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summary, a surprising number of expense accruals are
Expense accruals are recorded in a separate account,
labeled accrued expenses payable in Figure 5.3, because they
are quite different than accounts payable. For one thing, an
account payable is based on an actual invoice received by the
vendor, whereas accruals have no such hard copy that serves
as evidence of the liability. Accruals depend much more on
good faith estimates of the accountants and others making
these calculations. Suppose the business in the example
knows from experience that the balance of this operating lia-
bility tends to be about five weeks of its annual total operating
This ratio of accrued expenses payable to annual operating
expenses is based on the types of accruals that the company
records, such as accrued vacation and sick pay for employees,
accrued property taxes, accrued warranty and guarantee
costs on products, and so on. The five weeks reflects the aver-
age time between when these expenses are recorded and
when they are actually paid, which can be quite a long time
for some items but rather short for others. Thus, the year-end
balance of the company™s accrued expenses payable liability
account is about $1.6 million ($16.9 million annual operating
expenses — 5/52 = approximately $1.6 million).

Prepaid Expenses, Fixed Assets,
and Depreciation Expense
Chapter 2 explains the accrual basis of profit accounting and
cash flow from profit. One key point to keep in mind in com-
paring profit and cash flow is that a business has to prepay
some of its operating expenses. I won™t repeat that discussion
here; I™ll simply piggyback on the discussion and point out
that a business has an asset account called prepaid expenses,
which holds the prepaid cost amounts that have not been
charged off to expense by the end of the year. Usually, the
amount of the prepaid expenses asset account is relatively
small”although, if the ending balance were large compared
with a company™s annual operating expenses, this strange


state of affairs definitely should be investigated. A business
manager should notice an unusually large balance in the pre-
paid expenses and demand an explanation.
One of the operating expenses of a business is depreciation.
This is a very unique expense, especially from the cash flow
point of view (as Chapter 2 discusses at some length). I do not
separate depreciation expense in Figure 5.3, although I do
show a line of connection from the company™s fixed assets
account (property, plant, and equipment) to operating
expenses. As I explain in Chapter 2, the original cost of fixed
assets is spread over the years of their use according to an
allocation method.

What about Cash?
A business has one other asset not shown in Figure 5.3 or
mentioned so far”cash. Every business needs a working cash
balance. Recall that in the example the company™s annual
sales revenue is $52 million, or $1 million per week on aver-
age. But the actual cash collections in a given week could be
considerably less or much more than the $1 million average.
A business can™t live hand to mouth and wait for actual cash
collections to arrive before it writes checks. Employees have
to be paid on time, of course, and a business can™t ask its
creditors to wait for payment until it collects enough money
from its customers.
In short, a business maintains a minimum cash balance as
a safety buffer. Many businesses keep rather large cash bal-
ances, part of which usually is invested in safe, short-term
marketable debt securities on which the business earns inter-
est income. The average cash balance of a business relative to
its annual sales revenue may be very low or fairly high. Cash
balance policies vary widely from business to business. If I
had to guess the cash balance of the business in the example,
I would put it at around two or three weeks of annual sales
revenue, or about $2 to $3 million. But I wouldn™t be sur-
prised if its cash balance were outside this range.
There™s no doubt that every business needs to keep enough
cash in its checking account (or on hand in currency and coin
for cash-based businesses such as grocery stores and gambling
casinos). But precisely how much? Every business manager


would worry if cash were too low to meet the next payroll.
Some liabilities can be put off for days or even weeks, but
employees have to be paid on time. Beyond a minimum, rock-
bottom cash balance amount to meet the payroll and to pro-
vide at least a bare-bones margin of safety, it is not clear how
much additional cash balance a business should carry, just as
some people may have only $5 or $10 in walking-around
money and others could reach in their wallet and pull out

Unnecessary excess cash balances should be avoided. Excess
cash is an unproductive asset that doesn™t pay its way toward
meeting the company™s cost of capital (i.e., the interest on debt
capital and the net income that should be earned on equity
capital). For another thing, excess cash balances can cause
managers to become lax in controlling expenses. Money in the
bank, waiting only for a check to be written, is often an incen-
tive to make unnecessary expenditures, not scrutinizing them
as closely as needed. Also, excess cash balances can lead to
greater opportunities for fraud and embezzlement.
Yet having a large cash balance is a tremendous advantage

in some situations. The business may be able to drive a hard
bargain with a major vendor by paying cash up front rather
than asking for the normal credit terms. There are many

such reasons for holding a cash balance over and above
what™s really needed to meet payroll and to provide for a
safety buffer for the normal lags and leads in the cash
receipts and cash disbursements of the company. Frankly, if
this were my business I would want at least a three weeks™
cash balance.
An executive of a leading company said he kept the com-
pany™s cash balance “lean and mean” to keep its managers on
their toes. There™s probably a lot of truth in this. But if too
much time and effort goes into managing day-to-day cash
flow, then the more important strategic factors may not be
managed well.
Figure 5.3 does not present a complete picture of the com-
pany™s financial condition. Cash is missing, as just discussed,
and the sources of the company™s capital are not shown. It™s
time to fill in the remaining pieces of the statement of finan-
cial condition of the business, otherwise known as the balance


Figure 5.4 presents the income statement and balance sheet
(statement of financial condition) for the business example.
The income statement includes interest expense, income tax
expense, and net income (which are discussed earlier in the
chapter). The balance sheet includes the sources of capital
that the business has tapped to invest in its assets”interest-
bearing debt and owners™ equity. The balance sheet is pre-
sented according to the discussion earlier in the chapter. In
particular, note that the total amount of operating liabilities
(the sum of accounts payable and accrued expenses payable)
is deducted from total assets to determine the capital invested
in assets.

Note: Amounts are in millions of dollars.

Income Statement Balance Sheet
Cash $ 3.0
Accounts receivable $ 5.0
Inventories $ 7.2
Prepaid expenses $ 1.0
Property, plant, and
Sales revenue $52.0
equipment $17.5
Cost-of-goods-sold expense $31.2
Accumulated depreciation ($ 7.7) $ 9.8
Gross margin $20.8
Total assets $26.0
Operating expenses $16.9
Earnings before interest
Operating Liabilities
and income tax $ 3.9
Accounts payable $ 3.4
Interest expense $ 0.6
Accrued expenses payable $ 1.6 $ 5.0
Earnings before income tax $ 3.3
Capital invested in assets $21.0
Income tax expense $ 1.1
Net income $ 2.2
Sources of Capital
Interest-bearing debt $ 7.5
Owners™ equity $13.5
Total sources of capital $21.0
FIGURE 5.4 Balance sheet and income statement.


Figure 5.4 displays lines of connection, or tether
lines, from sales revenue and expenses in the income
statement to their corresponding assets and operating liabili-
ties in the balance sheet. These lines are not actually shown in
financial reports, of course. I include them in Figure 5.4 to
stress that the profit-making activities of a business drive a
good part of its balance sheet. Also, you might note the line
from net income to owners™ equity; net income increases the
owners™ equity. All or part of annual net income may be dis-
tributed in cash to its shareowners, which is recorded as a
decrease in the business™s owners™ equity.

A business needs assets to make profit. Therefore a business
must raise capital for the money to invest in its assets. The
seed capital comes from shareowners; they may invest addi-
tional money in the business from time to time after the busi-
ness gets off the ground. Most businesses borrow money on
the basis of interest-bearing debt instruments such as notes
payable. Profitable businesses retain part or all of their
annual earnings to supplement the money invested in the
business by their shareowners.
The balance sheet, or statement of financial condition,
reports the debt and equity capital sources of a business and
the assets in which the business has invested. Several differ-
ent types of assets are listed in the balance sheet. The balance
sheet also reports the operating liabilities of a business that
are generated by its profit-making activities and not from bor-
rowing money. Operating liabilities are non-interest-bearing
payables of a business, which are quite different from its
interest-bearing debt obligations.
The relationships of sales revenue and expenses reported
in a company™s income statement to the assets and operating
liabilities reported in its balance sheet are not haphazard. Far
from it! Sales revenue and the different expenses in the
income statement match up with particular assets and operat-
ing liabilities. Business managers, lenders, and investors
should understand these critical connections between the
components of the income statement and the components of
the balance sheet. In particular, the amount of accounts


receivable should be reasonable in comparison with annual
sales revenue, and the amount of inventories should be rea-
sonable in comparison with annual cost-of-goods-sold
In short, the balance sheet of a business fits tongue and
groove with its income statement. These two financial state-
ments are presented separately in financial reports, but busi-
ness managers, lenders, and investors should understand the
interlocking nature of these two primary financial statements.



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