The Balance Sheet Game

This will be a series of posts which will be drawn from my learnings of reading ‘Financial Intelligence’ by Karen Berman and Joe Knight and the other book being ‘How Finance works’ by Mihir Desai. Since there are two months before I begin my college, I thought the buffer time could be put to a little use. But most importantly I think these are the kind of conversations that should be encouraged within our peer groups especially when we do not come from finance backgrounds.

One of the most asked questions in my B-School interviews was why MBA after Architecture ? Architecture in itself is a niche skillset so shifting to MBA had to make sense not just to the panel but also to me. Apart from stating my long term goals and what I had learnt on the job which led me to this, one of the things that I realized is that we as architects are not taught how to penetrate a market at macro level. We can definitely design at a macro scale but addressing the market at a macro level required design plus the understanding of the market holistically. What sets us apart from other service providers, because we essentially provide a service of catering to one’s accommodation needs but why is that OYO not similarly but could address the idea of temporary accommodation as well as rental accommodation at a much larger scale. Some reading this might think they are not same things because as architects we are keen on enhancing the spatial experience but what if we leave that aside for a minute and try to think of it from a business perspective. The other thing that distinguished architecture from this is that, we mostly do not work on brand development as a firm, rather the firm runs on Principal architect’s credibility. So when that happens how do you market yourself to a larger audience ? How do you pool in more customers who not just rely on you but on your firm’s brand. These are just a few questions that I started with but to come to address to all that I realized that, the first thing is to learn the basics of finance which makes it possible to understand how a business runs.

The first step to do that is aforementioned is to understand what a balance sheet is what does it entail. What story do the numbers tell ? Apart from assets, liabilities, gross profit, net income etc. who do these numbers if used to generate different ratios could tell? To delve into this I will draw examples from ‘How Finance works’ because the book had some really interesting case studies.

Part 1:

Assets:

Source: How Finance Works, Mihir Desai, Pg 16

The table shows 14 companies and their details about their assets and later in the post through all the deductions made, considering you find the series as interesting as I do, it will be revealed which company was which by understanding their balance sheets. If you are someone who enjoys connecting the dots as much as I do, you will have a fun time decoding!

Assets as the name suggests are critically important to realize your business idea and there are various things as you can see above in the table that comprise of assets. The first one being cash and marketable securities . What we notice here is that there is a varied percentage range of cash and its equivalents for the above companies, where company L has as low as 2 % and company G has as high as 64 %. The high percentage could indicate any future acquisition or lack of investment opportunities as businesses prefer to invest in marketable securities that can be cashed out at the time of need.

Accounts receivable indicates the amount company expects in return from the customer. The higher percentage indicates that it is business to business transaction as in those many companies extend their credit. In case of company N which has 83 % of its assets as accounts receivables, it indicates that it is most likely a bank as bank an institution earns through the interests on the money that it has lent. Companies with low percentage of accounts receivables could indicate retail stores where the consumer instantly pays for the product bought or it could also indicate business to consumer transaction where money has to be paid before to avail the service, for example a companies that earn their money through subscription models.

Inventories reveals another interesting thing in a balance sheet. It includes raw materials, products that are being finished and final goods. Companies E, M and N indicate a 0 under inventories which indicates that they are service oriented companies like banks, consultancies, travel, social media etc.

Property Plant and Equipment indicates the tangible and long term assets that company holds on which depreciation is calculated. A company with high PPE could indicate that it is a infrastructure company, power generation company, or company with comparable amount of brick and mortar stores etc. Companies I,L and M could indicate that.

Other assets includes the intangible assets which could in some cases indicate things like patent and brands or goodwill when any acquisition takes place.

Liabilities and Shareholders’ Equity:

Source: How Finance Works, Mihir Desai Pg no.19

Liabilities and Shareholders’ Equity is essential to understand as this is what finances the company, where the former represents that amount that is owed to the lenders who finance the company and the latter represents funds that shareholders provide.

The first part in the table mentioned above indicates notes and accounts payable. Company N indicates a high notes payable and a high accounts receivable as shown in Table 1, and this could imply that it is most likely a bank. One company’s accounts payable will represent another company’s accounts receivable. Accrued items represent the amounts due for the services already delivered. Some companies like J or L indicate high long term debt which could imply that could be a company which requires high gestation period before it starts showing considerable profits. Since long term debts, unlike other liabilities have a fixed interest rate, hence to get a clearer picture of the comparable growth companies show, the profit before EBIDTA is taken into account. EBIDTA stands for Earnings before Interest, Taxes ,Depreciation and Amortization.

Debt has a fixed return and no ownership claim but it is important to note that it gets paid before equity holders in the event of bankruptcy. This gives rise to the need of preferred stock as the above table indicates, which is essentially an hybrid instrument that combines both debt and equity claims. Like debt which has fixed interest to be paid, preferred stock has a preferred dividend which is a fixed and paid before common stock dividend . The reduces the risk for investors in an event of bankruptcy and companies in precarious situations can also raise money using this option. The preferred stock option , as the book mentions is used my venture capital firms for funding entrepreneurial ventures.

If you have read this far, I hope you found it easy to comprehend because it is using these various things that comprise assets and liabilities that we come to different ratios. Ratios are what make the balance sheet interesting.

Part 2:

Source : How Finance Works, Mihir Desai, Pg 23

Liquidity:

Liquidity ratios are important for suppliers as it indicates the paying capacity of the company. It indicates the highly liquid assets of the company. The current ratio which is current assets to current liability indicates whether the company will be able to pay in case it needs to close. A ratio greater than 1 would indicate a favorable scenario. The higher it is, the more confident supplier would be in extending credit. As inventories pose a risk in the current assets and hence to get a clear picture of the company’s liquidity quick ratio is used. Quick ratio is the ratio of current assets-inventories to current liabilities.

Profitability:

The profitability of the company is indicated through the ratio of net profit to revenue. Net Profit is calculated as gross profit- (operating costs + taxes) . In the above table company B indicates a negative profitability ratio as well as is the only company with the preferred stock option( Refer table 2). This indicates that the company is in a tight situation. Companies with high profitability generally are companies with low raw material costs. For example consultancies or tech companies, like Company D which indicates profitability of almost 25 percent.

Return on Equity ratio plays an important role for investors as it indicates the return on every dollar that is invested by the shareholder. This is calculated by net profit to shareholders’ equity. Company C and J indicate high returns. Another important ratio that should be taken into account before investing in return on assets which is indicates the how much is the company generating profits on its assets. EBIDTA/Revenue is also important to factor in , as company with higher infrastructure costs or long term debts distorts the profitability when we compare net profit to revenue. As company like Amazon has little profitability but significant EBIDTA. If you look at the table above ,Company D has significant EBIDTA/Revenue but very little profitability.

Financing and Leverage:

Leverage plays an important role in expanding a business as it lets you use assets which were not possible on your existing equity. This in turn could also lead to increase in returns but if things go south, it could also lead to an increase in losses. To understand how much could your company or the company that you are interested in could leverage, the ratio to understand would be, Total Debts to Total Assets. This ratio indicates how much of the assets are financed by debt, and this along with current ratio could give a clearer picture to the suppliers when it comes to extending credit. Higher debt could indicate that the company in the event of bankruptcy would have to clear off debt before clearing other accounts. So if a company finds itself in such a situation, then the suppliers would need to take into account the aforementioned ratio.

One important measure of understanding a company’s ability to finance its own interest payments from its own operations is understood through EBIT/Interest Expense. A ratio>=1 shows that the company can finance on its own and less than 1 indicates otherwise. Company B with a negative 6.21 indicates that it cannot.

Productivity:

This is an important to understand as it helps the company in getting a clearer idea in terms of growth. How effective are its assets in generating revenue for the company. This is calculated through asset turnover which Revenue to Total Assets. The companies which are not service oriented but generate revenue through selling a product have to take into account inventory turnover to understand how many times or rather how effectively is the company managing selling all its inventory a year. Inventory turnover is costs of goods sold to inventory.

Now, after all the ratios have been elaborated , is the time for the big reveal! The book made it fairly easy and I hope if you read so far then you will find it too.

Source: How Finance Works, Mihir Desai, Pg 32

As mentioned above absence of inventories, means they are service companies. This brings it down to Company E,G,M and N. Company N with its 83 % as accounts receivables and large part of its financing comes from notes payable clearly indicates that it is a bank. Also it has the highest leverage (total debt/total asset) and company N is Citigroup. The other 3 are South West Airlines, UPS Services and Facebook, though we don’t know which is which yet. Company E and M have high Property and plant percentage where as company G has fairly little. This means that company G is Facebook. The significant difference between company E and M is receivable collection period , where the former has that of 41 days and the latter has 7 days. Since the Airline is a B2C transaction , their receivable period is very less and is hence the south west Airlines and hence the remaining company E is UPS Services.

While looking at the receivables collection period, the companies that collect fairly quickly are retailers and it narrows it down to company A,B,H,I and K. The companies on the list are Amazon, Barnes&Noble, Kroger, Walgreens and Yum! In these companies inventory turnover is a big giveaway. Products which have low shelf life also indicate a high inventory turnover and this could point out that company H is Yum. Company B turns its inventory really slowly also is seeing a decline in profits and this possibly points towards a bookstore. Companies A,I K differ in terms of plant and equipment, where company A has the least. Since Kroger and Walgreens have brick and mortar stores as opposed to Amazon which has online market place, it indicates that company A is Amazon. The hints for identifying company I and K is the the days it requires to turn inventory where Walgreens is a drugstore and Kroger is grocery store.

The companies we are left with is Microsoft(look at profitability) , Nordstorm (P &P costs and inventory ),Duke Energy(look for P&P costs, high EBIDTA and inventory(negligible as they supply electricity)) ,Dell(look at the profitability) and Pfizer.

I hope this post helped you in understanding the basics of a balance sheet, as much as it helped me in understanding while writing it.

P.S. if you wanted to check which alphabets corresponded to the remaining companies then it was the following:

L-Duke Energy, J-Nordstorm,C-Dell, F-Microsoft, D-Pfizer

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