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Continuing the example introduced previously, the business
has several different assets that at year-end add up to $26
million. One of its assets is inventories, which are products
being held by the business for sale to customers. These prod-
ucts haven™t been sold yet, so the cost of the products is held
in the asset account and will not be charged to expense until
the products are sold. The cost of its inventories at year-end is
$7.2 million. Of this amount, $2.4 million hadn™t been paid for
by the end of the year. The business has an excellent credit
rating. Its suppliers give the business a month to pay for pur-
chases from them.
In addition to the amounts it owes for inventory purchases,
the business also has short-term liabilities of $2.6 million for
unpaid operating expenses at year-end. Of its $16.9 operating
expenses for the year (see Figure 5.1), $2.6 million had not
been paid by the end of the year. Both types of liabilities”
payables for purchases of inventory on credit and for unpaid
operating expenses”are short-term, non-interest-bearing obli-
gations of the business. These are called operating liabilities,
or spontaneous liabilities (as mentioned). The total of these two
short-term operating liabilities is $5 million in the example.
To summarize, the company™s total assets, operating liabili-
ties, and sources of capital for investing in its assets are
shown in Figure 5.2.
In Figure 5.2 note that the $5 million of operating liabilities

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BUILDING A BALANCE SHEET




Note: Amounts are in millions of dollars.

Total assets $26.0 Short-term and long-term debt $ 7.5
Less operating liabilities $ 5.0 Owners™ equity $13.5
Capital needed for assets $21.0 Capital from debt and owners™ equity $21.0
FIGURE 5.2 Summary of assets, operating liabilities, and sources of capi-
tal.




is deducted from total assets to determine the $21 million
amount, which is the total capital needed for investing in its
assets. I favor this layout for management analysis purposes
because it deducts the amount of spontaneous liabilities from
the total assets of the business. Recall that the normal operat-
ing liabilities from buying things on credit and delaying pay-
ment of expenses are called spontaneous because they arise
in the normal process of carrying on the operations of the
business, not from borrowing money at interest.
Operating liabilities do not bear interest (unless the busi-
ness delays too long in paying these liabilities). If the business
had paid all its operating liabilities by year-end, then its cash
balance would have been $5 million lower and its total assets
would have been $21 million. (I should mention that the busi-
ness probably would not have had enough cash to pay all its
operating liabilities before the end of the year.) A company™s
cash balance benefits from the float, which is the time period
that goes by until the company pays its short-term operating
liabilities. It™s as if the business gets a $5 million interest-free
loan from its creditors.

Debt versus Equity as Sources of Capital

The $21 million of its assets ($26 million total assets
minus the $5.0 million of its operating liabilities) is
the amount of money that the business had to obtain from
three general sources: (1) The business borrowed money; (2)
the business raised money from shareowners; and (3) the
business retained a good part of its annual earnings instead
of distributing all of its annual profits to shareowners. These
three sources of capital have provided the $21 million

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A S S E T S A N D S O U R C E S O F C A P I TA L


invested in its assets. Of this total capital, $7.5 million is from
short-term and longer-term debt sources. The rest of the com-
pany™s total capital is from owners™ equity, which consists of
the amounts invested by shareowners over the years plus the
accumulated retained earnings of the business. Figure 5.2
does not differentiate between the cumulative amounts
invested by shareowners and the retained earnings of the
business”only the total $13.5 million for owners™ equity is
shown in Figure 5.2.
Interest is the cost of using debt capital, of course. In con-
trast, a business does not make a contractual promise to pay
shareowners a predetermined amount or a percent of distri-
bution from profit each year. Rather, the cost of equity capital
is an imputed cost, equal to a sought-after amount of net
income that the business should earn annually relative to the
owners™ equity employed in the business. The owners™ equity
is $13.5 million of the company™s $21 million total capital.
Shareowners expect the business to earn annual net income
on owners™ equity that is higher than the interest rate on its
debt. Shareowners take more risk than lenders. Assume,
therefore, that the business™s objective is to earn a 15.0 per-
cent or higher annual net income on owners™ equity. In the
example, therefore, net income should be at least $2,025,000
($13.5 million owners™ equity — 15.0% = $2,025,000 net
income benchmark).
A company™s actual earnings before interest and income tax
(EBIT) for a year may not be enough to pay interest on its
debt capital, pay income tax, and achieve its after-tax net
income objective relative to owners™ equity. What about this
example, for instance? The business made $3.9 million EBIT,
as reported in Figure 5.1. The annual interest rate on its debt
was 8.0 percent, as mentioned earlier. So, its annual interest
expense was $600,000 ($7.5 million total debt — 8.0% annual
interest rate = $600,000).
So the business made $3.3 million earnings after interest
and before income tax. Its income tax rate is 34 percent of
this amount. Thus, its income tax is $1,122,000 and its net
income, or earnings after interest and income tax, is
$2,178,000. The business achieved its goal of earning 15.0
percent or better of net income on owners™ equity ($2,178,000
net income · $13,500,000 owners™ equity = 16.1%). The
shareowners may be satisfied with this 16.1 percent return on

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BUILDING A BALANCE SHEET


their capital, or they may insist that the business should do
better.
Chapter 6 explores the strategy of using debt to enhance
net income performance (as well as the risks of using debt
capital, which a business may or may not be willing to take).
The rest of this chapter focuses on the assets and operating
liabilities that are driven by the profit-making activities of a
business. A large chunk of a company™s balance sheet (state-
ment of financial condition) consists of these assets and oper-
ating liabilities.


CONNECTING SALES REVENUE AND
EXPENSES WITH OPERATING ASSETS
AND LIABILITIES
Figure 5.3 shows the lines of connection from sales revenue
and expenses to the company™s respective assets and operat-
ing liabilities. (The foregoing business example is continued in
this section.) The assets and operating liabilities shown in Fig-
ure 5.3 are explained briefly as follows:
• Making sales on credit causes a business to record
accounts receivable.




Note: Amounts are in millions of dollars.

Income Statement
Assets
Sales revenue $52.0 Accounts receivable
Cost-of-goods-sold expense $31.2 Inventories
Gross margin $20.8 Prepaid expenses
Operating expenses $16.9 Property, plant, and equipment
Earnings before interest and
Operating Liabilities
income tax (EBIT) $ 3.9
Accounts payable
Accrued expenses payable
FIGURE 5.3 Operating assets and liabilities driven by sales revenue and
expenses.



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A S S E T S A N D S O U R C E S O F C A P I TA L



• Acquiring and holding products before they are sold to cus-
tomers causes a business to record inventories.
• The costs of some operating expenses are paid before the
cost is recorded as an expense, which causes a business to
record prepaid expenses.
• Investments in long-term operating resources, called prop-
erty, plant, and equipment (or, more informally, fixed
assets), cause a business to record depreciation expense
that is included in operating expenses.
• Inventory purchases on credit cause a business to record
accounts payable.
• Many expenses are recorded before they are paid, which
causes a business to record its unpaid expense amounts in
either an accounts payable account or an accrued expenses
payable account. These two payables are called operating
liabilities.


Accounts Receivable
No dollar amounts (also called balances) are shown for the
assets and operating liabilities in Figure 5.3. The amounts
depend on the policies and practices of the business. The
amount of the accounts receivable asset depends on the credit
terms offered to the company™s customers, whether most of
the customers pay their bills on time, and how many cus-
tomers are delinquent. For example, assume the business
offers its customers one-month credit, which most take, but
the company™s actual collection experience is closer to five
weeks, on average, because some customers pay late. In this
situation the balance of its accounts receivable would be about
five weeks of annual sales revenue, or approximately $5 mil-
lion at the end of the year ($52 million annual sales revenue —
5/52 = approximately $5 million accounts receivable).


Inventories
The amount of the company™s inventories asset depends on
the company™s holding period”the time from acquisition of
products until the products are sold and delivered to cus-
tomers. Suppose that, on average, across all products sold, the
business holds products in inventory about 12 weeks. In this

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BUILDING A BALANCE SHEET


situation the company™s year-end inventory would be about
$7.2 million ($31.2 annual cost-of-goods-sold expense —
12/52 = approximately $7.2 million). At the end of the year,
recent acquisitions of inventory had not been paid for because
the company buys on credit from the sources of products.
See the line of connection in Figure 5.3 from the invento-
ries asset to accounts payable. Assume, for instance, that
about one-third of its ending inventories had not been paid
for. As a result, the year-end accounts payable would be about
$2.4 million from inventory purchases on credit. The total
amount of accounts payable also includes the amount of
unpaid expenses of the business at the end of the year for
which the business has been billed by its vendors.


Operating Liabilities
For most businesses, a sizable amount of operating expenses
recorded during the latter part of a year are not paid by the
end of the year. At the end of the year the business has unpaid
bills from its utility company for gas and electricity, from its
lawyers for work done during recent weeks, from the tele-
phone company, from maintenance and repair vendors, and
so on. A business records the amounts it has been billed for
(received an invoice for) in the accounts payable operating lia-
bility account. A business also has a second and equally
important type of operating liability. A business has many
expenses that accumulate, or accrue over time, for which it
does not receive bills, and to record these “creeping” expenses
a business uses a second type of operating liability account
that is discussed next.

In my experience, business managers and investors do not
appreciate the rather large size of accruals for various operat-
ing expenses. Many operating expenses are not on a pay-as-
you-go basis. For example, accumulated vacation and sick
leave benefits are not paid until the employees actually take
their vacations and sick days. At year-end, the company calcu-
lates profit-sharing bonuses and other profit-sharing amounts,
which are recorded as expense in the period just ended, even
though they will not be paid until some time later. Product
warranty and guarantee costs should be accrued and charged
to expense so that these follow-up costs are recognized in the

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A S S E T S A N D S O U R C E S O F C A P I TA L


same year that sales revenue is recorded”to get a correct
matching of sales revenue and expenses to measure profit. In

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