This post is a LeanPost: it will be developed further depending on feedback from my readers.
See my note here on what a LeanPost is.
Many companies are these days talking about reducing the balance sheet.
Another term used is de-leveraging.
In the simplest terms, this just means that a company is reducing the number of loans it has taken out. As a consequence, it will be probably be selling off assets to pay back those loans.
In this post we have a give some details on the borrowing/assets relationship for companies and mention some of the main concepts in corporate accounting that are useful to know if you are on the trading floor.
I always like to think in terms of concrete examples, so for this post I develop a story of setting up a business and show how we naturally come across the concepts of balance-sheet optimization, cost of capital, and other topics which are part of the standard courses in corporate finance.
The start: setting up a company
If you have a good idea for making money, you would probably first think of investing your savings to develop the idea into a business.
Let’s suppose that you spend GBP 10,000 of your savings on your idea:
- GBP 5,000 on equipment for making the products (these would be called fixed costs in a textbook),
- GBP 5,000 on materials to make the products that you will sell.
- You make 5,000 widgets and sell them all for GBP 1.50 each.
You have successfully sold each finished product for a profit of 50% over the costs of making, and let’s make it easy by supposing that you don’t need to pay any tax. You’ve made 2,500 quid with your business!
At this point something interesting has happened in the finances of your business and we now pause the story to see how these events get represented in the company’s balance sheet.
The balance sheet of your company
Most, if not all companies are set up by their founders in order to generate money (for the founders initially, then for the shareholders too).
This basic truth implies that company accounts must be naturally able to handle the concept of growing value.
The clever solution for this was first formally described by a 15th-century friend of Leonardo da Vinci, and it was called double-entry bookkeeping (click here for the Wikipedia page .)
The main concept is that
a company’s balance sheet shouldn’t just give a detailed breakdown of which assets the company owns, but also how it has found the money to own them.
The balance sheet is usually written as two columns of numbers : one for the listing the values of the assets, and one for listing the funds that ‘support’ those assets.
Yes, do note that I am being purposefully careful about the word ‘support’ for the funds column. For example, I could have written:
…and one for the funds that paid for those assets
but if you think about it for a second, every company owner hopes that this company will grow to be worth more than the amount he originally invested.
We’ll see what this ‘support’ means in a moment.
In our example, the GBP 7,500 cash you made from selling your products means that your company’s balance sheet has an assets column of:
| Assets | |
|---|---|
| Equipment | 5,000 |
| Cash | 7,500 |
| Total | 12,500 |
You only spent GBP 10,000 to start the business, so you can now understand why I don’t want to say that you ‘paid’ for your total assets.
Effectively we are talking about profits. You set up the business to make profits, and the profits are reflected in the increase in the value of the assets over and above the money you invested to start the business.
Getting to the point: your business has increased in value from GBP 10,000 to GBP 12,500.
This means that you now own a business which is worth GBP 12,500. And the term for this is to say:
Your equity has increased from GBP 10,000 to GBP 12,500
All in all, your balance sheet would look like this:
| Assets | Debt & Equity | ||
|---|---|---|---|
| Equipment | 5,000 | Loans | 0 |
| Cash | 7,500 | Equity | 12,500 |
| Totals | 12,500 | 12,500 | |
Where this post is going: main points to continue
This post is a LeanPost: it will be developed further depending on feedback from my readers.
See my note here on what a LeanPost is.
- Now we have seen how a balance sheet looks, we will then start to show how the company could be grown by taking on some debt, and see how that affects the financial ratios like return on equity, cost of capital.
- Specifically, it will be nice to see clearly how the return on equity reflects the size of a bet, as well as the actual performance of the company in its basic business of selling widgets.
Offshoots: themes that could be developed
These topics lead up to other discussions which may get developed in other posts:
- Some companies use a lot of debt and therefore run a large risk of failure if the widgets stop selling so well. In thinking about this I researched the history of Woolworths and wrote a short post on that previously (click here).
- Ever get a feeling that some companies seem to appear out of nowhere with a shop on every high street? My guess is that these are companies that are using a lot of leverage. The business model is to build a brand by being everywhere: (i) borrow lots of money and set up lots of shops, (ii) people notice you everywhere and start to believe you must therefore be ‘good’, (iii) people start to buy from your shops, (iv) job done!
