Synopsis

Business financial statements provide an extremely boring set of data until you realize what is going on behind the scenes. Financial statements represent the hard work of business employees and the satisfaction of business customers. I hope to present a basic understanding of the language of business and use it as a background for an explanation of the banking business.

Introduction

In college I had to take a course in accounting. At the time I didn’t think there was anything that could be more boring. All this talk about debits and credits made little sense to me. The professor described debits and credits as being on the right and left of the balance sheet. At the time that didn’t seem like a sufficient explanation for me.

Later, in the early 1970s, I worked as a credit analyst in a local bank. At first, I asked myself how I would survive all this accounting gobbledygook. But then I got the chance to make the connection between the figures on a balance sheet and what actually went on in the business.

I won’t bore you at this time with the details as to how I came to this realization, but I finally recognized that the numbers on the financial statements represented the accumulation of activities of people in the business. Reading a balance sheet became like reading the story about the business. But first, I had to understand the language.

In the course of writing these newsletters, I will make many references to business finance. I ask at this point that you bear with me to learn some of the language of business. (I must alert any reader familiar with GAAP accounting standards that I intend my explanation for layman.)

I have provided the following diagram to help you follow the explanation that I give below.

The Basics

A business balance sheet simply records amounts of money at a single point in time. It provides a sort of snapshot of the financial condition of the business at that one point in time. Liabilities and equity indicate the source of money received by the business. Assets indicate for what the business spent money. None of these categories provide any information about the sources and uses of funds.

I will discuss each of the subcategories in terms of three time frames: immediate, current, and long-term. Using these time frames helps indicate the amount of money that will be available within that timeframe to pay the obligations reflected in the liabilities.

Immediate

Assets

Cash in Bank

$5 million

Liabilities

None

The immediate timeframe includes only cash-in-bank. When the business presents a check to a payee, they should be able to withdraw or transfer those funds immediately. No immediate liability exists for a business entity.

Current

Assets

Accounts Receivable

Inventory

$80 million

Liabilities

Accounts Payable

Notes Due Bank

$60 million

The current timeframe includes assets that the business will convert to cash and liabilities that it must settle within one year. Normally, the business achieves these results in much shorter periods of time.

This business has $80 million in assets and $60 million in liabilities. This ratio indicates that the business should have little trouble paying its liabilities within the one-year timeframe.

Long-Term

Assets

Plant and Equipment

$200 million

Liabilities

Bonds

$50 million

The long-term timeframe includes assets that the business could convert to cash in over one year and liabilities that the business must settle in over one year.

This business has $200 million in long-term assets and $50 million in long-term liabilities. In a liquidation, this business should have sufficient assets to meet its long-term liabilities.

Equity

$175 million

In simple terms, the equity of the business amounts to the total assets minus total liabilities. It represents, in dollar terms, the ownership of the company.

Total: Assets and Liabilities

$285 million

No business can spend money that it does not receive from some source. As a result, total assets will always equal total liabilities plus equity.

Risk Assessment

All the entities that provide credit to a business accept a certain level of risk. If the business falters to one degree or another, the grantor of credit may suffer a financial loss to one degree or another.

Before they grant credit to the business, they need to make some sort of risk assessment. This point will become critically important when we discuss the finances of banks.

Conclusion

The business balance sheet consists of a static representation of the money received in the money spent in a business. Breaking these accounts into general time frames indicates whether the business will be able to meet its obligations when they come due.

I should make it clear that the figures on a business balance sheet simply reflect a record of the historic amounts originally received and spent by the business. They do not reflect the market price of the particular asset categories at the time of the preparation of the balance sheet. Plant and equipment, for example, suffers wear and tear during the period of its use; technological advances may drive liquidation prices even lower.

In addition to providing a reference for any future comments I might make about businesses, I wanted to provide this example to show why people should not interpret bank balance sheets using the same criteria. I will discuss bank balance sheets in an upcoming newsletter.