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Speaker: Marie-Lys Leschiera

I think we should also do a wrap-up of the learning acquired so far regarding balance sheets. So,
what is a balance sheet?

A balance sheet, we said, is a snapshot of a company's situation taken at one point in time, maybe
on December 31st or on March 31st, at the end of the fiscal year. A balance sheet has two sides:
assets versus liabilities and equity.

Assets represents what the company owns, liabilities and equity represents what the company
owes to external parties. Equity is owed to shareholders, liabilities to other parties, so technically
this is: where does the money come from and how it is utilised, invested.

And by definition, the total of the assets must match the total of the liabilities and equity. Whatever a
company owns, it owes it to external parties. Let's do a quick review of the main items that enter the
assets and the liabilities and equity.

As far as assets are concerned, you can see a big chunk which relates here to property, plant and
equipment. Actually, it's part of a bigger category that we usually call fixed assets. As far as fixed
assets are concerned, you can have property, plant and equipment.

These are tangible fixed assets. You could also think about intangible fixed assets, and you could
also think about financial assets when companies hold shares in other companies. Besides the fixed
assets, mainly the property, plant and equipment.

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Usually what do we have? We have inventories. Inventories, this is the valuation of the goods
stored, kept in the company to be sold or utilised for production purpose a little later. Of course, you
have different categories of inventories.

You have raw material inventories, you have finished goods inventories and you have
work-in-progress inventories. These are goods in the process of being transformed into finished
goods.

Depending on the type of product you're dealing with, you will hold more or less work-in-progress.
If your production process is very long, you will hold work-in-progress for long periods of time and
the majority of your inventories will be work-in-progress.

Companies try to limit the finished goods inventories they hold, but sometimes they still hold huge
inventories because, by definition that production process requires they always hold a big amount
of work in progress.

A key principle when we value inventories is to be prudent. Remember, the prudence principle we
already discussed. This prudence principle states that assets should not be overvalued and
liabilities should not be undervalued, in particular that applies to inventories.

Let's not overstate the value of our inventories. So, recognise the value of inventories at the lowest
value possible between the purchasing price, okay and the possible market value that can be
estimated.

Next to inventories, we can see, accounts receivable, so accounts receivable represents the
fraction of the sales revenue that we have not cashed in yet. This is how much money customers
still owe us and, lastly, you can see cash.

Cash is how much cash do we have on the bank account of the company or in on in its wallet at the
end of the period here at the end of the year.

This number comes straight from the cash flow statement, and you remember this link, we saw a
couple of times in the pizza exercise between the cash flow statement and the balance sheets.

That's for the main items on the asset side. On the liability side, we have two categories of items. If I
start at the bottom, I have all the liabilities.

So, accounts payable, this is how much cash we still owe to our suppliers, because we've not
finished to pay our bills. Then we have long-term and short-term debt.

This is the money we owe to banks. What's the difference between long-term and short-term debt?

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Well, financially speaking in accounting, we consider assets to be or liabilities to be short-term when
their maturity is less than one year. Anything with a longer maturity than a year is considered long
term.

So, here you can see that you know I will have to repay 2,600 of debt within the next year, because
it is short-term debt.

So, it's important to see how much of the debt is going to expire short term and maybe needs to be
renewed.

Okay and how much is more long term is going to stay there for a longer period of time will not
need any renewal for more than a year and will not necessitate any cash outflow over the next year.

That's the first category. The second category is owner's equity, so owner's equity represents all the
money that belongs to shareholders in the company.

This is composed of the initial share capital invested plus maybe additional share capital issued
during the life of the company.

Okay, and they are valued here at their issue price. Then we have the retained earnings, so
accumulated profits and losses since the creation of the company and not yet distributed in
dividends and, lastly, the net income of the year.

You have one balance sheet on screen here and it's pretty difficult to interpret anything from the
performance of the company during the year looking only at one balance sheet.

You seldom have access to only one balance sheet.

What is a lot more interesting is to be able to see two subsequent balance sheets, end of last year
end of this year, and then we can see the evolutions and we can find entry points to challenge the
performance achieved.

Speaker: Marie-Lys Leschiera

I also want to come back to the retained earnings. Some of you may, you know, feel like, yeah, but
how do we distribute dividends?

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We say dividends will be taken out of retained earnings, but how does that come into play?

So, here I'm putting on screen, two subsequent balance sheets of a fictitious company, and I'm
claiming that this company did distributes dividends during year end.

Can you guess why? So, actually I know that this company did distribute dividends during year end.
If I compare evolution of retained earnings from last year, this year, look at the end of year and
minus one.

The total of the retained earnings were amounting to 1,400 and last year the company made a profit
of 400.

So, if no dividend was distributed, then the retained earnings at the end of year end must be 1,800.
Previous retained earnings plus profit of last year.

But it's not the case. End of year end, the retained earnings are only 1,600, so 200 are missing.
Where are they? Cash cannot disappear. Retained earnings cannot disappear.

If 200 of retained earnings are missing, it means that 200 of dividends were distributed during year
end.

Therefore, my retained earnings only increased by $200 instead of 400. So, dividends make the
retained earnings account decrease on the balance sheet.

And of course on the other side of the balance sheet, dividends also make the cash decrease by
the same amount. And that way my balance sheet stays balanced.

Speaker: Marie-Lys Leschiera

I hope you also better realise the links that exist between these three statements and the fact that
the cashflow statement bottom line feeds the assets side of the balance sheet. Whereas the income
statement bottom line feeds the liability side of the balance sheet.

And as our balance sheet is always balanced, actually the three financial statements are always list
together like the three angles of a triangle.

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We often speak about the financial triangle. And definitely, I hope you are convinced that if we want
to have a comprehensive view of what happened in a company during a period of time, we need to
look at the three statements.

It's not enough to look at the income statement. We have key information embedded in the
cashflow statement and the balance sheet.

And also the other way around when we are managing a company, we can't manage only against
the income statements. You will come to look for profits only.

You need to pay attention to cash as well. You need to be aware of the resources you're employing
in the balance sheet to run your business.

So really, you know good Managers top performing Managers will be the ones that are able to take
into account the impact of the decisions on the three statements at the same time.

Speaker: Marie-Lys Leschiera

I order to wrap up what we've seen so far regarding how does a business work? I like to show with
you this short framework, if you, I we're about to start our businesses tomorrow.

Where would we start from, from a finance perspective? I bet we would start by raising funds. Who
would we raise funds from? Actually shareholders and bankers.

Maybe we will be the shareholders of our own companies. Maybe not. So, shareholders and
bankers, these are the fund holders of the company.

Once we do have that many, what do we do with it? Well, of course we invest it. Invest it in what?
Invest it into assets that are necessary to run the operations, to run the day-to-day business,
machines, inventories, and so on and so forth.

Once these assets are in place, what do we do? Well, of course, we start to run the operations and
hopefully, we are able to make a profit from the operations.

This is the so-called operating profits or operating income or EBIT. Then who has a claim on that
profit, on that operating profit. First, we will have to pay the interest expenses due to the banks
because we previously borrowed money from them.

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Second, we'll have to pay taxes to the government. And third.

If anything is left, it belongs to shareholders, who will be free to decide either to distribute
dividends, to get the liquid reward on their investment, or to leave the profits inside the company.

In that case, the earnings will be retained inside the business and available to grow it in the future.

That is to purchase more assets to run the operations, grow the sales, and hopefully grow the
profits next year and so on and so forth.

So, you realise probably that's the Northwest corner is pretty well described by the balance sheet.
Though, it would probably need some tweaks then the lower part and the right parts are showed by
the income statements.

And the cash flow statement. Well, the cash flow statement is everywhere in the framework.

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