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reports the debt and equity capital sources of a business and the assets in which the business has invested. Several different types of assets are listed in the balance sheet. The balance sheet also reports the operating liabilities of a business that are generated by its profit-making activities and not from borrowing money. Operating liabilities are non-interest-bearing payables of a business, which are quite different from its interest-bearing debt obligations.
The relationships of sales revenue and expenses reported in a company’s income statement to the assets and operating liabilities reported in its balance sheet are not haphazard. Far from it! Sales revenue and the different expenses in the income statement match up with particular assets and operating liabilities. Business managers, lenders, and investors should understand these critical connections between the components of the income statement and the components of the balance sheet. In particular, the amount of accounts 76
B U I L D I N G A B A L A N C E S H E E T
receivable should be reasonable in comparison with annual sales revenue, and the amount of inventories should be reasonable in comparison with annual cost-of-goods-sold expense.
In short, the balance sheet of a business fits tongue and groove with its income statement. These two financial statements are presented separately in financial reports, but business managers, lenders, and investors should understand the interlocking nature of these two primary financial statements.
77
C H A P T E R 6
Business Capital
Sources
TThis chapter explores the two basic sources of business capital: debt and owners’ equity. Every business must make a fundamental decision regarding how to finance the business, which refers to the mix or relative proportions of debt and equity. By borrowing money, a business enlarges its equity capital, so the business has a bigger base of capital to carry on its profit-making activities. More capital generally means a business can make more sales, and more sales generally mean more profit.
Using debt in addition to equity capital is referred to as financial leverage. If you visualize equity capital as the fulcrum, then debt may be seen as the lever that serves to expand the total capital of a business. The chapter explains the gain or loss resulting from financial leverage, which often is a major factor in bottom-line profit.
It’s possible, I suppose, to find a business that is so antidebt that the only liabilities it has are normal operating liabilities (i.e., accounts payable and accrued expenses payable).
These short-term liabilities arise spontaneously in making purchases on credit and from delaying the payment of certain expenses until sometime after the expenses have been 79
A S S E T S A N D S O U R C E S O F C A P I T A L
recorded. A business can hardly avoid operating liabilities.
But a business doesn’t have to borrow money. A business could possibly raise all the capital it needs from shareowners and from retaining all or a good part of its annual earnings in the business. In short, a business theoretically could rely entirely on equity capital and have no debt at all—but this way of financing a business is very rare indeed.
BUSINESS EXAMPLE FOR THIS CHAPTER
Figure 6.1 presents a very condensed balance sheet and an abbreviated income statement for a new business example.
The income statement is truncated at earnings before interest and income tax (EBIT). The two financial statements in Figure 6.1 are telescoped into a few lines. In this chapter we don’t need all the details that are actually reported in these two financial statements. (See Figure 4.2 for the full format of a balance sheet and Figure 4.1 for a typical format of an external income statement.)
To support its $18.5 million annual sales, the business used $11.5 million total assets. Operating liabilities provided $1.5
million of its assets. In Figure 6.1 the company’s operating
The relationships of sales revenue and expenses reported in a company’s income statement to the assets and operating liabilities reported in its balance sheet are not haphazard. Far from it! Sales revenue and the different expenses in the income statement match up with particular assets and operating liabilities. Business managers, lenders, and investors should understand these critical connections between the components of the income statement and the components of the balance sheet. In particular, the amount of accounts 76
B U I L D I N G A B A L A N C E S H E E T
receivable should be reasonable in comparison with annual sales revenue, and the amount of inventories should be reasonable in comparison with annual cost-of-goods-sold expense.
In short, the balance sheet of a business fits tongue and groove with its income statement. These two financial statements are presented separately in financial reports, but business managers, lenders, and investors should understand the interlocking nature of these two primary financial statements.
77
C H A P T E R 6
Business Capital
Sources
TThis chapter explores the two basic sources of business capital: debt and owners’ equity. Every business must make a fundamental decision regarding how to finance the business, which refers to the mix or relative proportions of debt and equity. By borrowing money, a business enlarges its equity capital, so the business has a bigger base of capital to carry on its profit-making activities. More capital generally means a business can make more sales, and more sales generally mean more profit.
Using debt in addition to equity capital is referred to as financial leverage. If you visualize equity capital as the fulcrum, then debt may be seen as the lever that serves to expand the total capital of a business. The chapter explains the gain or loss resulting from financial leverage, which often is a major factor in bottom-line profit.
It’s possible, I suppose, to find a business that is so antidebt that the only liabilities it has are normal operating liabilities (i.e., accounts payable and accrued expenses payable).
These short-term liabilities arise spontaneously in making purchases on credit and from delaying the payment of certain expenses until sometime after the expenses have been 79
A S S E T S A N D S O U R C E S O F C A P I T A L
recorded. A business can hardly avoid operating liabilities.
But a business doesn’t have to borrow money. A business could possibly raise all the capital it needs from shareowners and from retaining all or a good part of its annual earnings in the business. In short, a business theoretically could rely entirely on equity capital and have no debt at all—but this way of financing a business is very rare indeed.
BUSINESS EXAMPLE FOR THIS CHAPTER
Figure 6.1 presents a very condensed balance sheet and an abbreviated income statement for a new business example.
The income statement is truncated at earnings before interest and income tax (EBIT). The two financial statements in Figure 6.1 are telescoped into a few lines. In this chapter we don’t need all the details that are actually reported in these two financial statements. (See Figure 4.2 for the full format of a balance sheet and Figure 4.1 for a typical format of an external income statement.)
To support its $18.5 million annual sales, the business used $11.5 million total assets. Operating liabilities provided $1.5
million of its assets. In Figure 6.1 the company’s operating
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