© 2000 John Petroff
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© 2000 John Petroff |
A- Interpretation of numbers in the Liability and Equity portion of the balance sheet
So far there was an implied assumption that the capital structure of a company can be measured accurately. That is far from being true. It is now time to understand what distortions may be present.
The distortions on the assets (or debit) side of the balance sheet in inventory, fixed assets and intangible, which were outlined in previous chapters, must be matched by distortions in the credit side of the balance sheet. The balance sheet must balance. If there are deflated numbers on one side, there must be deflated numbers on the other side. And indeed, there are. But the distortion is not as glaring because there aren't market values with which to compare as in the case of inventory and fixed assets. Most of the understatement is captured in the equity component, and a small portion in long term debt. In addition, as opposed to items such as plant and equipment which have a replacement value which, while difficult to obtain, is precise and stable, total capitalized company stock changes continuously with shifting moods of investors in capital markets. Finally, there are items on the credit side of the balance sheet, that are really neither liability nor equity: for instance, deferred income tax or accrued revenue. Let's take a look at each item of liability and equity to see how precise is the information, or how deflated they may be.
See review questions Q-11A.1 through Q-11A.3.
1)- Current liabilities:
Most current liabilities represent actual obligations for the exact amount shown. This is true of accounts and notes payable, taxes due, salaries and bonuses due, accrued expenses, outstanding credit line and current portion of long term debt. To a large extent, this is also probably true for employee pension plan liability. But, this last item is usually difficult to interpret because of accounting alternatives. Under American accounting rules (i.e. SFAS 87), the company should record as a liability the portion of the accumulated pension benefits which has not been funded (i.e. the amount of pension liability that has not already been placed in assets held in a pension fund). How much a company recognizes as a liability for its employee pensions in the current year depends on 1) the fair market value of the asset already in the fund, 2) the projected benefit obligations (i.e. what pensioners will be entitled to) and 3) the newly vested employee pensions. This issue will be raise again in Chapter 11 when investigating earnings because the magnitude of an adjustment resulting from a change in pension accounting method at major American firms can dwarf profits, and has indeed caused spectacular loss years, not to mention revisions of balance sheet of major proportions.
As was already indicated in Cahpter 8, the current liability must be viewed not just strictly based on the numbers present in the balance sheet. First, liabilities must also be viewed on the basis of contractual arrangements that may avoid having to pay a given amount immediately, such as in the case of credit that can be refinanced. Second and more importantly, future changes in business conditions may quickly accumulate unpaid obligations. Here, the concern is whether there are potential creditors that can emerge from among suppliers, customers, service contractors or banks to whom the firm has made promises that it may be by itself unable to fulfill (e.g. performance warranties, affiliate debt guarantees, bonds with put options). At the opposite, the firm can rely on funding from short term liability: for instance, if the firm has been able in the past to run up large unpaid balances with its suppliers, while it is obviously a danger, it is also a strength because it gives the firm some flexibility.
As just mentioned above, other current liabilities may contain an item of accrued revenue which is not a real liability in the sense that there is no intention of paying that amount to anyone. Instead, this revenue has been received but will be entered as such in the income statement of next fiscal year. For instance, customer prepayments for purchases fall in this category (e.g. subscription to magazines). It has already been mentioned in the calculation of working capital and current ratio that an adjustment should be made for such items. In the analysis of the capital structure, no such adjustment is practically ever performed because the amount is almost always too small. Sometimes, however, other current liabilities may be used as a catch all for border line items including deferred taxes.
See review questions Q-11A1.1 through Q-11A1.4.
2)- Deferred income tax:
Deferred income tax originates from tax savings such as the use of accelerated depreciation on the income tax return: the actual tax paid is less than the tax shown in the financial statements where a straight line depreciation is most often taken. This is not a real liability in the sense that the company does not have to pay this amount to the government, neither now nor ever, as long as the company keeps taking accelerated depreciation on an ever growing pool of fixed assets, for instance. Notes to the financial statement must show temporary and permanent differences between tax as shown on the income statement and actual tax paid. Temporary differences may appear under current liabilities (and in some rare cases in current assets), whereas permanent differences appear as other non-current liabilities. A complete reconciliation of the deferred income tax amount it not always possible, as will be pointed out in Chapter 13.
See review questions Q-11A2.1 through Q-11A2.3.
The outstanding portion of term loans and bond obligations usually present no problem. Capital and finance leases are normally shown together with long term debt (or should be combined by the financial analyst if they are not), because in a sense they are one and the same (as discussed in Chapter 12). Operating leases are not shown on the balance sheet, except for the amount due in the current year. When comparing companies of different countries, care must taken to determine if long term leases are disguised as operating leases, they may have to be incorporated into long term debt. The analyst should also keep in mind that some of the convertible bonds could be converted into equity, especially if there is a call provision (see next chapter).
Although the obligations to pay principal, instalments and other amounts are undeniably those shown on the balance sheet and correspond to what eventually will be paid to creditors (except in the case of early redemption or repurchase: plus some possible call premium, or minus some gain if the bond is bought in the market), there may be a distortion in the real value of these obligations. If inflation is more than negligible, debt contracted many years ago is understated in comparison to what the company would need to raise to finance similar projects as those for which the debt was used for initially. In other words, old debt is stated in the same deflated currency as old fixed assets. Replacing both will be much more. This, naturally, mitigates somewhat the distortion in fixed assets, if there is a close match between debt and the assets it financed. But more often than not, one will find a mismatch. Moreover, comparison with other companies that have naturally different borrowing history, can be undermined.
See review questions Q-11A3.1 through Q-11A3.5.
4)- Provisions and reserves:
Provisions and reserves are justified by different motives, but appear invariably in a similarly ambiguous state, somewhere between long term debt and equity. Provisions are amounts of profit set aside because some potential obligation may be incurred in the future as a result of events in the past: for instance, from a warranty on merchandise sold, from a pending law suit, or from some other contingency linked to past decisions. Reserves are also amounts of profit set aside, but for a specific intended purpose in the future, such as plant expansion. Often, but not always, reserves are classified as part of equity, whereas provisions are classified with long term debt.
See review questions Q-11A4.1 and Q-11A4.2.
5)- Other non-current liabilities
Occasionally, one may find provisions and deferred income tax classified as other non-current liabilities. Another item that may appear there, is postretirement benefits for the companies that use defined benefits method of accounting for employee pensions. Pension liability amounts can be large. The actual pension liability may be quite different from the one shown depending on when employees decide to retire, and how long they live after taking retirement. Some companies will show minority interests in other non-current liabilities. Airlines and other transportation companies that use sale and lease back will show deferred gain on sales and lease back in this classification. None of these items constitute a source of funds that a company can rely for expansion or other projects.
See review question Q-11A5.1.
6)- Equity:
Capital and paid-in capital are likely to be grossly understated compared with the capitalized stock market value, even if the company has been profitable for only a few years. If treasury stock appears in the balance sheet, it comes as a deduction of capital because it represents shares of the company which have been repurchased for some specific purpose such as, for instance, distribution of stock bonuses or profit sharing. Retained earnings, which are earnings of prior years which have not been distributed as dividends to shareholder, are very likely to be distorted by inflation, as profits of prior years are combined with current year profits. The equity portion of the balance sheet may also contain adjustment accounts and some reserve accounts, especially if the company is not American. European and Latin American companies must set aside a certain portion of profits as "legal" reserves (as well as some other reserves). In American balance sheets, one will find adjustments for pension liability, unrealized investment gain and foreign exchange translation lumped together under the heading of "other comprehensive income (or loss)", but these are not income (or loss) at all because the fictious amounts may disappear or reverse as prices of securities and exchange rates change over the years (as discussed in Chapter 12).
Notwithstanding that the distortions in the balance sheet numbers are known to exist, outside analysts never make corrections because that would require knowledge that not even the management of the company is likely to have. This is true for the distortion in equity caused by the effect of inflation, as well as the possible uncertainty as to the refinancing of some of the liabilities. In countries where inflation has been at a high level for a while, the equity section of the balance sheet will include a provision for reevaluation of assets.
7)- Off-balance sheet
An analyst should also be aware of off-balance sheet liabilities. The most important type are the guarantees given in various contracts of the company or its affiliates. These may turn out to be sizeable obligations. As discussed in next chapter, operating leases can be an essential part of firms operation, and yet, not be shown on the balance sheet. Liabilities can also stem from law suits related to products or environmental impact.
There are also assets that the company may hold on behalf of others, and that may result in liabilities if the assets are not returned or used in the agreed manner. Finally, there are insurance policies that reduce the need to build up equity to safeguard the future. None of these are ever added to balance sheet assets or liabilities by an outsider. Here, one has to rely on the opinion of auditors. Presumably, if an inclusion of an amount in the balance sheet had been omitted by the company but justified by accounting rules, the auditor would have requested it or made a comment in the opinion.
See review questions Q-11A6.1 through Q-11A6.8.
See research assignments R-11A.1 through R-11A.3.
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