a balance sheet is to find out a company's
working capital (or "current") position. It reveals more about the financial condition of a
business than almost any other calculation. It tells you what would be left if a company
raised all of its short term resources, and used them to pay off its short term liabilities. The
more working capital, the less financial strain a company experiences. By studying a
company's position, you can clearly see if it has the resources necessary to expand
internally or if it will have to turn to a bank and take on debt.

Working Capital is the easiest of all the balance sheet calculations. Here's the formula:

Current Assets - Current Liabilities = Working Capital

One of the main advantages of looking at the working capital position is being able to
foresee any financial difficulties that may arise. Even a business that has billions of dollars
in fixed assets will quickly find itself in bankruptcy court if it can't pay its monthly bills.
Under the best circumstances, poor working capital leads to financial pressure on a
company, increased borrowing, and late payments to creditor - all of which result in a lower
credit rating. A lower credit rating means banks charge a higher interest rate, which can
cost a corporation a lot of money over time.

Companies that have high inventory turns and do business on a cash basis (such as a
grocery store) need very little working capital. These types of businesses raise money
every time they open their doors, then turn around and plow that money back into
inventory to increase sales. Since cash is generated so quickly, managements can simply
stock pile the proceeds from their daily sales for a short period of time if a financial crisis
arises. Since cash can be raised so quickly, there is no need to have a large amount of
working capital available.

A company that makes heavy machinery is a completely different story. Because these
types of businesses are selling expensive items on a long-term payment basis, they can't
raise cash as quickly. Since the inventory on their balance sheet is normally ordered
months in advance, it can rarely be sold fast enough to raise money for short-term financial
crises (by the time it is sold, it may be too late). It's easy to see why companies such as
this must keep enough working capital on hand to get through any unforeseen difficulties.

Working Capital per Dollar of Sales

To find the approximate amount of working capital a company should have, you should look
at "working capital per dollar of sales." In other words, you are going to have to compare
the amount of working capital on the balance sheet to the total sales (which is found on the
income statement - not the balance sheet). A business that sells a lot of low-cost items,
and cycles through its inventory rapidly (a grocery store) may only need 10-15% of working
capital per dollar of sales. A manufacturer of heavy machinery and high-priced items with a
slower inventory turn may require 20-25% working capital per dollar of sales. A company
such as Coca Cola would probably fall somewhere between the two.

Here's the formula for Working Capital per Dollar of Sales

Working Capital
-------------------------(divided by)---------------------------
Total Sales (Found on the Income Statement)

Let's look at an example:

Goodrich, Inc. (Symbol GR)

Goodrich provides systems for aircraft as well as manufacturers heavy-duty engines.
Working Capital: $933,000,000 (current assets - current liabilities)
Total Sales (found on the income statement) = $4,363,800,000

Let's plug the numbers into the formula:

Working Capital = $933,000,000

-------------------------(divided by)---------------------------
Total Sales (Found on the Income Statement) = $4,363,800,000

The answer for Goodrich is .2138, or 21.38%. As a manufacturer of heavy duty machinery,
GR falls within the 20-25% working capital per dollar of sales range. This is good.

Negative Working Capital

Some companies can generate cash so quickly they actually have a negative working
capital. This is generally true of companies in the restaurant business (McDonalds had a
negative working capital of $698.5 million between 1999 and 2000). Amazon.com is
another example. This happens because customers pay upfront and so rapidly, the
business has no problems raising cash. In these companies, products are delivered and
sold to the customer before the company ever pays for them.

Don't understand how a company can have a negative working capital? Think back to our
Warner Brothers / Wal-Mart example. When Wal-Mart ordered the 500,000 copies of a
DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or
seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the
country? By the twentieth day, they may have sold all of the DVDs. In the end, Wal-Mart
received the DVDs, shipped them to its stores, and sold them to the customer (making a
profit in the process), all before they had paid Warner Brothers! If Wal-Mart can continue to
do this with all of its suppliers, it doesn't really need to have enough cash on hand to pay all
of its accounts payable. As long as the transactions are timed right, they can pay each bill
as it comes due, maximizing their efficiency.
The bottom line: A negative working capital is a sign of managerial efficiency in a business
with low inventory and accounts receivable (which means they operate on an almost strictly
cash basis). In any other situation, it is a sign a company may be facing bankruptcy or
serious financial trouble.

Buying a Company for Free

If you can buy a company for the value of its working capital, you essentially pay nothing
for the business. Going back to our Goodrich example; the company has $933 million in
working capital. There are currently 101.9 million shares outstanding, which means each
share of Goodrich stock has $9.16 cents worth of working capital. If GR's stock was trading
for $9.16, you would basically be purchasing the stock for free (paying $1 for each $1 the
company had in its checking account, inventory, etc.). You would pay nothing for the
company's fixed assets (such as real estate, computers, & buildings) and earnings.

For the past ten or twenty years, it has been incredibly rare for a company to trade that
low. You can still use the basic concept to your advantage; if you can find a business that is
trading for working capital plus half the value of the fixed assets, you would be paying
$0.50 for every $1.00 of assets.

Current Ratio

The current ratio is another test of a company's financial strength. It calculates how many
dollars in assets are likely to be converted to cash within one year in order to pay debts that
come due during the same year. You can find the current ratio by dividing the total current
assets by the total current liabilities. For example, if a company has $10 million in current
assets and $5 million in current liabilities, the current ratio would be 2 (10/5 = 2).

An acceptable current ratio varies by industry. Generally speaking, the more liquid the
current assets, the smaller the current ratio can be without cause for concern. For most
industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls
below 1 (which means the company has a negative working capital), you will need to take a
close look at the business and make sure there are no liquidity issues. Companies that
have ratios around or below 1 should only be those which have inventories that can
immediately be converted into cash. If this is not the case and a company's number is low,
you should be seriously concerned.

Inefficiency

If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4, you
may want to be concerned. A number this high means that management has so much cash
on hand, they may be doing a poor job of investing it. This is one of the reasons it is
important to read the annual report, 10k and 10q of a company. Most of the time, the
executives will discuss their plans in these reports. If you notice a large pile of cash
building up and the debt has not increased at the same rate (meaning the money is not
borrowed), you may want to try to find out what is going on.

As I mentioned earlier, Microsoft current has the biggest cash hoard in the business world.
It's current ratio is in excess of 4. The company has no long term debt on the balance
sheet. What are they planning on doing? No one knows; the software giant may pay a
dividend for the first time, pour the money back into research and development, or buy
back shares.

Although not ideal, too much cash on hand is the kind of problem a smart investor prays
for.

Quick Test Ratio

The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is the most excessive and
difficult test of a company's financial strength and liquidity. To calculate the quick ratio,
take the current assets and subtract the inventory (current assets minus inventory is often
referred to as the "quick assets"). What you are left with are the items that can be
converted into cash immediately . Divide the result by the current liabilities. The answer is
the Quick Test ratio.

What does this tell you? It is a reflection of the liquidity of a business. The Quick Test ratio
does not apply to the handful of companies where inventory is almost immediately
convertible into cash (such as McDonalds, Wal-Mart, etc.) Instead, it measures the ability of
the average company to come up with cold, hard cash literally in a matter of hours or days.
Since inventory is rarely sold that fast in most businesses, it is excluded.

Long Term Assets

Everything we've discussed up until now has been a current asset or liability. Now, we are
going to take a look at the long term assets that are found on the balance sheet. These are
the things that a business owns but can't be used to fund day-to-day operations.

Long Term Investments

Long Term investments and funds are investments a company intends to hold for more than
one year. They can consist of stocks and bonds of other companies, real estate, and cash
that has been set aside for a specific purpose or project. In addition to investments a
company plans to hold for an extended period of time, Long Term Investments also consist
of the stock in a company's affiliates and subsidiaries.

The difference between Short Term and Long Term investments lie in the company's motive
for owning them. Short term investments consist of stocks, bonds, etc. a company has
bought and will sell shortly. The investments made under long term investments may never
be sold. An excellent example would be Berkshire Hathaway's relationship with Coca-Cola.
Berkshire owns 200 million shares of the soft-drink giant, and will most likely continue to
hold them forever, regardless of the price they are selling for in the open market.

Carrying Values of Stock Investments

As you now know, when a business purchases common stocks as an investment, they will
go into either the Short Term or Long Term Investment categories on the balance sheet.
These are normally carried on the balance sheet at cost or market value (whichever is
less). This means that most of the time, the stocks the company owns are worth far more
than they are on the balance sheet (for example, if a business owned 50,000 shares of
Sprint and they paid $10 per share, they would have $500,000 on the balance sheet under
either short term or long term investments. If Sprint rose to $35 per share, the value of
their holdings would be $1,750,000, yet the balance sheet would continue to carry
$500,000. Thus, the difference of $1,250,000 would not be included in the book value of
the company. (This is a prime example of how financial statements are only the beginning
of the valuation process. They have their limitations, but without them, we would have no
basis to calculate intrinsic value.)

Property, Plant and Equipment

These are referred to as "fixed assets". In other words, these are the corporation's real
estate, buildings, office furniture, telephones, cafeteria trays, brooms, factories, etc. They
are the physical assets the company owns but can't quickly convert to cash.

Depending on the type of business, these may or may not make up a large percentage of
the total assets. Most of the assets of a railroad or airline will fall into this category (these
companies must continue to buy railroad cars and planes to survive - both of which are
fixed assets). An advertising agency on the other hand, will have far fewer fixed assets.
They require nothing but their employees, some pencils, and a few computers.

You must be careful not to pay too much attention to this number. Since companies are
often unable to sell their fixed assets within any reasonable amount of time (who would be
willing to buy 3 notebook binders, a factory, the broom in the broom closet, etc. at a
moment's notice?) they are carried on the balance sheet at cost regardless of their actual
value. It is possible for companies to grossly inflate this number (which is called "watering"
the stock), or to write the values down to nothing (some companies have $1 million dollar
buildings carried for $1 on the balance sheet).

When analyzing a balance sheet, you will want to look at this number with a raised
eyebrow. Don't completely ignore it (that would be foolish), but certainly don't take it too
seriously.

Intangible Assets

Companies often own things of value that cannot be touched, felt, or seen. These consist of
patents, trademarks, brand names, franchises, and economic goodwill (which is different
than the accounting goodwill we've discussed. Economic goodwill consists of the intangible
advantages a company has over its competitors such as an excellent reputation, strategic
location, business connections, etc.) While every effort should be made for businesses to
carry them at costs on the balance sheet, they are normally given completely meaningless
values.

To prove the point that the intangible value assigned on the balance sheet can be deceptive,
here's an excerpt from Michael F. Price's introduction to Benjamin Graham's "The
Interpretation of Financial Statements"...

In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max Heine
asked me to look at a small brewery - the F&M Schaefer Brewing Company. I'll never forget
looking at the balance sheet and seeing a +/- $40 million net worth and $40 million in
'intangibles'. I said to Max, 'It looks cheap. It's trading for well below its net worth.... A
classic value stock!' Max said, 'Look closer.'
 I looked in the notes and at the financial statements, but they didn't reveal where the
intangibles figure came from. I called Schaefer's treasurer and said, 'I'm looking at your
balance sheet. Tell me, what does the $40 million of intangibles related to?' He replied,
'Don't you know our jingle, 'Schaefer is the one beer to have when you're having more than
one.'?'

That was my first analysis of an intangible asset which, of course, was way overstated,
increased book value, and showed higher earnings than were warranted in 1975. All this to
keep Schaefer's stock price higher than it otherwise would have been. We didn't buy it."

When analyzing a balance sheet, you should generally ignore the amount assigned to
intangible assets. These intangible assets may be worth a huge amount in real life (Coca-
Cola's brand name is priceless), but it is the income statement, not the balance sheet, that
gives investors insight into the value of these intangible items.

Goodwill

In the accounting sense, Goodwill can be thought of as a "premium" for buying a business.
When one company buys another, the amount they pay is called the purchase price.
Accountants take the purchase price and subtract it by a company's book value. The
difference is called Goodwill. (There is a review of book value in Part 27.)

When a company buys another company, they can use one of two accounting methods:
pooling of interest or purchase. When the pooling of interest method is used, the
balance sheets of the two businesses are combined and no goodwill is created. When the
purchase method is used, the acquiring company will put the premium they paid for the
other company on their balance sheet under the "Goodwill" category. Accounting rules
require the goodwill be amortized over the course of 40 years.

What does that mean? Let's use McDonalds and Wendy's as an example since most people
are familiar with them.

McDonalds
Earnings: $1,977,300,000
Shares Outstanding: 1.29 Billion
(You don't need McDonalds other information for this example)

Wendy's
Book Value: $1,082,424,000
Book Value per Share: $10.3482
Shares Outstanding: 104.6 Million
Earnings: $169,648,000

Say McDonalds decided to buy all of Wendy's stock using the purchase method. Wendy's
has a book value of $10.3482 per share, yet is trading at $32 per share. If McDonalds were
to pay the current market price, they would spend a total of $3,347,200,000 (104.6 million
shares x $36 per share). To keep this example simple, we are going to assume the
shareholders of Wendy's approved the merger for cash. McDonalds would mail a check to
the Wendy's shareholders, paying them $32 for each share they owned.
Since the book value of Wendy's is only $1,082,424,000, and McDonalds paid
$3,347,200,000, McDonalds paid a premium of $2,264,776,000. This is going to go onto
their balance sheet as Goodwill. It is required to be amortized against earnings for up to 40
years. This means that each year, 1/40 of the goodwill amount must be subtracted from
McDonalds' earnings so that by the 40th year, there is no goodwill left on the balance sheet.

Now that McDonalds and Wendy's are one company, their earnings will be combined.
Assuming next year's results were identical, the company would earn $2,146,948,000, or
$1.66 per share1. Remember that goodwill must be amortized, meaning 1/40 the amount
must be deducted from next year's earnings. McDonalds must deduct $56,619,400 from
earnings next year as a charge against goodwill2. Now, McDonalds can only report earnings
of $2,090,328,600, or $1.62 per share (compared to the $1.66 they would have been able
to report before the goodwill charge). Goodwill reduced earnings by 4¢ per share.

If the pooling of interest method had been used, no goodwill would have been created, and
McDonalds would have reported EPS (earnings per share) of $1.66. Meaning that
depending on how the accounting was handled, the exact same transaction could have two
vastly different impacts on earnings per share.

It is no wonder that managements, in order to avoid this reduction in reportable earnings,

frequently opt to use the pooling of interest method when they complete a merger. Since
no goodwill is created, over-eager managers are able to pay outrageous prices for
acquisitions with little or no accountability on the balance sheet. Since it makes no sense to
have two different ways for accounting for a merger, the FASB (the folks in charge of
coming up with these accounting rules) decided they should eliminate the pooling of interest
method and force all transactions to be done via the purchase method. Executives and
politicians claimed this will significantly reduce the number of mergers since the new
standards would cause reportable earnings to drop as soon as a company had completed an
acquisition. As a concession, the FASB will no longer require goodwill to be written off
unless the assets became impaired (which means it becomes clear that the goodwill isn't
worth what the company paid for it).

Pay careful attention to the mergers a company has made in the past few years. Once you
are able to value a business, you will want to look at recent acquisitions to determine if they
were too expensive. If you find this to be the case, you will probably want to avoid the
stock (why would you want to invest in a company that was throwing your money around?).

Notes:
1.) Since McDonalds purchased Wendy's, the two companies' profits will be combined. $1,977,300,000 + $169,648,000 =
$2,146,948,000. To get the earnings per share, you would simply divide it by the number of shares outstanding (1.29
billion). We're assuming McDonalds bought Wendy's for cash. If stock had been used, the number of shares would
change, but for simplicity sake, we are going to assume this not to be the case.
2.) Take the premium $2,264,776,000 and divide it by 40 years = this is the charge against earnings each year
3.) Companies purchased before 1970 are not required to be amortized off the balance sheet. They can stay there
forever.

Other Assets

Other Assets are non-cash assets which are owed to the company for a period longer than
one year.

Deferred Long Term Asset Charges

These are expenses which the company has paid for but not yet subtracted from the
assets. They are very similar to Prepaid Expenses (where rent would be counted as an
asset until it came due each month, then would be subtracted from the balance sheet). In
fact, Prepaid Expenses are type of deferred charge. The difference is, when companies
prepay rent or some other expense, they have a legal right to collect the service. Deferred
Long Term Asset Charges have no legal rights attached to them.

For example, if a company prepaid rent on a storage building, and then spent $30,000
moving all of their equipment into it, they could set the $30,000 up on the balance sheet as
a deferred charge. This way, they wouldn't be forced to take a hit by reducing their
earnings $30,000 the same month they paid for the relocation costs. They could then write
this amount down over time.

These charges are intangible and should be given very little weight when analyzing a
balance sheet.

Long Term Debt

The amount of long term debt on a company's balance sheet is crucial. It refers to money
the company owes that it doesn't expect to pay off in the next year. Long term debt
consists of things such as mortgages on corporate buildings and / or land, as well as
business loans.

A great sign of prosperity is when a balance sheet shows the amount of long term debt has
been decreasing for one or more years. When debt shrinks and cash increases, the balance
sheet is said to be "improving". When it's the other way around, it is said to be
"deteriorating". Companies with too much long term debt will find themselves overwhelmed
with interest payments, a risk of having too little working capital, and ultimately,
bankruptcy. Thankfully, there is a financial tool that can tell you if a business has borrowed
too much money.

Debt to Equity Ratio

The Debt to Equity Ratio measures how much money a company should safely be able to
borrow over long periods of time. It does this by comparing the company's total debt
(including short term and long term obligations) and dividing it by the amount of owner's
equity (which is explained in part 23. For now, you only need to know that the number can
be found at the bottom of the balance sheet. You'll actually calculate the debt to equity
ratio in segment two when we look at real balance sheets.)

The result you get after dividing debt by equity is the percentage of the company that is
indebted (or "leveraged"). The normal level of debt to equity has changed over time, and
depends on both economic factors and society's general feeling towards credit. Generally,
any company that has a debt to equity ratio of over 40 to 50% should be looked at more
carefully to make sure there are no liquidity problems. If you find the company's working
capital, and current / quick ratios drastically low, this is is a sign of serious financial
weakness.

Profitable Borrowing
If a business can earn a higher rate of return than the interest rate at which it borrows, it
becomes profitable for the business to borrow money. (An example: If a corporation earned
15% on its investments and borrowed funds at 8%, it would make 7% on the borrowed
money [15% return - 8% cost of money = 7% net profit]. This boosts what analysts call
"Return on Equity". We will talk about Return on Equity, or ROE, in a future lesson. It is
briefly touched on in the Retained Earnings section of this lesson.)

Other Liabilities

Like the few other "other" parts of the balance sheet, "Other Liabilities" is a catch-all
category where companies can consolidate their miscellaneous debt. You can normally find
an explanation of what makes up these other liabilities somewhere in the financial reports.
Often times, they consist of things such as inter-company borrowings (where one of a
company's divisions or subsidiaries borrows from another), accrued expenses, sales tax
payable (in the instance of retail stores), etc.

Generally, you should take the time to look at the various other liabilities a company has.
Most are self explanatory and are not as important as the other major liabilities already
discussed.

Minority Interest

When you look at a balance sheet, you will see an entry called "Minority Interest". This
refers to the equity of the minority shareholders in a company's subsidiaries. An example
will help clarify.

In 1983, Nebraska Furniture Mart was the most successful home furnishings store in the
United States. It's gross annual sales exceeded $88.6 million, and the company had no
debt. At the time, Warren Buffett, the CEO of Berkshire Hathaway, was searching for great
businesses to acquire. After noticing how successful the furniture business appeared to be,
he approach the owner, Rose Blumpkin, and offered to buy the company.

Almost immediately, Rose offered to sell 90% of Nebraska Furniture Mart to Berkshire for
$55 million. The next day, Buffett walked into the store and handed her a check. This
made NFM a partially-owned subsidiary of Berkshire. (A subsidiary is a company controlled
by another company through ownership of at least a majority of the voting stock.) Since
subsidiaries are controlled by their parent companies, accounting rules allow for them to be
carried on the parent company's balance sheet1. When Berkshire bought its 90% stake in
Furniture Mart, it was able to add the assets of the furniture giant to its own balance sheet.

This presents a problem. Berkshire can now add the assets of Nebraska Furniture Mart to
its balance sheet, but technically, it doesn't own them all. Remember, Rose Blumpkin only
sold 90% of her company - she kept the other 10%. Berkshire will somehow have to show
that some of the assets on its balance sheet belong to Rose, who has a minority interest in
NFM. To do this, it will calculate the value of Rose's stake in the subsidiary and put it under
a liability account called "Minority Interest". These are the assets Berkshire "owes" Rose.

A company may have several minority partners in many subsidiaries. The minority interest
of all of these partners is added together and placed on the balance sheet.

1
A company can integrate the balance sheet of its subsidiary if it owns 80% or more. It can report earnings of the
subsidiary if it owns 20% or more.
Shareholder Equity

Shareholder Equity is the net worth of a company. It represents the stockholders' claim to
a business's assets after all creditors and debts have been paid. Shareholder equity is also
referred to as Owner's or Stockholders' Equity. It can be calculated by taking the total
assets and subtracting the total liabilities.

Shareholder equity usually comes from two places. The first is cash paid in by investors
when the company sold stock; the second is retained earnings, which are the accumulated
profits a business has held on to and not paid out to its shareholders as dividends. Because
these are the two ways a company generally creates shareholders' equity, the balance sheet
is organized to show each parts' contribution.

Book Value

Book Value and Shareholder Equity are not quite the same thing. To find a company's book
value, you need to take the shareholders' equity and exclude all intangible items. This
leaves you with the theoretical value of all of the company's tangible assets (those which
can be touched, seen, and felt). For this reason, book value is sometimes also called "Net
Tangible Assets".

Net Tangible Assets (or Book Value)

The amount of net tangible assets a company has is particularly important. Since you
should always analyze the balance sheet you get directly from the company (as opposed to
the ones you find on Yahoo or other financial sites), you may not always have this figure
calculated for you. To calculate it, take the total assets and subtract all of the intangible
assets such as goodwill. What you are left with is the nuts and bolts of the company; the
buildings, computers, telephones, pencils, and office chairs.

In the past, it was generally thought the more assets a company had the better. Over the
past twenty years, value investors have come to reject this idea in its pure form; it is
actually preferable to own a business that generates earnings on a lower asset base.

Why? Let's say your company earns $10 million a year and has $30 million in assets. My
company earns the same $10 million but has $50 million assets. It is generally understood
that a relationship exists between the amount of assets a company has and the profit it
generates for the owners. If you wanted to double the earnings of your company, you
would probably have to invest another $30 million into the company. After the
reinvestment, the business would have $60 million in assets and earn $20 million a year.

On the other hand, if I wanted to double the earnings of my company, I would have to
invest another $50 million into the business (which would double the assets). After the
reinvestment, my business would have $100 million in assets and generate $20 million a
year.

What does that mean?

You would have to retain $30 million in earnings to double your profits. I would have to
retain $50 million to get the same profit! That means that you could have paid out the
difference (in this case $20 million) as dividends, reinvested it in the business, paid down
debt, or bought back shares! We will talk more about this in the future.

Balance Sheet 1: Microsoft

The main purpose of balance sheet analysis is to determine if a company is financially

strong and economically efficient. The first balance sheet we are going to look at is a
perfect example of both. It can be found in Microsoft's 2001 10K statement. (Note that an
excerpt from the income statement is provided so you can calculate receivable and
inventory turns). You need to keep this information in front of you as we analyze. I
recommend you either print this page or open it in a new browser window.

Balance Sheet - 2001

(In millions)

June 30 2001
2000
Assets
Current assets:
Cash and equivalents $ $ 3,922
4,846
Short-term investments 18,952 27,678
Total cash and short-term investments 23,798 31,600
Accounts receivable 3,250 3,671
Deferred income taxes 1,708 1,949
Other 1,552 2,417
Total current assets 30,308 39,637
Property and equipment, net 1,903 2,309
Equity and other investments 17,726 14,141
Other assets 2,213 3,170
Total assets $52,150 $59,257

Liabilities and stockholders’ equity

Current liabilities:
Accounts payable $ $ 1,188
1,083
Accrued compensation 557 742
Income taxes 585 1,468
 Unearned revenue 4,816 5,614
Other 2,714 2,120
Total current liabilities 9,755 11,132
Deferred income taxes 1,027 836
Commitments and contingencies
Stockholders’ equity:
Common stock and paid-in capital—shares 23,195 28,390
authorized 12,000; shares issued and outstanding
5,283 and 5,383
Retained earnings, including accumulated other
comprehensive income of $1,527 and $587 18,173 18,899
Total stockholders’ equity 41,368 47,289
Total liabilities and stockholders’ equity $52,150 $59,257

Income Statement
(In millions, except earnings per share)

Year Ended June 30 1999 2000 2001

Revenue $19,747 $22,956 $25,296
Operating expenses:
Cost of revenue 2,814 3,002 3,455

A Quick Note on Microsoft's Balance Sheet

Before we begin analyzing, notice that unlike most balance sheets, the most recent year is
on the right hand side in bold. I highlighted the column so you would be sure to look at the
correct figures.

An additional point: when companies put together their balance sheet, they tend to omit the
000's at the end of long numbers to save space. If you see on the top of a balance sheet
that numbers are stated "in thousands", add "000" to find the actual amount (i.e., $10
stated in thousands would be $10,000). If a balance sheet is stated in millions, you will
need to add "000,000" (i.e., $10 stated in millions would be $10,000,000).

Keep in mind we are analyzing the fiscal balance sheet as of June, 2001. This information
may be different when you go to search on Moneycentral, Yahoo!, or TheStreet since they
will use the most recent data available. The purpose of this analysis is not to advice you on
what to buy, but rather to show you the process of analyzing a balance sheet.

Let's Begin Analyzing!

Cash Position

The first thing you will notice is that Microsoft has $31.6 billion in cash and short term
investments. This doesn't mean much unless you compare it to the company's debt to find
out if it is borrowed money. Glance down the balance sheet and look for any long-term
debt. You'll notice there isn't an entry for it. This isn't a mistake; Microsoft has no long
term debt.

Don't get too excited yet. Remember that some businesses fund day-to-day operations
with short-term loans (think back to our department store executive at Christmas in Part
10). To see if Microsoft is using short term debt to survive, look at the current liabilities. In
2001, the entire value of Microsoft's current liabilities was $11,132. Compare that to the
$31.6 billion in cash the company has. Does it have enough money to pay off its debt?
Absolutely. Microsoft's balance sheet has 3x the cash necessary to pay off current liabilities
and long term debt. This is without calculating in receivables and other assets. You can be
sure the company is not in any danger of going bankrupt.

Working Capital

Let's calculate the company's working capital. Take the current assets ($39,637) and
subtract the current liabilities ($11,132). The answer is $28,505. Microsoft has $28.5
billion in working capital. To find the working capital per share, look at the bottom of the
balance sheet. You'll see there are 5.383 billion shares outstanding. Take the working
capital of $28.5 billion and divide it by the 5.383 billion shares outstanding. The answer,
$5.29, is the amount of working capital per-share.

If you could buy Microsoft's stock at $5.29 per share, you would be getting all of the
company's fixed assets (real estate, computers, long term investments, etc.) plus its
earnings / profit each year from now until eternity for free! The company will probably
never trade that low; but you should always keep this in mind when analyzing a business.
Sometimes, especially during serious economic downturns, you will find companies selling
close to working capital. (Note: We will discuss stock option dilution and other advanced
concepts in later lessons.)

Working Capital per Dollar of Sales

We calculated working capital at $28.505 billion. According to Microsoft's income

statement, total revenue (the same thing as total sales) came to $25.296 billion. Following
the formula for Working Capital per Dollar of Sales, we come up with 1.12 (or 112%). This
means Microsoft has more working capital than its sales last year; if you remember from
the lesson, manufacturers of heavy machinery require the most working capital and range
from 20-25%. The 112% figure is excessive by anyone's standard. The main concern
should not be financial safety, but efficiency. Why isn't Microsoft putting this money to
work?

Current Ratio

The current ratio should be at least 1.5 but probably not over 3 or 4. Taking Microsoft's
current assets and dividing them by the current liabilities, we find the software company
has a current ratio of 3.56. Unless the business is saving resources to launch new products,
build new production facilities, pay down debt, or pay a dividend to shareholders, a current
ratio this high usually signals that management is not using cash very efficiently.

Quick Ratio

To calculate the quick ratio, we have to take the quick assets and divide them by current
liabilities. If you've studied Microsoft's current assets, you will notice there is no entry for
inventory. You know that Microsoft sells software; meaning its products consist of
information It doesn't need to carry inventory. As soon as a customer places an order, the
company can load its program onto a CD-ROM or DVD and ship it out the same day.
Because there is no inventory, there is no risk of spoilage or obsolesce.

Inventory is what causes the biggest difference between the current and quick ratio. The
quick ratio was designed to measure the immediate resources of a company against its
current liabilities. Almost all of Microsoft's resources are already liquid. The only things
that aren't are the $1.949 billion in deferred income taxes (how are you going to use it to
raise cash?) and the $2.417 billion attributed to "other" current assets. Subtract these from
the $39,637 billion in current assets and you get $35.271 billion. This $35 billion in quick
assets represents the things the company can turn in to cash almost immediately. Divide it
by the current liabilities ($35.271 divided by $11,132) and you get 3.168. Even under the
most stringent test of financial strength, Microsoft has $3.168 in current assets for every $1
in liabilities.

Inventory Turn & Average Age of Inventory

We already discovered that Microsoft carries no inventory. It is absolutely efficient. Its

products are already sold before they are manufactured.

Receivable Turn and Age of Receivables

You'll notice that on the income statement excerpt, credit sales is not listed as a separate
item. Instead, we have to use the less accurate total sales or revenue figure to calculate
receivable turn. Take the $25.296 billion in revenues and divide it by the average
receivables, $3.4605 billion ($3250 + 3671 divided by 2). You will end up with 7.30 turns.
To calculate the number of days this translate into, take 365 divided by 7.3. In Microsoft's
case, the answer is 50 days.*

Debt to Equity Ratio

Microsoft is debt free. It has no long or short term debt. If you take $0 (the amount of the
company's debt) and divide it by the shareholder equity ($47.289 billion) you will get 0.
This means that 0% of the company's equity consists of debt; the shareholders own it all.

Final Thoughts

All of our calculations have shown one thing; the company has virtually no risk of
bankruptcy. Microsoft has 3x the cash it needs to survive, no long term debt, no inventory
to worry about, and extremely strong current and quick ratios. Its working capital per
dollar of sales is 112%, excessive by any standard (especially compared to its competitors.
Adobe Software had a ratio of 36%, while Oracle Systems came in at 46.5%). The main
question an investor should ask when looking at the balance sheet is, "why so much
cash?". None of the company's top management has given any clues as to the plans for the
growing pile of greenbacks.

*You should generally calculate turns for the past several years, as well as between quarters. The numbers will almost
always fluctuate during the normal course of business; regardless, a superior company will tend to have superior ratios
over the long term.

Simon Transportation Services

Now that we've looked at an outstanding balance sheet, let's look at one that signals the
company may be running into trouble. Simon Transportation is a trucking company that
specializes in temperature-controlled transportation for major corporations such as
Anheuser Busch, Campbell's Soup, Coors, Kraft, M&M Mars, Nestle, Pillsbury, and Wal-Mart.
If you look closely, you will start to see problems develop in 2000 that foretell of future
financial difficulties.

Simon Transportation Services, Inc.

Consolidated Balance Sheet - September 30, 2001
Assets
Current Assets Sep 30, 2001 Sep 30, 2000
Cash and Cash Equivalents N/A $3,331,119
Short Term Investments N/A N/A
Receivables $36,495,339 $34,265,075
Inventories $1,302,067 $1,330,462
Prepaid expenses and other $2,528,675 $2,325,199
Total Current Assets $40,326,081 $41,251,855

Long Term Assets

Long Term Investments N/A N/A
Property, Plant and Equipment $83,795,541 $49,403,534
Goodwill N/A N/A
Intangible Assets N/A N/A
Accumulated Depreciation (or
N/A N/A
Amortization)
Other Assets $5,574,182 $451,603
Deferred Long Term Asset
N/A N/A
Charges
Total Assets $129,695,804 $91,106,992

Liabilities
Current Liabilities
Accounts Payable $46,031,588 $21,844,631
Short Term Debt $74,537,820 $3,437,120
Other Current Liabilities N/A N/A
 Total Current Liabilities $120,569,408 $25,281,751

Long-Term Liabilities
Long Term Debt $835,000,000 $16,376,791
Other Liabilities N/A N/A
Deferred Long Term Liability
N/A $4,604,318
Charges
Minority Interest N/A N/A
Total Liabilities $120,569,408 $46,262,860

Shareholder's Equity
Misc. Stock Option Warrants N/A N/A
Redeemable Preferred N/A N/A
Preferred Stock $5,195,434 N/A
Common Stock $62,917 $62,877
Retained Earnings ($50,503,733) ($2,451,176)
Treasury Stock ($1,053,147) ($1,053,147)
Capital Surplus $51,865,007 $48,285,578
Other Stockholder Equity $3,559,918 N/A
Total Stock Holder Equity $9,126,396 $44,844,132

Income Statement
Total Revenue $278,818,242 $231,396,894
Cost of Revenue $253,268,462 $163,611,569

Simon Transportation Services

Simon Transportation Services filed for Chapter 11 bankruptcy in the early part of 2002.
The company's balance sheet showed signs of strain almost two years prior. We are going
to focus most of our attention on the 2000 part of the balance sheet to demonstrate that an
intelligent investor could have seen warning signs before the company went under. Note:
Since we are going to be focusing on 2000's numbers, we will not average in 2001's
numbers to calculate inventory and receivable turn.

Cash Position

Simon had $3,331,119 in cash in September of 2000. It also had $3,437,120 in short term
loans. This is the first sign the company was using borrowed money to operate. Almost all
of the company's current assets are tied up in receivables, which is a real concern that
customers may not be paying on time.

Working Capital

In 2000, the company had working capital of $15,970,104.

Working Capital per Dollar of Sales

In 2000, the company had total sales / revenues of $231,396,894. With working capital of
$15,970,104, the company had a total Working Capital per Dollar of Sales percentage of
6.9%. Simon operates in the trucking industry, so most of its assets are fixed (in the form
of diesels, trucks, semis, etc.)

Current Ratio

The current ratio should be at least 1.5 but probably not over 3 or 4. Simon had a current
ratio of 1.631 in 2000. This is mediocre. The quick ratio will be a much better indication of
the company's financial health.

Quick Ratio

The company's quick assets come out to around 1.487.

Inventory Turn & Average Age of Inventory

The company's inventory turn for 2000 only is 122.97 (meaning the company clears its
inventory around every 3 days). In most situations, this would mean the company would
have smaller working capital needs. However, if you look at the current assets, you notice
they consist almost entirely of accounts receivable. Although the business sells its
inventory frequently, it isn't converting those sales into cash immediately. Thus, the
receivable turn is going to be very important to the success of this business.

Receivable Turn and Age of Receivables

Credit Sales are not carried individually. Thus, we will have to use the total sales /
revenues of $231,396,894 with receivables of $34,265,075 in 2000. The receivable turn
comes out to 6.75 times per year, or once every 54 days. So, although the company is
clearing its inventory every 3 days, it is only getting paid every 54 days. Since the
inventory turns aren't being converted to cash, the business needs more working capital.
The 6% of working capital per dollar of sales we calculated earlier is dangerously low.

Debt to Equity Ratio

Combine Simon's short and long term debt, and you'll come up with $19,813,911. Divide
the $44,844,132 in shareholder equity by this amount and you'll see that 44.18% of the
company's equity is made up of debt. This would be acceptable if Simon enjoyed high
enough return on equity to justify such a high borrowing level. A glance at the company's
income statement shows that this is not the case; Simon lost money in 2000. Not only is
the company not making money, it is losing money altogether. Common sense tells you
that a business that is heavily in debt and is losing money probably isn't financially secure.

A quick look into the company's 10k and 10q statements reveals that the short term loans
are secured by the receivables. In plain English, if Simon Transportation fails to pay its
short term loans on time, the bank can go to court and take control of the receivables. If
this were to happen, the business may not have enough cash on hand to pay its long term
debt, which makes up a sizable part of the balance sheet. If Simon ran into a bump in the
road, it probably wouldn't be able to survive because of cash flow issues.
Final Thoughts

Here's what we've observed: In 2000, a full year before declaring bankruptcy, Simon
Transportation had very little working capital, barely acceptable current and quick ratios, a
high percentage of debt to equity, and inventory that was quickly sold but slowly collected
for. The company may be able to survive as long as it doesn't run into any problems. An
increase in fuel prices, a driver strike, or some other unfavorable event that increased
losses would quicken the company's financial demise. An item of particular concern is found
in the company's 10k, "The Company's top 5, 10, and 25 customers accounted for 24%,
39%, and 57% of revenue, respectively, during fiscal 2000. No single customer accounted
for more than 10% of revenue during the fiscal year."

According to these numbers, each of the top five customers accounted for nearly 5% of
Simon's business. If just one of these switched to another trucking company, five percent
of the business' revenues would have been lost. If the company had profitable with little or
no debt, this would not be a concern. When you're counting on things going smoothly and
you're playing with money that's not your own, you're almost always headed for disaster.

The bottom line: This is not a company you would invest in if you were looking for
something long term and considerably safe.

Epilogue

On December 14, 2000, Simon issued a press release. It had run into a bump in the road.
Here's an excerpt:

"In addition to the change in accounting method, during the quarter, Simon
experienced the highest driver turnover in its history. Turnover exacerbated
recruiting costs and contributed to increased claims and repair expense, and low
tractor utilization. In addition, high fuel prices continued to affect the
truckload industry, including Simon."

To correct this problem, Simon's management increased driver pay by 2¢ per mile, an
increased cost the company could hardly afford. Perhaps most disturbing of all, the
company openly acknowledged in its 10k around the same time that it was in violation of its
long term debt agreements.

"The Company's secured line of credit agreement contains various

restrictive covenants including a minimum tangible net worth requirement and a
fixed charge coverage covenant. As of September 30, 2000, the Company was in
violation of the minimum tangible net worth requirement. The Company obtained a
waiver of the violation and as discussed in Note 10 has amended the covenant
subsequent to September 30, 2000."

In February of 2002, the company filed for Chapter 11 bankruptcy protection. Had an
investor been able to analyze a balance sheet, they would have been warned in advance of
the company's problems and possibly avoided huge losses to their portfolio.

Copyright © 2002 Joshua Kennon