Hi everybody. So far, you have learned the various valuation methods, given earnings or cash flows. You may wonder where these numbers come from. In this class, we are going to learn the basics of financial statements. At the end of this class, you will understand where earnings and cash flows come from. The first financial statement we are going to learn is the balance sheet. The balance sheet is a snapshot of the firm. It shows what a firm owns as its assets, what a firm owes as its liabilities, and the firm's equity at a given point in time. The sum of liabilities and equity is the same as assets and it is called balance sheet identity. Assets are classified as either current or fixed. An example of fixed assets are truck, computer, land, building, and patent. And examples of current assets are inventory and account receivables. Account receivables means the record of what the firm is supposed to receive from its customer. As you can tell from the examples, fixed assets are for long term use, no matter it is tangible or intangible. While current assets are for short term use, then you can tell whether cash is a fixed asset or a current asset. Yes, it is a current asset. On the right side of the balance sheet the first thing is the firm's liabilities. That is what the firm owes to others. As assets are classified as current and long term, liabilities are also classified as either current or long term. The examples of current liabilities are accounts payable, and short term debt. The examples of long term liabilities are, a loan that will be paid off in five years, and corporate bond that has maturity longer than a year. As you can tell from the examples, current liabilities are short term debt the firm will pay back within a year while long term liabilities are long term debt that the firm will pay back for a period longer than a year. Finally, equity means what share holder's or equity holder's portion of the fund's value. Shareholders are also called residual claimants, because debt holders are paid before equity holders if there is a liquidation of assets. By definition, owners' equity is the difference between the total value of assets and the total value of the liabilities. In other words, the firm's total assets is equal to the sum of its liabilities and shareholders' equity. That is why the balance sheet is called balance sheet. Again, this equation is called the balance sheet identity, and it always holds. The difference between current assets and current liabilities is called net working capital. In other words, the net working capital is short-term assets minus short-term debt. Capital means money that is for long-term use. Then you may wonder why short term assets minus short term debt is long term capital. In order to understand this let's consider an example. Suppose a firm has an inventory in a store. And part of the inventory is bought in credit. That is the firm has to pay the cost of inventory some time later. So even though there is an inventory of $1,000, for example, it does not mean that the firm has to invest $1,000 in that store to keep the inventory. However, the firm has to invest some money in the inventory, if the inventory is not sold yet, but the firm has to pay back the cost of inventory. This partial investment in inventory is an example of net working capital. The firm has to finance the part of the inventory using its own long term money, and it is called net working capital. When net working capital is positive it means that current assets are larger than current liabilities. And it also means that short-term assets are more than short-term debt. Therefore you have more assets that can be quickly turned into cash than liabilities that you have to pay back sooner or later. That is why the firm with positive net working capital is considered a healthy firm. Let's take a look at an example of building a balance sheet. Suppose a firm has current assets of $200, net fixed assets of $800, Short term debt of $100, and long term debt of $400. What does the balance sheet look like? What is shareholder's equity? What is net working capital? In this case total assets are $1000 so according to balance sheet identity, total liabilities and shareholder's equity should be also $1000. Next, we can find shareholder's equity by subtracting short term and long term debt from the total assets. That is $500. The balance sheet would look like this. Net working capital is the difference between current assets, and short term debt. So net working capital of this one is 200 minus 100 equal to $100. This table shows you a simplified balance sheet for Samsung Electronics in Korea. The assets of the balance sheet are listed in the order of the length of time it takes for them to convert to cash in the normal course of business. Similarly the liabilities are listed in the order in which day would normally be paid. Especially Samsung Electronics has lots of cash on hand, and therefore it is very liquid. However, too much cash or liquid assets such as accounts receivables, and inventories, are generally less profitable to hold. Therefore there is a trade off between the advantage of liquidity and foregone potential profits. As we learned, long term debt is also a capital, so were the shareholder's equity. Samsung Electronic’s long term financing is 191 trillion Korean won. Of this amount 12.6 trillion divided by 179 trillion is equal to 7.05%. What’s long term debt? This percentage reflects capital structure decisions made in the past by the management. The use of debt in a firm’s capital structure is called financial leverage. As we can see in this balance sheet Samsung Electronics seems to have very little financial leverage. Retained earnings are accumulated earnings not paid to shareholders as dividends. Therefore it is also what shareholders invested in the firm. The sum of common stock and retained earnings is total stockholder's equity and it is also called book value of equity. When the company's equity is traded in the market, the value of equity is different from the book value. Then it is called market value. For example in December 2015, the book value of SamSung Electronics equity is about 179 trillion Korean won, while the market value is about 185 trillion Korean won. Suppose a firm has current assets of 200, net fixed assets of 800, short term debt of 100, long term debt of 400. Net working capital is $100 and it is assumed to be $100 if all the current accounts were liquidated. Net fixed assets book value is $800 and an appraised market value is about $1,000. The company has $400 of long term debt in both book value and market value. Then what is the book value of equity? What is the market value of equity? We know the sum of book value of net working capital and net fix asset is $900. Using the balance sheet identity, the book value of equity is 900 minus 400 is equal to $500. We know the sum of market value of net working capital and net fixed assets is $1,100. Using the balance sheet identity, the market value of equity is $1,100- $400 = $700. As we can see from this example, book and market values are quite different, because book values can be so different from true economic value.
