Liabilities and Equity
We said earlier that liabilities are what a company owes and that equity is its net worth. There’s another—only slightly different—way to look at this side of the balance sheet, which is that it shows how the assets were obtained. If a company borrows funds in any way, shape, or form to obtain an asset, the borrowing is going to show up on one or another of the liabilities lines. If its owners put money into the business (and of course, receive stock) to obtain an asset, that will be reflected on one of the lines under owners’ equity. This way of looking at this side of the balance sheet can be important to an entrepreneur. It gives you a picture of how your company is funded, which is critical to any future decisions about debt and equity. Funding a business with debt is usually more risky because of the legal responsibility to pay back the debt. Equity, on the other hand, requires giving up partial ownership in the business, if you are selling shares to anyone besides yourself.
But first things first, which on this side of the balance sheet means liabilities, the financial obligations a company owes to other entities. Liabilities are always divided into two main categories. Current liabilities are those that have to be paid off in less than a year. Long-term liabilities are those that come due over a longer time frame. Liabilities are usually listed on the balance sheet from shortest term to longest term, so the very layout tells you something about what’s due when.
If your company owes $100,000 to a bank on a long-term loan, maybe $10,000 of it is due this year. So that’s the amount that shows up in the currentliabilities section of the balance sheet. The line will be labeled “current portion of long-term debt” or something like that. The other $90,000 shows up under “long-term liabilities.”
Short-term loans are lines of credit and short-term revolving loans. These credit lines are usually secured by current assets, such as accounts receivable and inventory. The entire balance outstanding is shown here.
Accounts payable shows the amount the company owes its vendors. The company receives goods and services from suppliers every day and typically doesn’t pay the bill for at least thirty days. The vendors, in effect, have loaned the company money. Accounts payable shows how much was owed on the date of the balance sheet. Any balance on a company’s credit cards is usually included in accounts payable.
The catchall category of accrued expenses and other short-term liabilities includes everything else the company owes. One example is payroll. Let’s assume that your office manager gets paid on October 1. Does it make sense to charge her pay as an expense on the income statement in October? Probably not—her October paycheck is for work performed in September. So the accountants would figure out or estimate how much the company owes her on October 1 for work completed in September and then charge those expenses to September. This is an accrued liability. It’s like an internal bill in September for a payment to be made in October. Accrued liabilities are part of the matching principle—we have matched expenses with the revenue they help bring in every month.
Most long-term liabilities are loans. But there are also other liabilities that you might see listed here. Examples include deferred bonuses or compensation and deferred taxes. If these other liabilities are substantial, this section of the balance sheet needs to be watched closely.
Finally—owners’ equity! Remember the equation? Owners’ equity is what’s left after we subtract liabilities from assets. Equity includes the capital provided by you and the other investors in your company and the profits retained by the company over time. Owners’ equity goes by many names, including shareholders’ equity and stockholders’ equity. The owners’ equity line items listed in some companies’ balance sheets can be quite detailed and confusing. They may include the following categories.
Preferred shares—also known as preference stock or shares—are a specific type of stock. People who hold preferred shares receive dividends on their investment before the holders of common stock get a nickel. But preferred shares typically carry a fixed dividend, so (in public companies) their price doesn’t fluctuate as much as the price of common shares. Investors who hold preferred shares may not receive the full benefit of a company’s growth in value. When the company issues preferred shares, it sells them to investors at a certain initial price. The value shown on the balance sheet reflects that price.
The word capital means a number of things in business. Physical capital is plant, equipment, vehicles, and the like. Financial capital from an investor’s point of view is the stocks and bonds he holds; from a company’s point of view, it is the shareholders’ equity investment plus whatever funds the company has borrowed. “Sources of capital” in an annual report shows where the company got its money. “Uses of capital” shows how the company used its money.
Most preferred shares do not carry voting rights. In a way, they’re more like bonds than like common stock. The difference? With a bond, the owner gets a fixed coupon or interest payment; with preferred shares, the owner gets a fixed dividend. Companies use preferred stock to raise money because it does not carry the same legal implications as debt. If a company cannot pay a coupon on a bond, bondholders can force it into bankruptcy. Holders of preferred shares normally can’t. Entrepreneurial companies often issue preferred shares to venture capital investors. These shares often have preferred payout rights senior to the common shares held by the original owners. If you take this route, make sure you understand the terms and conditions involved.
Common shares are the type of ownership shares that most small, nonpublic companies issue. This is probably what you and the other owners of your company hold. Unlike most preferred shares, common shares usually carry voting rights. People who hold them can vote for members of the board of directors (usually one vote per share) and on any other matter that may be put before the shareholders. Common shares may or may not pay dividends. The value shown on the balance sheet is typically shown at par value, which is the nominal dollar amount assigned to the stock by the issuer. Par value is usually a very small amount and has no relationship to the stock’s actual value or market price. The balance sheet of our sample company (see appendix A) shows the common stock with a par value of $1.
Additional paid-in capital is the amount over the par value that investors initially paid for the stock. For example, if the stock is initially sold at $5 per share, and if the par value is $1 per share, the additional paid-in capital is $4 per share. It is summed up over time—so, for example, if a company issues additional shares, the additional paid-in capital is added to the existing amount.
Retained earnings, or accumulated earnings, are the profits that have been reinvested in the business instead of being paid out in dividends to the owners. The number represents the total after-tax income that has been reinvested or retained over the life of the business. Sometimes a company that holds a lot of retained earnings in the form of cash—Microsoft is one highly visible example—comes under pressure to pay out some of the money to shareholders, in the form of dividends. After all, what shareholder wants to see his money just sitting there in the company’s coffers, rather than being reinvested in productive assets? Of course, you may see an accumulated deficit—a negative number—on the retained earnings line, which indicates that the company has lost money over time.
Dividends are funds distributed to shareholders taken from a company’s equity. Public companies typically distribute dividends at the end of a quarter or year. Privately held companies can distribute them at any time, but many do it monthly or annually.
So owners’ equity is what you and any other shareholders would receive if your company were sold, right? Of course not! Remember all those rules, estimates, and assumptions that affect the balance sheet. Assets are recorded at their acquisition price less accumulated depreciation. Goodwill is piled up with every acquisition the company makes, and it is never amortized. And of course, the company has intangible assets of its own, such as its brand name and customer list, which don’t show up on the balance sheet at all. The moral: the market value of a company almost never matches its equity or book value on the balance sheet. The actual market value of a company is what a willing buyer would pay for it. In the case of a public company, that value is estimated by calculating the company’s market cap, or the number of shares outstanding multiplied by the share price on any given day. In the case of private companies, the market value can be estimated by one of the valuation methods described in part 1—at least as a start.