The Balance Sheet

The balance sheet is a listing of the company’s assets and liabilities.  If you think of your own personal finances, you have things that you own: a house, a car, furniture, food and so on.  You also might owe money.  There could be a mortgage on the house; a home equity loan, a car loan and some credit card debt.  The difference between what you own (your assets) and what you owe (your liabilities) is what you’re worth (your equity).

A balance sheet is a listing of the assets and liabilities of a company together with a listing of the shareholders equity.  If you think about it, if you subtract off the liabilities from the value of the assets, you get the shareholders equity.  Think through the example of personal finances discussed in the preceding paragraph.

Balance Sheet from Clayton Homes for Fiscal Year 1999

Assets 

Assets are listed in a specific order: in the order of liquidity.  Liquidity is a subjective measure of how quickly and easily something can be converted into cash.  Cash is clearly liquid.  Stanley Cup Playoff tickets are pretty liquid too—fans will pay to buy them.  Property on the other hand can be illiquid.  Selling property takes time and involves expenses—if it takes time or there are costs involved in converting an asset to cash, it makes that asset illiquid.
Embedded into this document is the balance sheet for Clayton Homes, taken from the 1999 annual report.  Clayton Homes is provided as an example; you won't find it anywhere; I will talk more about this topic at the end of this section.  Note all figures are given in thousands, so $2,680 is really $2.68 million

Let me first run through some of the items on the balance sheet, just to explain what they are.  Whenever you see something in parentheses it means it’s a negative number.  For example, a loss of a million dollars would be abbreviated as ($1,000).  You’re going to have to think back to the example earlier of a company importing widgets from China.  Revenues are recognized as a receivable. .  You decide (based upon the norms in your industry) when you book the revenue.  It might be when you ship the widgets out of your warehouse, or when the FedEx acknowledges receipt.  Whenever that event occurs, you create a receivable.  When you receive the actual payment, the receivable becomes cash.  You can view a receivable as a sale that is not yet cash.  Say the receivable is $1,000; upon payment, receivables are decreased by $1,000 and cash is increased by that same amount.
The concept of an inventory as an asset is reasonably self-explanatory.  We covered it earlier in this chapter.  In the widget example, if you bought 1,000 widgets and stored them in your warehouse, those widgets would be your inventory.

Property, plant and equipment

Property, plant and equipment is pretty clear.   These are hard, tangible assets that you own.  They'll be depreciated, well not land.  They're usually also not very liquid, easy to convert into cash.

Deferred items 

Deferred income taxes are items marked for payment.  Deferred income taxes will be discussed in detail later on.

Accounts Payable 

Accounts payable is the mirror image of a receivable.  When the widgets arrive, the invoice might be “net 30”: you have 30 days to pay.  Payables are debts you owe.  Ideally, a company wants receivables to be paid as quickly as possible and payables to permit extension of payment over a long time.  The joke is receivables should be “net now,” while payables should be “net never”!  You receive cash immediately but you never have to pay a bill.

Equity Section of the Balance Sheet 

In the equity section of the balance sheet, Clayton Homes is a good example because there are two classes of stock: common and preferred.  Common stock, or shares of common stock, is something we’ve already discussed.  Preferred stock is something different.  Preferred shares are like common shares, but they have a “bond” flavor .  This class of shares is called preferred, because it is higher in the pecking order when it comes to getting a dividend.  The company might create a class of preferred shares that have no voting rights (often the case); the company may be able to buy them back at a fixed amount; there is a dividend—it’s normally higher than dividend given to common shareholders.  If a dividend is declared by the board, the preferred shareholders get paid first.  The preferred shares could have a convertible feature.  In other words, there might be a provision that allows conversion to common shares at the discretion of the company.  CMH is authorized to issue preferred shares, but has decided not to do so.

Now, when shares are created, they often have a par value!  I say often, because sometimes shares are “no par.”  There’s really no need to worry about what par value is—it’s an accounting relic. 

The only consequence of having a par value is how things get recorded.  For example, let’s say a company is authorized to issue shares with a par value of $1.  It goes ahead and sells 20 million shares, raising $200 million—in other words, the shares were sold at $10 each.  Since the par value is a dollar, one dollar of the sale of each share is accounted for under common stock, the other nine dollars is called “additional paid-in capital.”  It’s just an accounting way of divvying things up.

The reason that par value exists was probably to protect investors capital.  In some states, the value of the asset based was not allowed to go below the value of the common stock.  In other words, corporate officers just couldn’t pull all the invested money out of the company.

Corporate capital that comes from company operations is called retained earnings.   The total value of retained earnings—found in the statement of shareholders equity and the shareholders equity section of the balance sheet—is actually the total accumulation of company earnings less any dividends that have been paid out to shareholders.  Earnings for a given financial year are added to retained earnings from the previous year to give the new value for retained earnings.  Earnings are the raison d’être of the Income Statement.  Earnings start of in the income statement and then they make their way to the balance sheet via the statement of shareholders equity—what a great segue to the income statement!  In fact, earnings appear on each of the four financial statement that a public company is required to publish.

Why I picked Clayton Homes and what's happened to it since

What you're reading here was actually taken from a book that I wrote called Crawl, Stand, Walk, Run, Sprint.  This part is Crawl.  It was a simple explanation of the NAIC tool the Stock Selection Guide.  It was updated in 2000 and 2001 and called Dollars from Sense.  Real data was used and, even though I warn people that companies are provided for educational purposes only, there's always the fear that someone would go out and buy the stock.  Clayton Homes looked like a solid company to me.  I had owned it for years and bought it repeatedly on dips in price.  It turns out that Warren Buffett was watching the company too.  He ended up, through Berkshire Hathaway [NYSE.BRK.A], buying the company outright.  So, Clayton Homes is no more--well, not as a standalone, publicly traded company.  However, I will continue to use its financials as an example--I mean, you can't rush out an buy the company.  If you decide to buy Berkshire Hathaway, as long as Warren Buffett's at the helm, that's fine with me.  Looking at Clayton Homes may just also provide a modicum of insight into Buffett's thinking.  Clayton Homes (the ticker used to be CMH) is a great example to use.