Reading: The Accounting Framework

The balance sheet provides a snapshot of the firm's assets, liabilities, and equity. It shows who provided the firm's capital and how this capital is used. The basic structure of the balance sheet is as follows:

 

Assets	Liabilites and equity
Current assets	Operating liabilities
Non-current assets	Financial liabilities (Debt)
	Equity
Total assets	Total liabilities and equity

 

• Current assets: All assets that are reasonably expected to be converted into cash within 1 year. Examples: Cash, Inventory, Accounts receivable.

• Non-current assets: Assets that are expected to be in use for more than 1 year. Examples: Machines, Equipment, Real estate.

• Operating liabilities: Money that is owed to business partners from transactions related to the actual production and sale of the firm's goods and services. Examples: Accounts payable, Taxes payable.

• Financial liabilities (Debt): Money that is owed to the providers of debt. Examples: Bank loan, Mortgages, Long-term debt.

• Equity: Capital contributed by the owners of the company (shareholders). Examples: Share capital, Retained earnings.

 

Remember that our goal is to identify operating, investment, and financing activities. 

As we can see, the right side of the above balance sheet already adheres to that structure: Operating liabilities are part of the operating activities whereas financial liabilities and equity are part of the firm's financing activities. 

But what about the left side of the balance sheet? On the asset side, the situation is a bit more complicated. The following considerations should help us identify the relevant items:

• We typically assume that most of the current assets are the result of to the firm's operating activities. Accounts receivable, for example, reflect the fact that the firm has not yet cashed in on a portion of its sales. Sales are part of the operating activity. Similarly, the inventory reflects the fact that there is a time gap between purchasing and selling goods. Again, purchasing and selling goods is part of the operating activities.

• One position of the current assets is a bit trickier: Cash. Cash has at least two functions:
• Operating cash: To secure a smooth course of business, firms need a certain amount of cash. This is what we call operating cash. This cash is comparable to the oil an engine needs to run smoothly.
• Excess cash: Cash is also the ultimate outcome of all business activities. A cash balance larger than necessary implies that the firm has generated more cash with its operating, investment, and financing activities than these activities have absorbed. As this cash is not directly necessary to run the business, the firm could, in principle, distribute it to the owners. This part of the cash balance is therefore called Excess cash. 
• Consider Apple. At the end of 2015, the firm had approximately USD 200 billion in cash and financial investments. Clearly, not all this money is required to guarantee a smooth business. Let's assume that the firm's operating cash requirements are USD 20 billion. This implies that the rest - 180 billion - is excess cash. Ignoring tax considerations, the firm could distribute this money to its shareholders.
• For our financial analysis, it therefore makes sense to split the firm's cash balance in two types: Operating cash and excess cash.

• The non-current assets, in turn, are often the result of the firm's investment activities. The firm builds facilities and buys machines to produce goods and services. Building facilities and buying machines are investment activities. Also many intangible assets such as patents or goodwill paid in acquisitions are the result of investment activities.

 

In practice, it often makes sense to use the following simplified exclusion criteria to identify operating, investment, and financing activities on the balance sheet:

• Liabilities: All interest-bearing liabilities ("Debt") are part of the firm's financing activities. All liabilities that are not interest bearing are part of the firm's operating activities.

• Equity: All equity items reflect the firm's financing activities.

• Assets: All assets that are depreciated, amortized, or impaired are the result of investment activities.¹ All other assets are operating assets. We treat cash separately, as discussed above.

 

 

Using the considerations from above, we can simplify the balance sheet accordingly:

• Cash: Let's assume that the firm needs 1'000 of cash to support the business (Operating cash). The rest, if any, is excess cash. Put differently, a cash balance of 1'000 enters the firm's operating assets in Year 0 and Year 1. Excess cash is 0 in Year 0 and 200 in Year 1.
• Operating assets: In addition to the operating cash balance of 1'000, this includes all other assets that are not depreciated or amortized, namely Accounts receivable, Inventory, and Prepaid expenses.

• Long-term assets: Assets that are depreciated (Property, plant, and equipment), amortized (Intangible assets), or subject to impairment (Goodwill).

• Operating liabilities: All liabilities that are not interest bearing. In our case, this includes the items Accounts payable and Taxes payable.

• Financial liabilities: All interest-bearing liabilities. In our case, this includes the items Short-term debt and Long-term debt.

 

This allows us to derive the following simplified balance sheet: