HRER825:
Lesson 04: Balance Sheets and Cash
Lesson 04: Balance Sheets and Cash
Reading Assignment
- Lesson Commentary
- Review the Course Schedule for additional details on what to read for this lesson.
Learning Objectives
After successfully completing this lesson, you should be able to:
- Describe the concept of the balance sheet;
- Compare and contrast the uses of the balance sheet and income statements;
- Define the terms assets, liabilities and equity;
- Articulate the difference between profit and cash; and,
- Explain the critical function cash plays in the understanding the financial health of an organization.
Balance Sheets and Cash
The balance sheet is not quite as straightforward as the income statement (P&L); however, we can still break it down into simple terms and build from there.
- What is a balance sheet? It is a tool that compares Assets (what we own) against Liabilities (what we owe) and Equity (what we have accumulated in profits or losses).
- The balancing formula is that assets must equal liabilities plus equity. The balance sheet is constructed and presented using this formula.
Example:
Let's take a moment for an example that many of you will be able to relate to--your home. If you own your home, the value of it is considered an asset (you own it). You may also have a mortgage on your home which is considered a liability (what you owe the bank) and the difference between the value of your home and what you owe the bank is equity (value you have accumulated). Here is a breakdown using sample numbers:
| Value of your home (today) | $300,000 | (asset) |
| Less: Mortgage balance (today) | $200,000 | (liability) |
| Equity (today) | $100,000 | (equity) |
The reason we specifically noted each item above as "today" is because when you purchased the home it may not have been the same value as today (or any other date). That is also true of your mortgage balance, which will vary day-by-day. Changes in the previous two numbers mean that your equity would also be different. Your personal balance sheet, if you owned absolutely nothing other than your home, would look like this today:
|
Assets |
|
|
Home |
$300,000 |
|
Total Assets |
$300,000 |
|
Liabilities and Equity |
|
|
Mortgage to Bank |
$200,000 |
|
Equity |
$100,000 |
|
Total Liabilities and Equity |
$300,000 |
One difference between the balance sheet and the P&L is the time frame to which it pertains. The P&L covers a period of time such as a month, a quarter, or a year. The balance sheet is a snapshot of a specific point in time. If the date of the balance sheet is as of December 31st, it is literally a snap shot of that day.
Assets and Liabilities
Reflections about Assets
Assets are things owned by an organization that have economic value. At the same time there can be questions about whether everything of value should appear on the balance sheet. Consider the following situations.
Example 1:
If a company purchases a piece of equipment used to manufacture widgets, is that an asset on the balance sheet or does it belong in the P&L as part of cost of goods sold (direct expense) or an operating expense (indirect expense)? Like all expenses, we did have to purchase the equipment; however, the machine allows us to create value well beyond the interval of time the P&L statement represents.
The answer is that it belongs on the balance sheet as an asset. What has occurred with this transaction is that we have decreased one asset (cash) to acquire another asset of economic value (equipment).
Example 2:
An organization is required to purchase a large amount of paper from Staples to support its duplication services. Further, in order to take advantage of bulk purchase discounts, it orders large quantities of paper and stores it as inventory. Is the paper an asset (inventory) on the balance sheet or does it belong in the P&L as part of cost of goods sold (direct expense) or an operating expense (indirect expense)?
The answer is that it is an operating expense because paper is part of office supplies used for the purpose of supporting the operations of the company (not adding economic value).
Liabilities
Liabilities on the balance sheet are debts and obligations of an organization. The text doesn't have extensive discussions about liabilities because it is fairly straightforward. At the same time we want to caution students to avoid confusing a balance sheet liability with some underperforming element within an organization. Consider the following situation.
Example:
A local CPA firm was performing year-end accounting services for a company that had a P&L with a net loss. The primary owner/operator of the company was quite troubled because he had a group of investors who were going to be upset about the loss. When the accountant sat down to discuss the company's performance, she asked why the company sustained a loss for the year. The owner said there was a group of employees who didn't perform up to expectations and as a result, the company was not profitable. He went on to state that as far as he was concerned, they were all liabilities! The owner went on to say that he felt it was appropriate to move the costs related to these underperforming employees from the P&L to the balance sheet and classify them as liabilities because that is what they were. The accountant explained that she couldn't do that. Although the owner might view them as “liabilities”, they were, in reality, expenses which belonged on the P&L.
In order to provide additional instruction on the construction and use of the Balance Sheet, please review the following Khan video, Introduction to Balance Sheets (visual starts at about 00:01:04).
Cash is King
Over the years, companies come and go. Some succeed and others fail. The interesting part about the companies that fail is that it's often not bad ideas or bad management that cause their demise, rather, they simply run out of cash. A good example of this is restaurants. Restaurants tend to require a lot of cash in order to get started--primarily equipment and inventory. By the time they open their doors, they have no cash left to carry the operating expenses while waiting for sales to ramp up. This is precisely why so many of them fail within a short period of time. You have to wonder if they had just a little bit more cash to carry them for a few months whether they would have turned the corner and been successful. Who knows?
What I do know is that the text is accurate in saying that "cash is king." Cash allows organizations to take chances, to invest in research and development, to attract talent, and the list goes on and on. On the other hand, cash strapped companies are limited in what they can do and the lack of cash keeps them in survival mode. It's the equivalent of someone that lives paycheck to paycheck; it doesn't allow for anything to go wrong--and we all know that things do go wrong from time to time. Unless you are the federal government and can print your own money, every organization runs the risk of running out of cash. Therefore, often cash management is the single most important function in a company.
The topic of profit without cash and cash without profit is worth further discussion. We tend to think that when an organization is profitable, it has cash. This is logical, but not always true. Consider the pair of sunglasses we talked about earlier when we examined the question: When does the sale happen? If someone buys your sunglasses and doesn't pay you at that time, you no longer have your sunglasses and you also don't have any cash. What you have is a receivable or a promise to pay you. Your P&L statement will show a profit, but for this transaction you are cash poor. When you have cash, you have options. You could buy another pair of sunglasses; you could keep the cash in your pocket, etc. The point is that when you have cash in hand, you have flexibility; when you don't have cash, you are limited. In other words, cash really is king.
Cash is so important it has its own financial statement. The purpose of the statement of cash flows is to tell you where cash came from (inflows) and where it went (outflows). However, the statement of cash flows is not an easy statement to read or interpret. Leave it to accountants to complicate such a very simple concept! As an HR specialist, there is no need to actually prepare a cash flow statement. However, you should have a basic understanding of it. So let's break it down.
The cash flow statement is comprised of three separate categories or activities – operating, investing, and financing.
- The operating section relates to the actual operations of the company. If we sell widgets, this section lets us know if we increased or decreased cash as a result of producing and selling widgets.
- The investing section tells us whether we have increased or decreased cash as a result of capital investments related to producing and selling widgets.
- The financing section relates to money that has been borrowed and paid back in order to produce and sell widgets.
The net cash in and out of these three activities tells us the net change in cash from the beginning of the year. Those are the basics of the cash flow statement. But the most important thing to keep in mind is that this statement tells you what happened to cash (net increase/decrease) from the beginning of the year.
Lesson 04 Activities
Lesson 04 Discussion
The text and commentary both reference the concept of “cash as king.” Let’s think about this concept in the context of alternative business strategies.
Consider a situation in which an organization with which you are or were affiliated was “cash poor.” You may wish to keep the actual identity of the organization confidential. If this is the case, please use a fictional name for the organization when describing the circumstances and your recommendations.
If you have never worked with an organization that experienced being "cash poor," choose one to lightly research using the Internet or you may informally interview a business colleague, friend, or relative.
By Saturday at 3:00 p.m. (ET):
Submit an initial post of at least 250 words addressing the following:
- Briefly describe the situation.
- In seeking to create a competitive advantage given the organization’s economic circumstances, what options might the company have to achieve a more favorable cash position?
By Monday at Noon (ET):
- Respond substantively to TWO other students’ initial posts, indicating whether from the facts presented by the initial posts, the options appear feasible. Explain.
- Make every effort to choose two posts that have not yet received a response.
- Check back to review responses to your original post.
Lesson 04 Assignment
A balance sheet in good order is broken down into categories as follows:
- Current Assets
- Non-Current Assets
- Current Liabilities
- Non-Current Liabilities
- Shareholders' Equity
Use the Worksheet_Lesson4.doc to complete this assignment. Submit your completed document for grading by uploading it as an attachment.