1.1.4 Liabilities and Owner’s Equity

1.1.4 Liabilities and Owner’s Equity

Now that we’ve discussed what a company owns – its Assets – we can switch to the other side of the balance sheet, the Liabilities and Equity (or Net Worth) section.  In short, this provides a sense of the sources of financing for a company. You might notice parallels to your own life.  Your Debts – credit cards, mortgages, car loans, and student loans – have helped you finance your Assets – a house, a car and, most importantly, your very valuable human capital.  The difference between your Assets and Liabilities is your net worth.

 

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Which Liabilities Seem Really Interesting?

Liabilities and Equity

Balance Sheet Percentages A B C D E F G H I J K L M N
Notes payable 0 0 8 3 5 2 0 0 11 0 4 4 1 50
Accounts payable 41 22 24 2 6 3 2 8 18 12 13 2 6 21
Accrued items 17 15 8 1 5 3 3 9 4 5 5 1 6 0
Other current liabilities 0 9 9 9 6 18 2 7 11 10 4 2 12 3
Long-term debt 9 2 11 17 29 9 10 33 25 39 12 32 16 13
Other liabilities 7 17 17 24 38 9 5 18 13 10 7 23 22 4
Preferred stock 0 15 0 0 0 0 0 0 0 0 0 0 0 0
Common stock 25 19 23 44 12 55 78 25 17 24 54 36 38 10
Total liabilities and net worth 100 100 100 100 100 100 100 100 100 100 100 100 100 100

Take a look at this section.  Identify three numbers from the Liabilities and Net Worth section that seem particularly interesting to you. Why are they intriguing?

 

 

Accounts Payable

Accounts Payable represents amounts due to others, typically the company’s suppliers. One company’s Accounts Payable typically corresponds to another company’s Accounts Receivable.

Sometimes firms may have Notes Payable, which is a short-term financial obligation also from a customer of sorts.

 

We discussed how Walmart (a multinational retail corporation), Staples (an office supplies chain), and Intel (a semiconductor chip manufacturer) have Accounts Receivable balances, representing amounts owed to them by their customers.  For each of those companies, think about who might owe them money as a customer. In other words, which companies have Accounts Payable which correspond to the Accounts Receivable for these three companies?

 

 

Intel is the easiest of the three companies to think about. As Intel sell its chips to manufacturers of electronics with computing ability, Lenovo or Dell would be a customer of Intel. So, the Accounts Receivable of Intel correspond to the Accounts Payable of Dell or Lenovo.

Accrued Items

Accrued Items can mean many things.  One example is salaries: at the time a balance sheet is produced, it may be in the middle of a pay period, and some salaries may be owed but not yet paid.

Long-term Debt

As we move from short-term liabilities to long-term liabilities, we encounter debt for the first time.  Unlike everything we’ve seen so far, Debt is unique in that it has an explicit interest rate.  You’ve likely encountered Debt in your life.  For example, students borrow money, and in doing so, take on Debt, to pay for college just as home owners borrow to buy homes.

Take a look at the percentage of Assets that are associated with Long-term Debt for Company D (17%) and Company M (16%).  Which company’s Debt do you think is riskier?

Assets

Balance Sheet Percentages D M
Cash and marketable securities 25 16
Accounts receiveable 7 2
Inventories 4 0
Other current assets 5 5
Plant & equipment (net) 8 69
Other assets 52 9
Total assetsa 100 100

Liabilities and Equity

Balance Sheet Percentages D M
Notes payable 3 1
Accounts payable 2 6
Accrued items 1 6
Other current liabilities 9 12
Long-term debt 17 16
Other liabilities 24 22
Preferred stock 0 0
Common stock 44 38
Total liabilities and net wortha 100 100

 

One thing you may have noticed is the cash levels of those two companies – Company D has far more cash than Long-term Debt, while Company M has about the same amount of cash as they have debt.  Financial analysts sometimes think of cash as “Negative Debt.” In this case, Company D can be considered to have “Negative Debt.”  A company that has more cash on hand than debt may be considered much less risky for banks to lend to than one with less cash than debt.

Preferred and Common Stock

While Debt has a fixed interest rate and no ownership claim, Equity represents a residual ownership claim with variable returns.

Common Stock, also called Owner’s Equity or Shareholder’s Equity, represents the owners of the company.  Because Common Stock holders have a residual claim, their return is what is available after costs are paid out.  In the event of a bankruptcy, Debt holders are paid back first, while Equity holders receive whatever is left over.

Preferred Stock is often called a hybrid instrument because it combines elements of both Debt and Equity claims. Like Debt, the dividend is fixed and paid prior to when common stock dividends are paid, but like Equity, Preferred Stock is associated with ownership, and is paid after Debt in the event of a bankruptcy.

 

Venture Capital firms, which provide funding for entrepreneurial ventures, almost always receive Preferred Stock in exchange for their funding.  Why do you think they prefer this form of financing?

 

Preferred stock allows them to protect their investment in the event that the company does poorly, while still participating in the upside if the company does well. They do this by “converting” their preferred stock into regular common stock when things go well.