Entrepreneurial Finance. Robert D. Hisrich
are defined as the resources of the venture. Such assets were financed through liabilities or equity. Liabilities represent obligations the venture has to pay in the future, while equity defines the ownership interest of the venture. The relation between those three elements is the core of the balance sheet and is known as the accounting identity:
Table 3.1
Assets
Assets represent the tangible and intangible property that the venture owns and has accounting value. It is important to note that assets can be both physical assets and intangible assets. Examples of physical assets are inventory, company cars, and real estate. Examples of intangible assets are patents, copyrights, trademarks, and goodwill. Assets are usually ordered in the balance sheet in order of their liquidity. The most liquid assets appear first on the balance sheet followed by the least liquid ones. Current assets represent the most liquid assets of a venture, meaning they can more easily be turned into cash. Examples of current assets are cash, marketable securities, and accounts receivable.
A venture's requirement for current assets is dependent on its operating cycle. The operating cycle is measured based on the time it takes to convert an investment in cash into inventory and then back into cash proceeds from its sale to customers. As a general rule, the longer the operating cycle, the larger the venture's need for liquidity (i.e., cash).
Noncurrent assets may not be readily converted into cash and are usually subject to wide swings in value. These assets are composed of buildings, land, mineral interests, and equipment (ranging from computers to furniture). Assets in this category are “depreciated” over time. Depreciation is the “expensing” or “writing off” of an asset over its economic life. Depreciation affects the value of such items on the firm's books. The value of the asset is and lowered by a certain amount each year. The annual amount of depreciation depends on the type of item. The depreciation amount appears on the income statement (which we will cover next) and reduces taxable income. Accumulated depreciation is the cumulative sum of depreciation for physical assets such as property and equipment.
Intangible assets are assets other than real or tangible property and have no physical existence. They may or may not be reported on the balance sheet. Intangible assets can be and usually are amortized over time.
Liabilities
Liabilities are usually presented in order of their due date and divided in two main sections: current liabilities and long-term liabilities.
Current liabilities are generally due within 1 year, with most items usually having a cycle shorter than 12 months. Several of the items in this category are associated with day-to-day operating expenses and are usually paid within 30 to 180 days depending on the country and culture. Current liabilities may consist of the following:
1 Accounts payable (payments due to other parties)
2 Wages and salaries (payments due to employees)
3 Current portion of long-term debt
4 Short-term loans (from banks or other sources)
Long-term liabilities are obligations that are due beyond 1 year. These can include the following:
1 Notes payable and bonds
2 Mortgages and capital leases
3 Deferred taxes (taxes that may have to be paid in the future)
Shareholders' Equity
Equity represents the shareholders’ stake in the firm. The book value of equity known as shareholders’ equity or stockholders’ equity is the portion of firm capital provided by its investors. This amount is the cumulative amount shareholders have invested in the venture, plus or minus cumulative earnings or losses, minus distributions to owners. This section of the balance sheet is composed of the following:
1 Par value (nominal amount per share of stock or stated value if the stock has no par value)
2 Capital surplus (amount paid for shares of stock by investors in excess of par or stated value)
3 Retained earnings (prior and current periods’ earnings and losses minus dividend payment)
4 Accumulated other comprehensive income or losses (accumulated unrealized gains and unrealized losses such as foreign currency hedges or unrealized pension costs)
Reaching a Balance
The basic accounting equation must always be maintained; total assets must equal total liabilities plus total shareholders’ equity. With some effort and interpretation, assets, liabilities, and equity can be used to generate a picture of the company's health at a particular moment in time. In the real world, the venture's balance sheet will undoubtedly be composed of more items than have been described here, but the format of the balance sheet will be similar to the one presented.
All entrepreneurs need to develop a clear understanding of accounting principles. The first accounting concept should be the balance sheet. The balance sheet represents a view of the firm at a particular point in time.
In Chapter 4, we will explore the balance sheet using ratio analysis. Analysis of the balance sheet can be very helpful in generating insights into management's capabilities, trends in the firm's performance over time, and the firm's performance vis-à-vis peer groups at a point in time.
The Income Statement
The income statement describes the results of a company's operations over a specific interval of time. This interval could be a month, quarter, or year. The purpose of the income statement is to describe how much revenue was generated and what the associated level of expenses was. With these two pieces of information, we can determine whether the company is making a profit or not (see Table 3.2). The basic formula for the income (i.e., profit and loss) statement is simple:
A second use of the income statement is to provide the basis for calculating various measures of profit and cash flow. Various measurements of profit and cash flow include pretax net profit, net income (NI), and earnings before interest, taxes, depreciation, and amortization.
Pretax operating income is the primary measurement of the total earnings generated by the firm without regard to taxes and net interest income (expense). This measurement is an intermediate measure of firm performance that helps describe the firm's economic results over a period of time (see Table 3.2).
Table 3.2
Net income is the primary measurement of the after-tax total earnings of the firm. This measurement takes into account the firm's tax liability (see Table 3.2).
Earnings before interests, taxes, depreciation, and amortization (EBITDA) represent the profit generated after all expenses related to operations are paid. EBITDA is useful for comparison and valuation purposes as it paints a basic picture of the venture's operating capability as well as its ability to cover nonoperating payments such as taxes, interest payments, and principal (see