Examining the Balance Sheet

The working capital and quick ratios are only two of several that you would determine in a thorough financial statement analysis. Before going on to the other ratios, however, the question of whether or not the figures reported on a balance sheet are reliable must be considered. This topic discusses the fundamentals of examining the balance sheet.

Suppose you are credit manager of a manufacturing firm. One of your salespeople has just sent in a sizable order from a customer your company has never sold to before. Along with the order, the salesperson has procured the balance sheet.

At first glance Smith Company's financial position appears strong. Its working capital looks good:

The working capital ratio is a healthy 2.1:

Current Assets $63,000 / Current Liabilities $30,000 = Working Capital Ratio 2.1

And the firm reports more than one dollar in quick assets to every dollar in current liabilities:

Quick Assets $31,000 / Current Liabilities $30,000 = Quick Ratio 1.03

But these ratios are only as good as the figures you have used to determine them. And how reliable actually are these figures? Does the Smith Company really have the cash balance it professes to have, and is it freely available to meet its obligations as they mature? Are its accounts receivable in a healthy condition? Is the inventory worth what the balance sheet says it is worth?

As you can see, a financial statement in the form that the credit applicant works out may not answer these questions to your satisfaction. To get the answers your best bet is to send a professionally designed, self-mailing form, like the one shown here. Such a form has at least two important advantages:

1. It discourages the credit applicant from making fraudulent misrepresentations. Because federal laws prohibit the use of the mails for fraudulent purposes, the self-mailing form gives you the evidence you need to prosecute a debtor who used a financial statement to misrepresent financial strength.
   
2. It breaks down the customary financial statement entries into figures that are more meaningful for credit analysis-figures that tell you how well the customer will be able to meet current obligations. Notice, for example, the breakdowns this form requires under these ordinary balance sheet entries:
   

Cash

Cash is divided into two categories: cash in bank and cash on hand. This breakdown is especially important when you are evaluating the strength of a small company, particularly if the statement is not audited. Suppose, for example, that the Smith Company reports a bank balance of $1,500 and a cash-on-hand balance of $3,500. Such a disproportionately large cash-on-hand balance would warrant further investigation. You might find that it concealed IOUs from officers and employees, postdated checks, and other items that should not have been listed under Cash or even under Current Assets.

There are other ways the reporting firm can distort the cash figure which you should be on your guard against. The company may include money received after the close of the period for which the balances are shown. It may fail to deduct outstanding checks from the bank balance. And it may neglect to segregate amounts that it has set aside to meet sinking fund requirements or to meet specific debts.

Accounts Receivable

The sum listed beside the single entry Accounts Receivable on the Smith Company balance sheet may have to be divided among as many as four separate entries on the NACM (National Association of Credit Managers) form.

Any nonmerchandise receivables do not qualify as current assets and must be listed below fixed assets, beside the entry Due from Officers or Noncustomers.

Customer accounts receivable are divided according to those not yet due, those past due, and those that have been sold or pledged.

If Smith Company had to report that of its $26,000 in receivables, $5,000 was past due and $10,000 had been pledged, you would realize immediately that its favorable quick ratio was nothing but a mirage. The collectible value of the past-due accounts would probably be considerably less than their listed value. And their proportion to overall receivables would indicate haphazard credit and collection methods, depreciating the value of even those accounts that are not as yet due.

The significance of the amounts pledged is obvious, since property that has been pledged to one creditor would not be available to meet the demands of another. Notice that under the entry Notes and Trade Acceptances Receivable the amounts sold or pledged must also be listed separately.

Inventory

The inventory figure, like the accounts receivable figure, is broken out and qualified by the NACM (National Association of Credit Managers) form. The Smith Company has simply reported an inventory of $32,000 and let it go at that. If the form had been used, this figure might well have been reduced when put to the test of the following questions:

• Is it merchandise? Inventory should include only materials which are--or can be converted into--merchandise. Supplies that will never become a part of the finished product (such as stationery and other office supplies) should not be included in the inventory.
  
  
• Is it company owned? Only goods and merchandise the company had bought should be reported. Goods held on consignment belong to the consignor and do not constitute inventory.
  
  
• How and when was the amount of stock arrived at? As you can see in the lower section of the form, the officer signing the form certifies that the amount of stock was not estimated, but rather determined by a physical inventory taken on a specified date.
  
  
• How was it valued? Notice that the form requires inventory to be valued "at Cost or Market whichever is lower." This ensures conservative valuation, preventing the inventory from being priced above its current market value even if it cost more when purchased. This method of valuation is based on the theory that even if the cost of the goods is less than the current market price, no profit is actually made until the goods are sold. If the market price is lower, there is usually a corresponding decline in realizable value, and conservative stocktaking would place the inventory figure low enough so that the selling price may yield the normal gross profit.
  
  
• Is any of it pledged? Like accounts receivable, if any of the inventory is pledged to another creditor it would not be available to meet your collection demands.

Additional Paid in Capital*

Additional paid-in capital found in the equity section of the Balance Sheet represents the price paid for stock in excess of par value. Par value is the nominal dollar value assigned to stock by its issuer. Par value is usually a very small amount that bears no relationship to the market price of the stock. Par value is the minimum price below which the corporation will not sell its stock. The actual selling price of the stock is largely a function of supply and demand.

Additional paid-in capital represents the difference between the price the company receives for its stock and the par value of that stock. Thus, if one share of common stock with a par value of one dollar sold for $11.25 the equity account would show:

Common stock $ 1.00
Additional paid-in capital $10.25

Additional paid in capital (sometimes called contributed capital) does not represent a reserve of money that the corporation has on deposit somewhere. Additional paid in capital is spent by a corporation to acquire assets, or to pay liabilities.

There is considerable other information you can get from a professionally designed form that you are not apt to get otherwise. For example, the form gives you a good idea of whether or not all of the reporting company's current liabilities have been listed as current. And it may tell you how the company's credit is with its bank by indicating whether or not the bank required security on any loans.

These things will become clearer to you as your experience in financial statement analysis increases. In fact, with experience you will be able to sense when an asset is exaggerated, or a liability understated, simply from its relationship with the other items on the balance sheet. And you will become familiar with such peculiarities as the seasonal fluctuations which may distort your customers' balance sheets.

*Source: "Credit and Collection Manager's Manual" edited by Michael Dennis and Steven Kozack.