The Classified Balance Sheet

At the end of the last section we had a business, eleven transactions, and a balance sheet that balanced after every one of them. What we did not have was any way to look at that balance sheet and say whether the business was in trouble.

That is not a flaw in the arithmetic. It is a flaw in the layout. A balance sheet where cash and a building sit in the same column, and a bill due next week and a loan due in nine years sit in the same column on the other side, is a list. It is accurate, and it is nearly useless for the one question an owner asks most often, which is whether the business can pay what is coming.

It’s nice to have a classified balance sheet, instead of a big old list of assets, to break it up into current versus long term. The same thing with the liabilities, because the short term matters. We have to make sure we are operating well and can still pay off all of our debts, and can still maneuver.

You might have a ton of assets, but if they’re all long-term you can’t convert them into cash quickly. That is a position where you’re vulnerable, because all this stuff is locked up. Similarly, imagine you’ve got a lot of people who owe you, but they don’t owe you for the next ten years, and you’ve got some debts where you owe people right now. Even if it balances out, you’ve got a problem of liquidity, because you need to come up with money quick and you’re not going to get it until later.

It’s helpful to get a sense of all the things you’ve got: how much are things that can turn into cash quickly, versus how much would take a while. The same on the liability side. A long-term liability that’s not due for a long time is different from something that’s going to be due in a year. That’s why it’s important to be able to divide up a balance sheet into what’s current and what’s long-term, both on the asset and the liability side.

How you do it

Once we get a more complex business going, we like to add a refinement in how we report the balance sheet. In particular, we like to prepare “classified balance sheets”. This simply means that we group or classify the assets and liabilities in a particular way.

Here is how you do that.

On the asset side, we want to separate current assets from non-current assets.

Current assets are those that we expect to turn into cash in about a year, or in one operating cycle, whichever is longer.

We want to know what assets we can quickly convert to cash. Here is a list of some of those:

Cash of course is already in cash. Marketable securities are stocks that the business holds of other businesses. We could sell that for cash at the market rate pretty quickly. Accounts receivables represents trade debt from our customers that they will very quickly be paying us in cash. Inventory, if you sell stuff, is the stock that you’ll be selling pretty soon for cash, so that counts as current. Finally, insurance and supplies are usually only for the current period, so those are also classified as current.

What are non-current assets?

It’s everything else. The stuff you could not quickly turn into cash or use up. Think about the big investments that would be a pain to turn into cash, like land, building, big pieces of equipment.

We are going to classify the liabilities using the same approach of current vs. non-current.

Current liabilities are those obligations that we need to make good on in a year. This shows what is coming due in the next year: accounts payable are generally due soon after we buy something, we need to pay our employees pretty much every week or month, taxes of course are due within the year, and any outstanding interest we need to pay on our loans.

What’s long term?

We might have some long term debt that we don’t have to pay off until a long time out, that is non-current.

So the four boxes look like this.

Reading one

Here is a simple classified balance sheet, the full example.

This mirrors the accounting equation. Assets equals liabilities plus owner’s equity. That equation is the genesis, the origin, of what a classified balance sheet looks like.

The first thing you’re going to see is that we have the left side of the equation, assets, and on the right side of the equation we have liabilities and owner’s equity. We typically have assets listed over on the left, and then liabilities on the right side up top, and then owner’s equity underneath that. We sum them up, and you will see that both sides sum to $65,000.

What makes this a classified balance sheet is that we put current things at the top, things that are what we call liquid. Liquid means we can turn them into cash relatively easily, and we list them in decreasing rank of liquidity. The things that are going to be at the top, and this is standard for all balance sheets, are things that are more liquid. As we get towards the bottom we get things that are illiquid, things that are big purchases, difficult to turn into cash right away.

A relatively liquid item that you’ll see pretty close to the top is inventory. If you have inventory, the reason you’ve got it is you need some goods on hand to sell. You have the stuff ready to sell. It is waiting for a customer to walk in and buy that, and once they buy that, it is going to turn into cash for the business. That’s why we have it, and that stuff is near the top.

If you go to the bottom you’ll see things like property, plant and equipment. These are your buildings or big pieces of equipment that you have purchased. These are things that took a long time and a lot of consideration for you to buy. If you needed to get rid of them, it would take a long time to dispose of those assets or sell them off. Why? They’re expensive, which means that people tend to spend a long time before they actually make expensive purchases, so that can take a while.

Think about your own analogy personally. If you had a house, selling a house is not something you can do in five minutes. It takes a lot of time. There’s a lot of due diligence. People want to be careful. They’re going to get home inspectors. All of this takes time, which means these assets, if you wanted to turn them into cash, would take a while.

Equipment tends to be specialized to what you produce. If you have an assembly line, all that equipment is configured carefully to produce what you want to do. If you want to sell it to somebody, they’d have to do exactly what you do to take this whole assembly line wholesale. Even then they’d have to move things. They’d have to test it. There would be a very long time, by the way, to install it. And if they wanted to take that equipment and integrate it into some other process for some other product, that would take even longer.

That’s why all this stuff takes a long time to turn into cash. Those things are illiquid, and they’re further down the page on the left side because they are more illiquid assets.

Now walk down the example.

Current assets: we generally think about anything that’s going to turn to cash in the next year. We’ve got cash, that’s obvious, at $10,000. That’s cash right now. We don’t even have to turn it into cash. Accounts receivable is when you sell things and your customers haven’t quite paid you, and they’re going to pay you a little bit later, say in the next couple of weeks or a month. They can have an account open with you. You’re telling them, I can give you the stuff, you don’t have to pay me right away. That is stuff we’re expecting to get from them relatively soon.

In this case that’s $5,000. Inventory is stuff that we hold that we are going to sell to customers. We intend to sell that as quickly as we can, and certainly relatively soon. All that stuff is going to get turned into cash pretty soon, which is why it’s a current asset.

Prepaid expenses. This is an asset because let’s imagine we have something we have to pay, like a subscription or the right to use some kind of software, but we have to pay it in advance. This is an asset because even though we are paying it up front, we’re going to receive some future benefit from that. That is the definition of assets: something that we hold that is of value, and we can ascribe a dollar amount to it, and we expect to have some future value for the business coming from it. When we prepay an expense, even though that money is gone, we expect to have the rights and the benefits of using this over a future period. Prepaid expenses are things we expect to use up relatively soon. That’s a current asset.

When we sum all this up, the $10,000 plus the $5,000 plus the $8,000 plus the $2,000, we get total current assets of $25,000.

Moving down the line to non-current assets, these are things that are long-term. We have some long-term investments, $15,000 here. Things like property, land, plant, equipment, buildings and big pieces of equipment are big-ticket items. These are not things we expect to have to replace very soon. If we had to turn this into cash, first of all that’d be a pretty big change for our business, but it would take us a long time to do it. That’s what we consider illiquid.

Below the $30,000 amount is accumulated depreciation. As we use this equipment we take depreciation on it, so we’re matching the cost of this asset over time. This is the account that lowers the value of property, plant and equipment, so we subtract that from $30,000 to get $25,000.

When we sum all of that up in non-current assets, it’s going to be a total of $40,000. When we add total current assets plus total non-current assets, that’s total assets. It’s $65,000. That’s the left side.

Let’s move to the right side. Liabilities and owner’s equity are both on the right side. Liabilities are the things that represent not future benefits for the business, but things that in the future are going to reduce the value of the business at some point.

What we have here is accounts payable. Again we divide the top and the bottom by what’s current versus non-current. Current are things that are going to happen in the next year, and non-current things are going to happen later on.

Accounts payable is the analog of accounts receivable. It’s when we buy from suppliers and we don’t have to pay right away. That is what we owe our suppliers, and that’s the $4,000. If there’s some debt that’s coming due in the next year, that’s the short-term debt part, in this case $3,000. Our total current liabilities, what we’re going to have to pay out in the next year, is $7,000.

Moving to non-current, we have some long-term debt. This stuff isn’t going to come due until later. That’s $10,000. When we add our total current liabilities and our non-current liabilities, it is a total of $17,000. And what lies underneath that is owner’s equity.

Step back. We know from the accounting equation that assets equals liabilities plus owner’s equity. Now that we know assets and liabilities, you can do the algebra: owner’s equity, if we isolate it on the right side, equals assets minus liabilities. So we know what owner’s equity is going to be before we read it, and we can foretell that it’s going to be $48,000.

We break that into two parts, paid-in capital and retained earnings, for the reasons in the last section. Here it is $20,000 and $28,000. When you add those two up, it’s $48,000, and $48,000 plus total liabilities of $17,000 equals $65,000. The balance sheet here balances. Balance sheets always have to balance. That’s why they’re called that. Assets equals liabilities plus owner’s equity.

Read as a list, that statement says a business has some cash and some equipment and owes some people. Read as a classified statement, it says something much more specific: $25,000 is coming available inside a year and $7,000 is coming due inside a year. That is a ratio of more than three to one, and it is the first thing on this page that resembles a diagnosis rather than an inventory.

Where the line gets blurry

Where is the current line? What’s current versus long term? I don’t think this is that blurry. These are pretty good bright line rules.

Generally it’s stuff that’s going to happen within a year: current. Stuff that’s going to happen beyond a year: long term.

Now there are some ways to get a bit more nuance about this. We think about the business cycle. If a business has a very long business cycle, imagine long-term construction. From the time we buy something, to the time we use it, to the time we build it and deploy it and bill for it, that’s a really long time. We might extend what we mean by current versus long term, because the cycle is so long.

Things that are within one business cycle we call current, and things that are outside are going to be non-current. Generally a good guideline is to think of it that way. A lot of people use the year: if it’s going to happen within one year, or within one business cycle. The second one is a bit more of a judgment call.

What accumulated depreciation tells you

That negative line under property, plant and equipment is worth pausing on, because it carries information that nothing else on the statement gives you.

When you take depreciation on the income statement, we adjust it as a negative against all the assets that we have. If you’ve got $30,000 of PP&E and you’ve taken $5,000 of depreciation on the income statement, you’ll have a negative $5,000. You net this off, so your total net PP&E is $25,000.

What that tells you is that if you bought $30,000 worth of equipment and you have $5,000 of depreciation, this stuff is pretty young. We still have a long way to go before we use up all the value of this plant, property and equipment.

That is very different from if we had accumulated depreciation of $27,000. Net assets are only going to be $3,000. That means we’ve used up something like 90 percent of our PP&E. What that means is this stuff is probably old. If we have equipment, it’s probably going to have to get replaced pretty soon, and we’re going to have to have some cash on hand to replace it.

That’s an important part of looking at the balance sheet. We can get an idea of not only what assets we have, but how old they are. And what does that mean about our timing of having to replace or reinvest in the business?

Notice that both columns are identical on the total-assets line if you only look at net PP&E plus everything else. The classification is what makes the second business’s problem visible, and the problem is a cash requirement that has not happened yet and does not appear anywhere on the statement as a liability.

What the point of all this is

To monitor this, managers like to track not just their assets and liabilities, but also how much is current vs. non-current. Liquidity refers to the ability for a firm to pay its debts.

What’s the point in doing this? Say you have a lot of assets, $10 million worth. And you only have $3 million in liabilities. You might think you are in a pretty good position, since you have more than 3 times assets vs. liabilities.

But, what if I told you $8 million of that asset value was tied up in an asset like a cruise ship. That’s tough to sell, and if you sell it, you probably can’t make a lot of money (if you run a cruise company).

Now say your liabilities are all current - you need to pay off the $3 million in the next year. Now, your situation doesn’t look so great. You don’t have enough current assets to pay off your current liabilities.

The two tables describe the same company. The first one is the reason classification exists.

Selling the ship

Let’s say you have a lot of debts coming up and you don’t have much cash on hand. In order to pay off your debts on time, you’re either going to get sued because you can’t pay your debts on time, or you have to liquidate something. And it’s really hard to sell an office building, sell a piece of property, or sell a big piece of equipment.

First of all, those aren’t very liquid. It’s going to take a long time. It’s going to be very distracting to find an owner, to find somebody who’s going to buy this asset that is difficult to sell, so you’ll be distracted by that. They’re going to know that you’re desperate, so maybe in a fire sale you have to deal with a lower price than it’s worth. And the last thing is that in the long run that can really compromise you. You no longer have the story, you don’t have the plan, and losing this equipment will harm your ability to make value in the long run.

We don’t want to be in that situation. Even though we’ve got some assets that are very valuable, if they’re locked up long term, that’s not going to be very good for settling up short-term liabilities. We always have to have enough current assets to service all of these upcoming debts that are quick to come up. It’s helpful to differentiate that. For liabilities that aren’t going to be due for a long time, we have more time to deal with that. But for stuff that is due up front, we want to make sure that we also have some current assets to service that.

Three separate costs are named in that passage and they are worth separating, because only one of them is the one people expect. There is the discount, selling below worth. There is the distraction, which is management time you were spending on the business. And there is the capability you gave up, which does not show up anywhere as a number and which you find out about later.

The harder case

The cruise ship company is in trouble and you can see it from the classification alone. Here is the version you cannot.

Let’s say you’ve got a good current ratio. You’ve got a lot of current assets, and you’re thinking, I have some current liabilities coming up but I have a lot of current assets, so it should still be fine.

You could still be in trouble, because some of these current assets still aren’t cash. Imagine it’s inventory. We expect to sell that and turn it into cash, but the problem is we haven’t turned it into cash yet. You can’t pay off your bills with inventory. You have to pay them in cash.

Even if we have a lot of stuff ready to sell, if we haven’t sold it, we don’t have the cash yet. And the bill is coming due next month. That could put us in a point of distress. Either we have to apologize and not pay people, or, to accelerate those payments, we have to discount and sell our inventory at a lower price just to get enough cash. That’s bad for the business, because it means lower prices, which means lower profits. Sometimes these fire sales are necessary just to survive.

So the classification tells you something real and it does not tell you enough. Current assets are not all equally current. Cash is cash. A receivable is a promise from someone who has already agreed to pay. Inventory is a promise from a customer who has not walked in yet.

A ratio can tell a story, but it doesn’t tell you everything. You need to be able to pull it apart to understand and diagnose the health and financial position of a business.

What comes next

We’ll talk about this later when we do some analysis. One of the things people do is look at ratios of current assets against current liabilities, because these are things that are going to move quickly. You always want to ask whether you have more assets than liabilities, but it also matters what the timing is. You want to make sure you’re going to have enough money on hand when you need it, to pay debts that are coming up. There are different ways of analyzing this, and it helps to have the balance sheet classified in these ways.

That is Chapter 5, and it is the whole reason this chapter exists in the shape it does. Chapter 2 gave you a statement of performance. This chapter gave you a statement of position, and then sorted it so that position means something you can act on. What is still missing is the comparison. A current ratio of three to one is a fact about this business on this day. Whether it is a good number depends on what business it is, what it looked like last year, and what everyone else in the industry looks like. None of that is on the balance sheet.

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