Fundamentals of Financial Management (Concise 6th Edition)

58 Part 2 Fundamental Concepts in Financial Management

The claims against assets are of two basic types—liabilities (or money the

company owes to others) and stockholders’ equity. Liabilities consist of claims

that must be paid off within one year (current liabilities), including accounts pay-

able, accruals (total of accrued wages and accrued taxes), and notes payable to

banks that are due within one year. Long-term debt includes bonds that mature in

more than a year.

Stockholders’ equity can be thought of in two ways. First, it is the amount that

stockholders paid to the company when they bought shares the company sold to raise

capital, in addition to all of the earnings the company has retained over the years:

Stockholders’ equity! Paid-in capital " Retained earnings

The retained earnings are not just the earnings retained in the latest year—they are

the cumulative total of all of the earnings the company has earned during its life.

Stockholders’ equity can also be thought of as a residual:

Stockholders’ equity! Total assets # Total liabilities

If Allied had invested surplus funds in bonds backed by subprime mortgages and

the bonds’ value fell below their purchase price, the true value of the! rm’s assets

would have declined. The amount of its liabilities would not have changed—the

! rm would still owe the amount it had promised to pay its creditors. Therefore,

the reported value of the common equity must decline. The accountants would

make a series of entries, and the result would be a reduction in retained earn-

ings—and thus in common equity. In the end, assets would equal liabilities and

equity and the balance sheet would balance. This example shows why common

stock is more risky than bonds—any mistake that management makes has a big

impact on the stockholders. Of course, gains from good decisions also go to the

stockholders; so with risk comes possible rewards.

Assets on the balance sheet are listed by the length of time before they will be

converted to cash (inventories and accounts receivable) or used by the! rm (! xed as-

sets). Similarly, claims are listed in the order in which they must be paid: Accounts

payable must generally be paid within a few days, accruals must also be paid promptly,

notes payable to banks must be paid within one year, and so forth, down to the stock-

holders’ equity accounts, which represent ownership and need never be “paid off.”

3-2a Allied’s Balance Sheet

Table 3-1 shows Allied’s year-end balance sheets for 2008 and 2007. From the

2008 statement, we see that Allied had $2 billion of assets—half current and half

long term. These assets were! nanced with $310 million of current liabilities,

$750 million of long-term debt, and $940 million of common equity. Comparing the

balance sheets for 2008 and 2007, we see that Allied’s assets grew by $320 million

and its liabilities and equity necessarily grew by that same amount. Assets must, of

course, equal liabilities and equity; otherwise, the balance sheet does not balance.

Several additional points about the balance sheet should be noted:

1. Cash versus other assets. Although assets are reported in dollar terms, only the
   cash and equivalents account represents actual spendable money. Accounts
   receivable represents credit sales that have not yet been collected. Inventories
   show the cost of raw materials, work in process, and! nished goods. Net! xed
   assets represent the cost of the buildings and equipment used in operations
   minus the depreciation that has been taken on these assets. At the end of 2008,
   Allied has $10 million of cash; hence, it could write checks totaling that amount.
   The noncash assets should generate cash over time, but they do not represent
   cash in hand. And the cash they would bring in if they were sold today could
   be higher or lower than the values reported on the balance sheet.