Accounting Basics: Part Four

 

Our earlier discussions on this blog of accounting basics have focused on the assets side of a balance sheet. Now let’s move over to the right-hand side. This includes the two great subdivisions of liabilities and equity. For a simple business entity we might break down the liabilities section into just two parts itself: accounts payable and notes payable.

Accounts payable is the obverse of the accounts receivable heading on the asset side. Payables are (typically non-interest bearing) debts that the firm must pay to its trade creditors, like the due bill to the electricity company for the juice that keeps that conveyor belt moving. 

A bit of forensic accounting here: when a business is audited because fraud is suspected (either because the principals of the business are worried about a crooked employee or because investors/creditors worry about the potential crookedness of the principals), the payables are always an object of great scrutiny. The diversion of funds to a bogus vendor through phony accounts is a very tempting way to loot a company.

There’s a fascinating mathematical principle called “Benford’s law” that comes into play when auditors are trying to ferret out this sort of fraud.  If you list the amounts that a given business owes its trade creditors, and then classify them by the first digit, then you’ll find more than 30 percent of the resulting numbers begin with the digit one. If some unscrupulous fellow were to try to phony up a bunch of invoices, he’d probably vary the numbers, consciously or not, so that about 11 percent began with 1, another 11 percent with 2, and so forth. Thus, if the accounts of a particular company don’t follow Benford’s law: consider that a red flag has been hoisted high.

Other liabilities represent interest-bearing loans. We’re here calling them all notes payable, though there are lots of more detailed ways to categorize them. These can represent bank loans in which the bank and the debtor enterprise have a stable ongoing enterprise, or transferable bank loans (in which case the entrepreneur may have no idea to whom the money is going month to month). Or they may represent the bonds a corporation has issued.

One critical point to remember is that many analysts see the debt-to-equity ratio—a fact that can be inferred by inspection of the right hand side of the balance sheet alone – as a critical measure of the long term sustainability of a company. If the total interest-bearing debt of all sorts adds up to $3,000 and the owner’s equity is $1,000 then the debt-equity ratio is 3.

Is that good or bad? By itself, it is neither one nor the other. Historically, a debt-to-equity ratio of 3 would be regarded as high in most industries. In a common bit of jargon, it would be called “highly leveraged.” Some analysts find this worrisome. But if the business is earning more on the borrowed money than they are paying in interest, then the leverage is doing its work. There are some businesses that fail in their responsibilities to their investors because they are too timid about borrowing.  

Equity

So we come at last to the bottom right hand corner of our sheet, the owner’s equity. Consider first a simple sole proprietorship. A single entrepreneur owns the business, is subject to its liabilities and has title to its assets. In such a case, the equity section has a residual significance. If we’re sure of ourselves about the assets, and we’re sure also in the valuation of the liabilities, then the equity is simply given by the fundamental equation: A – L = Eq.  If we’re confident in our valuations of the assets and the liabilities, we can be confident too that we know what the business is worth. That is the value of what our proprietor owns, and it needs no further subdivision.

 If there are partners involved, they’ll want to break down the equity section. Suppose Luigi and Vicky go into business together. Each contributes $1,000 of seed money. A balance sheet on Day 1, then, would show equity at $2,000. Balance sheets compiled thereafter would have to distinguish between owner’s equity on the one hand and retained earnings on the other. After a year has gone by, and a new annual statement is prepared, the profit from the year past, to the extent it has not been distributed to Luigi and Vicky, represents the retained earnings.

For a corporation, the owner’s equity portion of a balance sheet will have to record the value of the different classes of stock, perhaps simply preferred on one hand and common on the other, and – again – retained earnings on the third hand.

Market Cap versus Book Value

By this time, we can see perhaps that compliance with the fundamental equation won’t always be a simple matter of adjusting the equity figure to comply with the subtraction of L from A. The total amount of equity will always have to come out to equal A – L, but since each line in the equity portion has its own definition and consequent rules for its proper use, this sounds more like a substantive commitment than a tautology. 

There’s an important source of confusion to avoid here, though: the owners’ equity as shown on the balance sheet is not the same thing as the market value of the company.  Suppose there are 1,000 shares outstanding, regularly traded, and on the final day of the last quarter they closed at $1. That gives us a market cap of $1,000, but it would only be by coincidence that the balance sheet would show that same $1,000 as the owners’ equity.

The balance sheet value is known for short as the “book value.” The relationship of the book value to the market value (or “market cap”) of a company, known as the book-to-market or inversely as the price-to-book, is another of those ratios that is endlessly interesting to stock analysts: perhaps even more so that the debt-to-equity ratio I mentioned above. One school of investors or analysts looks for companies where the market value of the equity is lower than the book value. Those are presumably the bargains you want to snap up.