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## Investing Lesson 3 - Printable Version

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.

## 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
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]).

## 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-

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.

## 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

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)

## 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

## 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.

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
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
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

## 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.

## 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

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.

## 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 2000 2001
Assets
Current assets:
Cash and equivalents \$ 4,846 \$ 3,922
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 \$ 1,083 \$ 1,188
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 authorized 23,195 28,390
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.)

## 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.

## 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 \$83,795,541 \$49,403,534
Equipment
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

## 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

## 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

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

"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
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.