Understanding the Balance Sheet

The balance sheet has several purposes including telling you the assets a company
has to protect shareholders, how efficiently management is using capital, the risk of
bankruptcy, and how fast a business can grow. This table of contents has been put
together to make it easy for you to navigate Investing Lesson 3: How to Understand a
Balance Sheet. Whether you are researching a stock or running your own small
business, the balance sheet has never been easier to understand for new investors.

The table of contents below can help you navigate effortlessly - we've kept each
balance sheet topic on its own page to make learning even easier. Grab a cup of
coffee, and start reading through these pages. Please note, these lessons have been
designed to be read sequentially! You should start at the beginning and work your way
through, page by page, to learn the most.

How to Read a Balance Sheet Table of Contents

1. Introduction to the Balance Sheet
2. How to Get a Copy of a Company's Balance Sheet
3. What Is a Balance Sheet?
4. Sample Balance Sheet - The Coca-Cola Company
5. Current Assets on the Balance Sheet
6. What are Accounts Receivable?
7. Receivable Turns
8. Inventory on the Balance Sheet
9. Inventory Turns and Inventory Turnover Ratios
10. McDonald's vs. Wendy's - A Case Study in Inventory
11. Prepaid Expenses and Other Current Assets
12. Current Liabilities
13. Working Capital
14. Working Capital Per Dollar of Sales
15. Negative Working Capital
16. The Current Ratio
17. Quick Test Ratio
18. Long Term Investments
19. Property, Plant and Equipment
20. Intangible Assets
21. Goodwill on the Balance Sheet
22. Deferred Long-Term Asset Charges
23. Long Term Debt and Debt to Equity Ratio
24. Other Liabilities
25. Minority Interest on the Balance Sheet
26. Shareholder Equity
27. Book Value and Net Tangible Assets
28. Common, Preferred, and Convertible Shares
29. Capital Surplus and Reserves
30. Treasury Stock
31. Retained Earnings on the Balance Sheet
32. Formulas and Calculations for Analyzing a Balance Sheet
33. Putting It All Together - What the Balance Sheet Can and Cannot Tell You
34. Analyzing a Sample Balance Sheet - Microsoft Part I
35. Analyzing a Sample Balance Sheet - Microsoft Part II
36. Analyzing a Sample Balance Sheet - Simon Transportation Services
37. Epilogue for Simon Transportation

Introduction
Purposes of the Balance Sheet
How many times have you flipped to the back of a company's annual report and found
yourself blankly staring at the pages of numbers and tables? You know that these
should be important to your investing decision, but you're not quite sure what they
mean or where to begin.

In this investing lesson, we're going to take our first major step towards changing that
by teaching you about the balance sheet. Smart investors have always known that
financial statements are the keys to every company. They can warn of potential
problems, and when used correctly, help determine what a business is really "worth".
An investor who understands financial statements will never have to ask "is this
company a good investment?".

The Role of the Balance Sheet In the Financial Statements

For every business, there are three important financial statements you must examine:
The Balance Sheet, the Income Statement, and the Cash Flow Statement. The balance
sheet tells investors how much money the company has, how much it owes, and what
is left for the stockholders. The cash flow statement is like the checking account; it
shows you where the money is spent. The income statement is a record of the
company's profitability. It tells you how much money a corporation made (or lost).

In this lesson, we are going to learn to analyze a balance sheet. There are two
segments. In the first, we will go through a typical balance sheet and explain what each
of the items means. In the second, we will actually look at the balance sheets of several
American corporations and perform basic financial calculations on them.

Grab a cup of coffee, a nearby calculator and let's begin!

How to Get a Company's Annual Report, 10K, and Other

Financial Information
Since you can't do your analysis without a balance sheet, you're going to have to get
your hands on one. How do you get a company's financial statements? Generally, you
should look in one of three places.

1.) The Annual Report: The annual report is a document released by companies at the
end of their fiscal year which includes almost everything an investor needs to know
about the business. It generally contains pictures of facilities, branch offices,
employees, and products, all of which are completely unimportant to making your
investing decision. They are normally followed by a letter from the CEO and other
senior management which discusses the past as well as upcoming year. Tucked away
in the back of most annual reports is a collection of financial documents. Most of the
time you can go onto a company's website and find the Investor Relations link. From
there, you should be able to either download the annual report in PDF form or find
information on how to contact shareholder services and request a copy in the mail.

2.) The 10K: This is a document filed with the SEC which contains a detailed
explanation of a business. It is reported annually and contains the same financial
statements the annual report does, in a more detailed form. The benefit of the 10K is
that it allows you to find out additional information such as the amount of stock options
awarded to executives at the company, as well as a more in-depth discussion of the
nature of the business and marketplace. Sometimes you will find that a company has
no financial statements in the 10K, but instead has written, "incorporated herein by
reference" This means that the financial statements can be found elsewhere, such as in
the annual report or another publication. Even if this is the case, it is still worth it to get
a copy. You can find this by contacting the company, visiting their website, or going to
FreeEdgar (freeedgar.com) or SEC.gov.

3.) The 10Q: The is similar to the 10K, but is filed quarterly (four times a year - normally
the end of January, June, September, and December). If the company is planning on
changing its dividend policy, or something equally as important, they may bury it in the
10Q. These documents are critical and can be obtained in the same way as the annual
report and 10K.

You will want to get a copy of all three documents for the past year or two from the
company you are interested in investing in. Most of them can be found at
http://finance.yahoo.com - type in the ticker symbol of the company you want to
research and then click the "financials" link. This will bring up a copy of the latest
quarterly financial statements. (For all good purposes, I would recommend you first
analyze the annual balance sheet, which can be found by clicking "annual data" in the
upper right hand corner.) As always, it is best to get the information directly from the
company.

What Is a Balance Sheet?

Pretend that you are going to apply for a loan to put a swimming pool into your
backyard. You go to the bank asking to borrow money, and the banker insists that you
give him a list of your current finances. After going home and looking over your
statements, you pull out a blank sheet of paper and write down everything you have
that is of value (your checking and savings account, mutual funds, house, and cars).
Then, at the bottom of the sheet your write down all of your debt (the mortgage, car
payments, and your student loan). You subtract everything you owe by all the stuff you
have and come up with your net worth.

Congratulations, you just created a balance sheet.

Balance Sheets Required by the Securities and Exchange Commission

Just as the bank asked you to put together a balance sheet to evaluate your credit-
worthiness, the government requires companies to put them together several times a
year for their shareholders. This allows current and potential investors to get a
snapshot of a company's finances. Among other things, the balance sheet will show
you the value of the stuff the company owns (right down to the telephones sitting on the
desk of their employees), the amount of debt, how much inventory is in the corporate
warehouse, and how much money the business has to work with in the short term. It is
generally the first report you want to look at when valuing a company.

Before you can analyze a balance sheet, you have to know how it is set-up.

Assets, Liabilities & Shareholder Equity

on the Balance Sheet
The Three Parts of the Balance Sheet
Every balance sheet is divided into three main parts - assets, liabilities, and
shareholder equity.
  Assets are anything that have value. Your house, car, checking account, and the
antique china set your grandma gave you are all assets. Companies figure up
the dollar value of everything they own and put it under the asset side of the
balance sheet.
 Liabilities are the opposite of assets. They are anything that costs a company
money. Liabilities include monthly rent payments, utility bills, the mortgage on
the building, corporate credit card debt, and any bonds the company has issued.
 Shareholder equity is the difference between assets and liability; it tells you the
"book value", or what is left for the stockholders after all the debt has been paid.

Every balance sheet must "balance". The total value of all assets must be equal to the
combined value of the all liabilities and shareholder equity (i.e., if a lemonade stand
had $10 in assets and $3 in liabilities, the shareholder equity would be $7. The assets
are $10, the liabilities + shareholder equity = $10 [$3 + $7]).

What Does a Balance Sheet Look Like?

Below is an example of what a typical balance sheet looks like. I've taken it from an old
Coca-Cola annual report and, for the sake of space, removed lines that had a $0 value.
Don't worry, though, we will still discuss each line you are likely to encounter when
reading a balance sheet, whether for small business or a large publicly traded
corporation.

Sample Coca-Cola Balance Sheet

Coca-Cola Company
Consolidated Balance Sheet - January 31, 2001
Current Assets Dec. 31, 2001 Dec. 31, 1999
Cash & Equivalents $1,819,000,000 $1,611,000,000
Short Term Investments $73,000,000 $201,000,000
Receivables $1,757,000,000 $1,798,000,000
Inventories $1,066,000,000 $1,076,000,000
Pre-Paid Expenses $1,905,000,000 $1,794,000,000
Total Current Assets $6,620,000,000 $6,480,000,000

Long Term Assets $8,129,000,000 $8,916,000,000

Property, Plant, & Equipment $4,168,000,000 $4,267,000,000
Goodwill $1,917,000,000 $1,960,000,000
Total Assets $20,834,000,000 21,623,000,000

Current Liabilities
 Accounts Payable $9,300,000,000 $4,483,000,000
Short Term Debt $21,000,000 $5,373,000,000
Total Current Liabilities $9,321,000,000 $9,856,000,000

Long-Term Liabilities
Long-Term Debt $835,000,000 $854,000,000
Other Liabilities $1,004,000,000 $902,000,000
Deferred Long Term Liability Charges $358,000,000 $498,000,000
Total Liabilities $11,518,000,000 $12,110,000,000

Shareholders' Equity
Common Stock $870,000,000 $867,000,000
Retained Earnings $21,265,000,000 $20,773,000,000
Treasury Stock ($13,293,000,000) ($13,160,000,000)
Capital Surplus $3,196,000,000 $2,584,000,000
Other Stockholder Equity ($2,722,000,000) ($1,551,000,000)
Total Stockholder Equity $9,316,000,000 $9,513,000,000

Current Assets on the Balance Sheet

The first thing listed under the asset column on the balance sheet is something called
"current assets". This is where companies list all of the stuff that can be converted into
cash in a short period of time, usually a year or less. Because these assets are easily
turned into cash, they are sometimes referred to as "liquid". They normally consist of:

Cash and Cash Equivalents

Cash and Cash Equivalents is the amount of money the company has in bank
accounts, savings bonds, certificates of deposit, and money market funds. It tells you
how much money is available to the business immediately. How much should a
company keep on the balance sheet? Generally speaking, the more cash on hand the
better. Not only does a decent cash hoard give management the ability to pay
dividends and repurchase shares, but it can provide extra wiggle-room when times get
bad.

There are some cases where cash on the balance sheet isn't necessarily a good thing.
If a company is not able to generate enough profits internally, they may turn to a bank
and borrow money. The money sitting on the balance sheet as cash may actually be
borrowed money. To find out, you are going to have to look at the amount of debt a
company has (we will be discussing this later on in the lesson). The moral: You
probably won't be able to tell if a company is weak based on cash alone; the amount of
debt is far more important.

Short Term Investments on the Balance Sheet

These are investments that the company plans to sell shortly or can be sold to provide
cash. Short term investments aren't as readily available as money in a checking
account, but they provide added cushion if some immediate need were to arise. Short
Term Investments become important when a company has so much cash sitting around
that it has no qualms about tying some of it up in slightly longer-term investment
vehicles (such as bonds which have maturities of less than one year). This allows the
business to earn a slightly higher interest rate than if they stuck the cash in a corporate
savings account.

From time to time, companies become known for their legendary cash hoards. A
decade ago, Microsoft was known for its $5.25 billion in cash and $32.973 billion in
short term investments. Berkshire Hathaway has kept as much as $40+ billion in cash
on hand.

Accounts Receivables
Accounts Receivable as a Balance Sheet Asset
Receivables are also sometimes known as accounts receivables and represents
money that is owed to a company by its customers.

How Accounts Receivable Are Recorded on the Balance Sheet

Here's how it works: Let's say Wal-Mart wants to order a new DVD which is being
released by Warner Brothers. Wal-Mart orders 500,000 copies for its stores. Warner
Brothers receives the order, and within a week, ships the DVDs to one of Wal-Mart's
warehouses. Included in the shipment is a bill (let's say WB charged Wal-Mart $5 per
DVD for half a million copies - that's $2.5 million). Warner Brothers has already sent the
movies to Wal-Mart, even though Wal-Mart hasn't paid a penny. In essence, Wal-Mart
is buying on credit and promising to pay WB's the $2.5 million.

The $2.5 million would go on Warner Brother's balance sheet as accounts receivables.

Accounts Receivable Terms

Generally a company that sells a product on credit sets a term for its accounts
receivable. The term is the number of days customers must pay their bill before they
are charged a late fee or turned over to a collection agency (most terms are, 30, 60 or
90 days). If Warner Brothers sold the DVDs to Wal-Mart on a 30 day term, Wal-Mart
must pay its bill during that time.
While accounts receivable are good, they can bring serious problems to a business if
they aren't handled properly. What if Wal-Mart went bankrupt or simply didn't pay
Warner Brothers? WB would then be forced to write down its receivables on the
balance sheet by $2.5 million. This is what is called a delinquent account. Normally,
companies build up something called a reserve to prepare for situations such as this.
Reserves are set amounts of money that are taken out of the profits each year and put
into an account specifically designed to act as a buffer against possible loses the
company may incur. (Reserves are touched on in Part 29). When customers don't pay
their bills, companies can take money out of the reserve they had built up to pay back
suppliers. Most companies, however, don't actually set aside the money they charge to
reserves, but instead just write it off the income statement. In other words, you can't
"dip into the reserves" in the traditional sense unless you were dealing with an
extremely conservative management that actually believed a set percentage of sales
should be put aside in safe cash equivalents.

Receivable Turns
The receivable turns or receivable turnover is a great financial ratio to learn when you
are analyzing a business or a stock because common sense tells you the faster a
company collects its accounts receivables, the better. The sooner customers pay their
bills, the sooner a company can put the cash in the bank, pay down debt, or start
making new products. There is also a smaller chance of losing money to delinquent
accounts. Fortunately, there is a way to calculate the number of days it takes for a
business to collect its receivables. The formula looks like this:

Receivable Turns Calculation

Credit Sales1 ÷ Average Accounts Receivables
1: Credit sales are found on the income statement, not the balance sheet

Let's look at an example. I've built a table at the bottom of this page that will provide
you with the numbers you need for a fictional company, H.F. Beverages.

An Example of Calculating Receivable Turns

H.F. Beverages is a major manufacturer of soft drinks and juice beverages. It sells to
supermarkets and convenience stores across the country on a 30 day term. To see if
customers are paying on time, we need to look for the income statement. It is normally
found within a page or two of the balance sheet in the annual report or 10K. With the
income statement in front of you, look for an item called "Credit Sales" (if you can't find
it, there is an item called "Total Sales" which is acceptable but not as accurate).

In 2009, H.F. Beverages reported credit sales of $15,608,300. If we look at the excerpt
from its balance sheet (above), we will see that in 2009, it had $1,183,363 in
receivables and in 2008, $1,178,423. We need to find out the average amount of
receivables H.F. had in 2009, so we would take $1,1873,363 + $1,178,423 and divide it
by 2. The answer is $1,180,893.

Plug the two numbers into the receivable turn formula.

Credit Sales of $15,608,300 ÷ Average Receivables = $1,180,893

The answer, called receivable turns by financial analysts and professional investors, is
13.2173. This means that H.F. Beverages collects its accounts receivable 13.2173
times per year. Once you calculate this number, finding out the number of days it takes
for customers to pay their bills is simple. Since there are 365 days in a year and the
company gets 13.2173 turns per year, take 365 ÷ 13.2173. The answer is the number
of days it takes the average customer to pay (in H.F.'s case, we come up with 27.61).

This means the company is doing a good job managing its accounts receivable
because customers aren't exceeding the 30 day policy. Had the answer been greater
than 30, you would have been wise to try to find out why there were so many late
payments, which could be a sign of trouble. (Keep in mind you will need to read
through the company's reports to find out what its collection deadline is. Not all
companies require their customers to pay within 30 days).

Inventory on the Balance Sheet

Inventory Is Especially Important to Investors
When looking at a company's current assets, you need to pay special attention to
inventory. Inventory consists of merchandise a business owns but has not sold. It is
classified as a current assets because investors assume that inventory can be sold in
the near future, turning it into cash.

To come up with a balance sheet amount, companies must estimate the value of their
inventory. For instance, if Nintendo had 5,000 units of its new video game system, the
Game Cube, sitting in a warehouse in Japan, and expected to sell them to retailers for
$300 each, they would be able to put $1,500,000 on their balance sheet as the value of
their current inventory (5,000 units x $300 each = $1.5 million).

The Risk of Too Much Inventory

This presents an interesting problem. When inventory piles up, it faces two major risks.
The first is the risk of obsolesce. In another year, few stores will probably be willing to
buy the Game Cube video game system for $300 simply because a newer, faster, and
better system may have come along. Although the inventory is carried on the balance
sheet at $1.5 million, it may actually lose value as time passes. When you hear that a
company has taken an inventory write-off charge, it means that management
essentially decided the products that were sitting in storage or on the store shelves
weren't worth the values they were stated at on the balance sheet. To correct this, the
company will reduce the carrying value of its inventory.
If a year passes and Nintendo still has 3,000 of the 5,000 units in storage, the
executives may decide to lower their prices hoping to sell the remaining inventory. If
they lower the Game Cube's price to $200 each, they would have 3,000 units at $200.
Before, those 3000 units were stated at a value of $900,000 on the balance sheet.
Now, because they are selling for less, the same units are only worth $600,000. The
risk of obsolesce is especially present in technology companies or manufacturers of
heavy machinery.

Inventory Spoilage
Another inventory risk is spoilage. Spoilage occurs when a product actually goes bad.
This is a serious concern for companies that make or sell perishable goods. If a grocery
store owner overstocks on ice cream, and two months later, half of the ice cream has
gone bad because it has not been purchased, the grocer has no choice but to throw it
out. The estimated value of the spoiled ice cream must be taken off the grocery store's
balance sheet.

The moral of the story: the faster a company sells its inventory, the smaller the risk of
value loss.

Inventory Turns / Inventory Turnover

Before you invest, you are going to have to make an informed decision about how
much you think the inventory on the balance sheet is really worth. A major part of this
decision should be based on how fast the inventory is "turned" (or sold). Two
competing companies may each have $20 million sitting in inventory, but if one can sell
it all every 30 days, and the other takes 41 days, you have less of a risk of inventory
loss with the 30 day company.

Finding out how fast a company turns its inventory is simple. Here's the formula.

Calculating Inventory Turns / Inventory Turnover Ratio

Cost of Goods Sold1 ÷ Average Inventory for the Period2
1: This is found on the income statement, not the balance sheet
2: Average inventory is calculated by taking the last period's inventory plus the current period inventory and dividing them by two.

Real World Example of Inventory Turns / Inventory Turnover

Let's look at a real world example. At the bottom on the page, I've provided an older
excerpt from the financial statements of Coca-Cola. The cost of goods sold is
$6,204,000,000. The average inventory value between 1999 and 2000 is
$1,071,000,000 (average the values from 1999 and 2000). Plug them into the formula
for inventory turn.
Current Year's Cost of Goods Sold of $6,204,000,000 ÷ Average Inventories of
$1,071,000,000

The answer is the number of inventory turns - in Coca-Cola's case, 5.7927. What this
means is that Coca Cola sells all of its inventory 5.79 times each year. Is this good? To
answer this question, you must find out the average turn of Coke's competitors and
compare. If you do the research, you find out that the average turnover of a company in
Coke's industry is 8.4. Why is Coca-Cola's turn rate lower? Should it affect your
investing decision? The only way you can answer these kinds of questions is if you
truly understand the business you are analyzing. This is why it is important that you
read the entire annual report, 10K and 10Q of the companies you have taken an
interest in. Although Coke's turn rate is lower, further analysis of the balance sheet will
reveal that it is 4 to 5x financially stronger than its industry averages. With such
outstanding economics, you probably don't need to worry about inventory losing value.

Using Inventory Turnover to Calculate Average Days to Sell a Product

Let's take the inventory analysis a step further. Once you have the inventory turn rate,
calculating the number of days it takes for a business to clear its inventory only takes a
few seconds. Since there 365 days in a year and the Coca Cola clears its inventory
5.7927 times per year, take 365 ÷ 5.7927. The answer (63.03) is the number of days it
takes for Coke to go through its inventory. This is a great trick to use at cocktail parties;
grab a copy of an annual report, scribble the formula down and announce loudly that
"Wow! This company takes 63 days to sell through its inventory!" People will instantly
think you are an investing genius.

What Is a Normal Inventory Turnover Ratio?

The number of days a company should be able to sell through its inventory varies
greatly by industry. Retail stores and grocery chains are going to have a much higher
inventory turn rate since they are selling products that generally range between $1 and
$50. Companies that manufacture heavy machinery such as airplanes, are going to
have a much lower turn over rate since each of their products may sell for millions of
dollars. Hardware companies may only turn their inventory 3 or 4 times a year, while a
department store may do twice that, turning at 6 or 7.

A useful exercise is to compare the inventory turnover rate of a potential investment

against that of its competitors to see which management team is more efficient.

Inventory in Relation to Current Assets

When analyzing a balance sheet, you also want to look at the percentage of current
assets inventory represents. If 70% of a company's current assets are tied up in
inventory and the business does not have a relatively low turn rate (less than 30 days),
it may be a signal that something is seriously wrong and an inventory write-down is
unavoidable.
McDonald's vs. Wendy's - A Case Study In Inventory on the
Balance Sheet
It's easy to see how a higher inventory turn than competitors translates into superior
business performance. McDonald's is unquestionably the largest and most successful
fast food restaurant in the world. Let's compare it to one of its main competitors,
Wendy's.

Use the inventory turn formula (cost of goods sold divided by the average inventory
values) to come up with the number of inventory turns for each business. Between
1999 and 2000, McDonald's had an inventory turn rate of 96.1549, incredible for even a
high-turn industry such as fast food. This means that every 3.79 days, McDonald's
goes through its entire inventory. Wendy's, on the other hand, has a turn rate of 40.073
and clears its inventory every 9.10 days.

This difference in efficiency can make a tremendous impact on the bottom line. By tying
up as little capital as possible in inventory, McDonald's can use the cash on hand to
open more stores, increase its advertising budget, or buy back shares. It eases the
strain on cash flow considerably, allowing management much more flexibility in
planning for the long term.

The Final Word on Inventory

The bottom line: Investors want as little money as possible tied up in inventory. It is fine
to have a lot of inventory on the balance sheet if it is being sold at a fast enough rate
there is little risk of becoming obsolete or spoiled. Great companies have excellent
inventory handling systems so they only order products when they are needed - they
never buy too much or too little of something. Businesses that have too much inventory
sitting on the shelves or in a warehouse are not being as productive as they could be:
had management been wiser, the money could have been kept as cash and used for
something more productive.

McDonald's vs. Wendy's Inventory Turnover Calculation

McDonald's
2000 1999
Inventory on Balance Sheet $99,300,000 $82,700,000
Cost of Goods Sold on Income Statement $8,750,100,000

Wendy's
2000 1999
Inventory on Balance Sheet $40,086,000 $40,271,000
Cost of Goods Sold on Income Statement $1,610,075,000
Prepaid Expenses and Other Current Assets
In the course of every day operations, businesses will have to pay for goods or services
before they actually receive the product. If a jewelry store moved into your
neighborhood mall, it would most likely have to sign a rent agreement and pay six to
twelve months' rent in advance. If the monthly rent was $1,000 and the business
prepaid for an entire year, they would put $12,000 on the balance sheet under Prepaid
Expenses ($1,000 monthly rent x 12 months = $12,000). Each month, they would
deduct 1/12 from the prepaid expenses until the end of the year, at which point, the
amount would be $0.

Sometimes companies decide to prepay taxes, salaries, utility bills, rent, or the interest
on their debt. These would all be pooled together and put on the balance sheet under
this heading.

By their very nature, Prepaid Expenses are a small part of the balance sheet. They are
relatively unimportant in your analysis and shouldn't be given too much attention.

Notes Receivable
Notes Receivable are debts owed to the company which are payable within one year.

Other Current Assets

Other current assets are non-cash assets that are owed to the company within one
year.

Non Standard Items

Sometimes companies put items on their balance sheet which aren't standard. If you
find yourself analyzing a balance sheet and an oddball term shows up, search for it at
investorwords or investopedia. If that still doesn't work, you can call your broker or a
local banker, all of whom should be happy to give you an explanation of a term.

I would recommend you get a copy of Barron's "Dictionary of Finance and Investing
Terms". They are relatively inexpensive ($10 or $11), and define over 4,000 terms. This
can be a huge asset regardless of the financial statement you are looking at. You may
also find the "Dictionary of Business Terms" useful as well. It has 7,500 entries covering
almost every business definition you could possibly ask for. While neither is required to
do balance sheet analysis, they can be a big help.

Current Liabilities
Current liabilities are the debts a company owes which must be paid within one year.
They are the opposite of current assets. Current liabilities includes things such as short
term loans, accounts payable, dividends and interest payable, bonds payable,
consumer deposits, and reserves for Federal taxes.
Let's take a look at some of the most common and important current liabilities on the
balance sheet.

Accounts Payable - The Most Popular Current Liability

Accounts payable is the opposite of accounts receivable. It arises when a company
receives a product or service before it pays for it. Accounts payable, or A/P as it is often
shorthanded, is one of the largest current liabilities a company will face because they
are constantly ordering new products or paying vendors for services or merchandise.
Really well managed companies attempt to keep accounts payable high enough to
cover all existing inventory, meaning that the vendors are paying for the company's
shelves to remain stocked, in effect.

Accrued Benefits and Payroll as a Current Liability

This item in the current liabilities section of the balance sheet represents money owed
to employees as salary and bonus that the company has not yet paid.

Short Term and Current Long Term Debt

These current liabilities are sometimes referred to as notes payable. They are the most
important item under current liabilities section of the balance sheet and most of the
time, they represent the payments on a company's bank loans that are due in the next
twelve months. Borrowing money in itself is not necessarily a sign of financial
weakness; an intelligent department store executive may work out short term loans at
Christmas so she can stock up on merchandise before the Holiday rush. If demand is
high, the store would sell all of its inventory, pay back the short term loans, and pocket
the difference. This is known as utilizing leverage. The department store used borrowed
money to make a profit.

So how can you ever hope to tell if a company is wisely borrowing money (such as our
department store), or recklessly going into debt? Look at the amount of notes payable
on the balance sheet (if they aren't classified under 'notes payable', combine the
company's short term obligations and long term current debt). If the amount of cash
and cash equivalents is much larger than the notes payable, you shouldn't have any
reason to be concerned.

If, on the other hand, the notes payable has a higher value than the cash, short term
investments, and accounts receivable combined, you should be seriously concerned.
Unless the company operates in a business where inventory can quickly be turned into
cash, this is a serious sign of financial weakness.

Other Current Liabilities

Depending on the company, you will see various other current liabilities listed.
Sometimes they will be lumped together under the title "other current liabilities."
Normally, you can find a detailed listing of what these "other" liabilities are buried
somewhere in the annual report or 10k. Often, you can figure out the meaning of the
entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a
current liability, you can be fairly confident the amount listed is what will be paid out to
the company's bond holders in the short term.

Consumer Deposits Are Liabilities to Banks

If you are looking at the balance sheet of a bank, you will want to pay close attention to
an entry under the current liabilities called "Consumer Deposits". Often, they will be will
lumped under other current liabilities. This is the amount that customers have
deposited in the bank. Since, theoretically, all of the account holders could withdrawal
all of their funds at the same time, the bank must list the deposits as a current liability.

Working Capital
The number one reason most people look at a balance sheet is to find out a company's
working capital (or "current") position. It reveals more about the financial condition of a
business than almost any other calculation. It tells you what would be left if a company
raised all of its short term resources, and used them to pay off its short term liabilities.
The more working capital, the less financial strain a company experiences. By studying
a company's position, you can clearly see if it has the resources necessary to expand
internally or if it will have to turn to a bank and take on debt.

Calculating Working Capital

Working Capital is the easiest of all the balance sheet calculations. Here's the formula.

Current Assets - Current Liabilities = Working Capital

One of the main advantages of looking at the working capital position is being able to
foresee any financial difficulties that may arise. Even a business that has billions of
dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay its monthly
bills. Under the best circumstances, poor working capital leads to financial pressure on
a company, increased borrowing, and late payments to creditor - all of which result in a
lower credit rating. A lower credit rating means banks charge a higher interest rate,
which can cost a corporation a lot of money over time.

Negative Working Capital Can Be a Good Thing for High Turn Businesses
Companies that have high inventory turns and do business on a cash basis (such as a
grocery store) need very little working capital. These types of businesses raise money
every time they open their doors, then turn around and plow that money back into
inventory to increase sales. Since cash is generated so quickly, managements can
simply stockpile the proceeds from their daily sales for a short period of time if a
financial crisis arises. Since cash can be raised so quickly, there is no need to have a
large amount of working capital available.

A company that makes heavy machinery is a completely different story. Because these
types of businesses are selling expensive items on a long-term payment basis, they
can't raise cash as quickly. Since the inventory on their balance sheet is normally
ordered months in advance, it can rarely be sold fast enough to raise money for short-
term financial crises (by the time it is sold, it may be too late). It's easy to see why
companies such as this must keep enough working capital on hand to get through any
unforeseen difficulties.

Working Capital Per Dollar of Sales

To find the approximate amount of working capital a company should have, you should
look at "working capital per dollar of sales." In other words, you are going to have to
compare the amount of working capital on the balance sheet to the total sales, which is
found on the income statement, not the balance sheet. A business that sells a lot of
low-cost items, and cycles through its inventory rapidly (a grocery store) may only need
10-15% of working capital per dollar of sales. A manufacturer of heavy machinery and
high-priced items with a slower inventory turn may require 20-25% working capital per
dollar of sales. A company such as Coca Cola would probably fall somewhere between
the two.

Calculating Working Capital Per Dollar of Sales

Here's the formula for Working Capital per Dollar of Sales

Working Capital ÷ Total Sales (Found on the Income Statement)

Let's look at an example taken from an old annual report of Goodrich.

Sample Working Capital Per Dollar of Sales Calculation

Goodrich provides systems for aircraft as well as manufacturers heavy-duty engines.
Working Capital: $933,000,000 (current assets - current liabilities) Total Sales (found on
the income statement) = $4,363,800,000

Let's plug the numbers into the formula:

Working Capital of $933,000,000 ÷ Total Sales of $4,363,800,000

The answer for Goodrich is .2138, or 21.38%. As a manufacturer of heavy duty

machinery, GR falls within the 20-25% working capital per dollar of sales range. This is
good and compares favorably to competitors.

Negative Working Capital Can Be Good ... Sometimes

Some companies can generate cash so quickly they actually have a negative working
capital. This is generally true of companies in the restaurant business (McDonald's had
a negative working capital of $698.5 million between 1999 and 2000). Amazon.com is
another example. This happens because customers pay upfront and so rapidly, the
business has no problems raising cash. In these companies, products are delivered
and sold to the customer before the company ever pays for them.
Don't understand how a company can have a negative working capital? Think back to
our Warner Brothers / Wal-Mart example. When Wal-Mart ordered the 500,000 copies
of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the
sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores
across the country? By the twentieth day, they may have sold all of the DVDs. In the
end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the
customer (making a profit in the process), all before they had paid Warner Brothers! If
Wal-Mart can continue to do this with all of its suppliers, it doesn't really need to have
enough cash on hand to pay all of its accounts payable. As long as the transactions are
timed right, they can pay each bill as it comes due, maximizing their efficiency.

The bottom line: A negative working capital is a sign of managerial efficiency in a

business with low inventory and accounts receivable (which means they operate on an
almost strictly cash basis). In any other situation, it is a sign a company may be facing
bankruptcy or serious financial trouble. You can tell if this is the case by comparing a
company's accounts payable to the total inventory on the balance sheet.

Buying a Company for Free

If you can buy a company for the value of its working capital, you essentially pay
nothing for the business. Going back to our Goodrich example; the company has $933
million in working capital. There are currently 101.9 million shares outstanding, which
means each share of Goodrich stock has $9.16 cents worth of working capital. If GR's
stock was trading for $9.16, you would basically be purchasing the stock for free
(paying $1 for each $1 the company had in its checking account, inventory, etc.). You
would pay nothing for the company's fixed assets (such as real estate, computers, &
buildings) and earnings.

For the past ten or twenty years, it has been incredibly rare for a company to trade that
low. You can still use the basic concept to your advantage; if you can find a business
that is trading for working capital plus half the value of the fixed assets, you would be
paying $0.50 for every $1.00 of assets.

The Current Ratio

The current ratio is another test of a company's financial strength. It calculates how
many dollars in assets are likely to be converted to cash within one year in order to pay
debts that come due during the same year. You can find the current ratio by dividing the
total current assets by the total current liabilities. For example, if a company has $10
million in current assets and $5 million in current liabilities, the current ratio would be 2
(10/5 = 2).

An acceptable current ratio varies by industry. Generally speaking, the more liquid the
current assets, the smaller the current ratio can be without cause for concern. For most
industrial companies, 1.5 is an acceptable current ratio. As the number approaches or
falls below 1 (which means the company has a negative working capital), you will need
to take a close look at the business and make sure there are no liquidity issues.
Companies that have ratios around or below 1 should only be those which have
inventories that can immediately be converted into cash. If this is not the case and a
company's number is low, you should be seriously concerned.

Inefficiency
If you're analyzing a balance sheet and find a company has a current ratio of 3 or 4,
you may want to be concerned. A number this high means that management has so
much cash on hand, they may be doing a poor job of investing it. This is one of the
reasons it is important to read the annual report, 10K and 10Q of a company. Most of
the time, the executives will discuss their plans in these reports. If you notice a large
pile of cash building up and the debt has not increased at the same rate (meaning the
money is not borrowed), you may want to try to find out what is going on.

Microsoft has a current ratio in excess of 4, a massive number compared to what it

requires for its daily operations. The company has no long term debt on the balance
sheet. What are they planning on doing? No one knew until the company paid its first
dividend in history, bought back billions of dollars worth of shares, and made strategic
acquisitions.

Although not ideal, too much cash on hand is the kind of problem a smart investor
prays for.

Quick Test Ratio

The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is the most excessive
and difficult test of a company's financial strength and liquidity. To calculate the quick
ratio, take the current assets and subtract the inventory (current assets minus inventory
is often referred to as the "quick assets"). What you are left with are the items that can
be converted into cash immediately. Divide the result by the current liabilities. The
answer is the Quick Test ratio, one of the most difficult balance sheet tests.

What does this tell you? It is a reflection of the liquidity of a business. The Quick Test
ratio does not apply to the handful of companies where inventory is almost immediately
convertible into cash (such as McDonalds, Wal-Mart, etc.) Instead, it measures the
ability of the average company to come up with cold, hard cash literally in a matter of
hours or days. Since inventory is rarely sold that fast in most businesses, it is excluded.

Long Term Investments

Long Term Assets
Everything we've discussed up until now has been a current asset or current liability.
Now, we are going to take a look at the long term assets that are found on the balance
sheet. These are the things that a business owns but can't be used to fund day-to-day
operations.
Long Term Investments
Long Term investments and funds are investments a company intends to hold for more
than one year. They can consist of stocks and bonds of other companies, real estate,
and cash that has been set aside for a specific purpose or project. In addition to
investments a company plans to hold for an extended period of time, Long Term
Investments also consist of the stock in a company's affiliates and subsidiaries.

The difference between short term and long term investments lie in the company's
motive for owning them. Short term investments consist of stocks, bonds, etc. a
company has bought and will sell shortly. The investments made under long term
investments may never be sold. An excellent example would be Berkshire Hathaway's
relationship with Coca-Cola. Berkshire owns 200 million shares of the soft-drink giant,
and will most likely continue to hold them forever, regardless of the price they are
selling for in the open market.

Carrying Values of Stock Investments

As you now know, when a business purchases common stocks as an investment, they
will go into either the short term or long term investment categories on the balance
sheet. These are normally carried on the balance sheet at cost or market value
(whichever is less). This means that most of the time, the stocks the company owns are
worth far more than they are on the balance sheet (for example, if a business owned
50,000 shares of Sprint and they paid $10 per share, they would have $500,000 on the
balance sheet under either short term or long term investments. If Sprint rose to $35
per share, the value of their holdings would be $1,750,000, yet the balance sheet would
continue to carry $500,000. Thus, the difference of $1,250,000 would not be included in
the book value of the company. (This is a prime example of how financial statements
are only the beginning of the valuation process. They have their limitations, but without
them, we would have no basis to calculate intrinsic value.)

Property, Plant and Equipment

These are referred to as "fixed assets". In other words, these are the corporation's real
estate, buildings, office furniture, telephones, cafeteria trays, brooms, factories, etc.
They are the physical assets the company owns but can't quickly convert to cash.

Depending on the type of business, these may or may not make up a large percentage
of the total assets. Most of the assets of a railroad or airline will fall into this category
(these companies must continue to buy railroad cars and planes to survive - both of
which are fixed assets). An advertising agency on the other hand, will have far fewer
fixed assets. They require nothing but their employees, some pencils, and a few
computers.

You must be careful not to pay too much attention to this number. Since companies are
often unable to sell their fixed assets within any reasonable amount of time (who would
be willing to buy three notebook binders, a factory, the broom in the broom closet, etc.
at a moment's notice?) they are carried on the balance sheet at cost regardless of their
actual value. It is possible for companies to grossly inflate this number (which is called
"watering" the stock), or to write the values down to nothing (some companies have $1
million dollar buildings carried for $1 on the balance sheet).

When analyzing a balance sheet, you will want to look at this number with a raised
eyebrow. Don't completely ignore it (that would be foolish), but certainly don't take it too
seriously.

Intangible Assets
Companies often own things of value that cannot be touched, felt, or seen. These
consist of patents, trademarks, brand names, franchises, and economic goodwill (which
is different than the accounting goodwill we've discussed. Economic goodwill consists
of the intangible advantages a company has over its competitors such as an excellent
reputation, strategic location, business connections, etc.) While every effort should be
made for businesses to carry them at costs on the balance sheet, they are normally
given completely meaningless values.

To prove the point that the intangible value assigned on the balance sheet can be
deceptive, here's an excerpt from Michael F. Price's introduction to Benjamin Graham's
"The Interpretation of Financial Statements" ...

In the spring of 1975, shortly after I began my career at Mutual Shares Fund, Max
Heine asked me to look at a small brewery - the F&M Schaefer Brewing Company. I'll
never forget looking at the balance sheet and seeing a +/- $40 million net worth and
$40 million in 'intangibles'. I said to Max, 'It looks cheap. It's trading for well below its
net worth.... A classic value stock!' Max said, 'Look closer.'

I looked in the notes and at the financial statements, but they didn't reveal where the
intangibles figure came from. I called Schaefer's treasurer and said, 'I'm looking at your
balance sheet. Tell me, what does the $40 million of intangibles related to?' He replied,
'Don't you know our jingle, 'Schaefer is the one beer to have when you're having more
than one.'?'

That was my first analysis of an intangible asset which, of course, was way overstated,
increased book value, and showed higher earnings than were warranted in 1975. All
this to keep Schaefer's stock price higher than it otherwise would have been. We didn't
buy it."

When analyzing a balance sheet, you should generally ignore the amount assigned to
intangible assets. These intangible assets may be worth a huge amount in real life
(Coca-Cola's brand name is priceless), but it is the income statement, not the balance
sheet, that gives investors insight into the value of these intangible items.

Goodwill on the Balance Sheet

In the accounting sense, Goodwill can be thought of as a "premium" for buying a
business. When one company buys another, the amount it pays is called the purchase
price. Accountants take the purchase price and subtract it by a company's book value.
The difference is called Goodwill.

For decades, when a company bought another company, it could use one of two
accounting methods: pooling of interest or purchase. When the pooling of interest
method is used, the balance sheets of the two businesses are combined and no
goodwill is created. When the purchase method is used, the acquiring company will put
the premium they paid for the other company on their balance sheet under the
"Goodwill" category. Accounting rules require the goodwill be amortized over the course
of 40 years.

An Example of Balance Sheet Goodwill

What does that mean? Let's use McDonald's and Wendy's as an example since most
people are familiar with them.

McDonald's
Earnings: $1,977,300,000
Shares Outstanding: 1.29 Billion
(You don't need McDonald's other information for this example)

Wendy's
Book Value: $1,082,424,000
Book Value per Share: $10.3482
Shares Outstanding: 104.6 Million
Earnings: $169,648,000

Say McDonald's decided to buy all of Wendy's stock using the purchase method.
Wendy's has a book value of $10.3482 per share, yet is trading at $32 per share. If
McDonald's were to pay the current market price, they would spend a total of
$3,347,200,000 (104.6 million shares x $36 per share). To keep this example simple,
we are going to assume the shareholders of Wendy's approved the merger for cash.
McDonald's would mail a check to the Wendy's shareholders, paying them $32 for each
share they owned.

Since the book value of Wendy's is only $1,082,424,000, and McDonald's paid
$3,347,200,000, McDonald's paid a premium of $2,264,776,000. This is going to go
onto their balance sheet as Goodwill. It is required to be amortized against earnings for
up to 40 years. This means that each year, 1/40 of the goodwill amount must be
subtracted from McDonald's earnings so that by the 40th year, there is no goodwill left
on the balance sheet.

Now that McDonald's and Wendy's are one company, their earnings will be combined.
Assuming next year's results were identical, the company would earn $2,146,948,000,
or $1.66 per share1. Remember that goodwill must be amortized, meaning 1/40 the
amount must be deducted from next year's earnings. McDonald's must deduct
$56,619,400 from earnings next year as a charge against goodwill2. Now, McDonald's
can only report earnings of $2,090,328,600, or $1.62 per share (compared to the $1.66
they would have been able to report before the goodwill charge). Goodwill reduced
earnings by 4¢ per share.

If the pooling of interest method had been used, no goodwill would have been created,
and McDonald's would have reported EPS (earnings per share) of $1.66. Meaning that
depending on how the accounting was handled, the exact same transaction could have
two vastly different impacts on earnings per share.

Goodwill on the Balance Sheet Receives New Accounting Rules

It is no wonder that managements, in order to avoid this reduction in reportable
earnings, frequently opted to use the pooling of interest method when they complete a
merger. Since no goodwill is created, over-eager managers are able to pay outrageous
prices for acquisitions with little or no accountability on the balance sheet. Since it
makes no sense to have two different ways for accounting for a merger, the FASB (the
folks in charge of coming up with these accounting rules) decided they should eliminate
the pooling of interest method and force all transactions to be done via the purchase
method. Executives and politicians claimed this will significantly reduce the number of
mergers since the new standards would cause reportable earnings to drop as soon as
a company had completed an acquisition. As a concession, the FASB will no longer
require goodwill to be written off unless the assets became impaired (which means it
becomes clear that the goodwill isn't worth what the company paid for it).

Pay careful attention to the mergers a company has made in the past few years. Once
you are able to value a business, you will want to look at recent acquisitions to
determine if they were too expensive. If you find this to be the case, you will probably
want to avoid the stock (why would you want to invest in a company that was throwing
your money around?).

Deferred Long-Term Asset Charges

Other assets are non-cash assets which are owed to the company for a period longer
than one year. The most common of these other assets is an entry called Deferred
Long Term Asset Charges.

Deferred Long Term Asset Charges

These are expenses which the company has paid for but not yet subtracted from the
assets. They are very similar to Prepaid Expenses (where rent would be counted as an
asset until it came due each month, then would be subtracted from the balance sheet).
In fact, Prepaid Expenses are type of deferred charge. The difference is, when
companies prepay rent or some other expense, they have a legal right to collect the
service. Deferred Long Term Asset Charges have no legal rights attached to them.
For example, if a company prepaid rent on a storage building, and then spent $30,000
moving all of their equipment into it, they could set the $30,000 up on the balance sheet
as a deferred charge. This way, they wouldn't be forced to take a hit by reducing their
earnings $30,000 the same month they paid for the relocation costs. They could then
write this amount down over time.

These charges are intangible and should be given very little weight when analyzing a
balance sheet.

Long Term Debt and the Debt to Equity Ratio on the Balance
Sheet
The amount of long term debt on a company's balance sheet is crucial. It refers to
money the company owes that it doesn't expect to pay off in the next year. Long term
debt consists of things such as mortgages on corporate buildings and / or land, as well
as business loans.

A great sign of prosperity is when a balance sheet shows the amount of long term debt
has been decreasing for one or more years. When debt shrinks and cash increases,
the balance sheet is said to be "improving". When it's the other way around, it is said to
be "deteriorating". Companies with too much long term debt will find themselves
overwhelmed with interest payments, a risk of having too little working capital, and
ultimately, bankruptcy. Thankfully, there is a financial tool that can tell you if a business
has borrowed too much money.

Debt to Equity Ratio

The debt to equity ratio measures how much money a company should safely be able
to borrow over long periods of time. It does this by comparing the company's total debt
(including short term and long term obligations) and dividing it by the amount of
shareholder equity. (We haven't covered shareholder equity yet, but we will later. For
now, you only need to know that the number can be found at the bottom of the balance
sheet. You'll actually calculate the debt to equity ratio in segment two when we look at
real balance sheets.

The result you get after dividing debt by equity is the percentage of the company that is
indebted (or "leveraged"). The normal level of debt to equity has changed over time,
and depends on both economic factors and society's general feeling towards credit.
Generally, any company that has a debt to equity ratio of over 40% to 50% should be
looked at more carefully to make sure there are no liquidity problems. If you find the
company's working capital, and current ratio / quick ratios drastically low, this is is a
sign of serious financial weakness.

Profitable Borrowing
If a business can earn a higher rate of return than the interest rate at which it borrows,
it becomes profitable for the business to borrow money. (An example: If a corporation
earned 15% on its investments and borrowed funds at 8%, it would make 7% on the
borrowed money [15% return - 8% cost of money = 7% net profit]. This boosts what
analysts call "Return on Equity". We will talk about Return on Equity, or ROE, in a
future lesson. It is briefly touched on in the Retained Earnings section of this lesson.)

Other Liabilities
Like the few other "other" parts of the balance sheet, "Other Liabilities" is a catch-all
category where companies can consolidate their miscellaneous debt. You can normally
find an explanation of what makes up these other liabilities somewhere in the financial
reports. Often times, they consist of things such as inter-company borrowings (where
one of a company's divisions or subsidiaries borrows from another), accrued expenses,
sales tax payable (in the instance of retail stores), etc.

Generally, you should take the time to look at the various other liabilities a company
has. Most are self explanatory and are not as important as the other major liabilities
already discussed.

Minority Interest on the Balance Sheet

When you look at a balance sheet, you will see an entry called "Minority Interest". This
refers to the equity of the minority shareholders in a company's subsidiaries. An
example will help clarify. Beginning in 2008 and 2009, the FASB is requiring
companies to classify minority interest under Shareholder Equity and not
Liabilities. This is a major change and means that you will need to look further
down the balance sheet for all newer reports!

In 1983, Nebraska Furniture Mart was the most successful home furnishings store in
the United States. It's gross annual sales exceeded $88.6 million, and the company
had no debt. At the time, Warren Buffett, the CEO of Berkshire Hathaway, was
searching for great businesses to acquire. After noticing how successful the furniture
business appeared to be, he approach the owner, Rose Blumpkin, and offered to buy
the company.

Almost immediately, Rose offered to sell 90% of Nebraska Furniture Mart to Berkshire
for $55 million. The next day, Buffett walked into the store and handed her a check.
This made NFM a partially-owned subsidiary of Berkshire. (A subsidiary is a company
controlled by another company through ownership of at least a majority of the voting
stock.) Since subsidiaries are controlled by their parent companies, accounting rules
allow for them to be carried on the parent company's balance sheet 1. When Berkshire
bought its 90% stake in Furniture Mart, it was able to add the assets of the furniture
giant to its own balance sheet.

This presents a problem. Berkshire can now add the assets of Nebraska Furniture Mart
to its balance sheet, but technically, it doesn't own them all. Remember, Rose Blumpkin
only sold 90% of her company - she kept the other 10%. Berkshire will somehow have
to show that some of the assets on its balance sheet belong to Rose, who has a
minority interest in NFM. To do this, it will calculate the value of Rose's stake in the
subsidiary and put it under a liability account called "Minority Interest". These are the
assets Berkshire "owes" Rose. Again, in all reports following 2008 and 2009, this
account will appear in the Shareholder Equity section of the balance sheet and not as a
liability. This is extremely important. The theory behind this shift was that the money
owed to Rose wasn't really a debt of the company, it represents allocation of
ownership.

A company may have several minority partners in many subsidiaries. The minority
interest of all of these partners is added together and placed on the balance sheet.
1.) A company can integrate the balance sheet of its subsidiary if it owns 80% or more. It can report earnings of the subsidiary if it owns 20% or more.

Shareholder Equity
Shareholder Equity is the net worth of a company. It represents the stockholders' claim
to a business' assets after all creditors and debts have been paid. Shareholder equity is
also referred to as Owner's or Stockholders' Equity. It can be calculated by taking the
total assets and subtracting the total liabilities.

Shareholder equity usually comes from two places. The first is cash paid in by investors
when the company sold stock; the second is retained earnings, which are the
accumulated profits a business has held on to and not paid out to its shareholders as
dividends. Because these are the two ways a company generally creates shareholders'
equity, the balance sheet is organized to show each parts' contribution.

Book Value
Book Value and Shareholder Equity are not quite the same thing. To find a company's
book value, you need to take the shareholders' equity and exclude all intangible items.
This leaves you with the theoretical value of all of the company's tangible assets (those
which can be touched, seen, and felt). For this reason, book value is sometimes also
called "Net Tangible Assets".

Net Tangible Assets (or Book Value)

The amount of net tangible assets a company has is particularly important. Since you
should always analyze the balance sheet you get directly from the company (as
opposed to the ones you find on Yahoo or other financial sites), you may not always
have this figure calculated for you. To calculate it, take the total assets and subtract all
of the intangible assets such as goodwill. What you are left with is the nuts and bolts of
the company; the buildings, computers, telephones, pencils, and office chairs.
In the past, it was generally thought the more assets a company had the better. Over
the past twenty years, value investors have come to reject this idea in its pure form; it is
actually preferable to own a business that generates earnings on a lower asset base.

Why? Let's say your company earns $10 million a year and has $30 million in assets.
My company earns the same $10 million but has $50 million assets. It is generally
understood that a relationship exists between the amount of assets a company has and
the profit it generates for the owners. If you wanted to double the earnings of your
company, you would probably have to invest another $30 million into the company.
After the reinvestment, the business would have $60 million in assets and earn $20
million a year.

On the other hand, if I wanted to double the earnings of my company, I would have to
invest another $50 million into the business (which would double the assets). After the
reinvestment, my business would have $100 million in assets and generate $20 million
a year.

What does that mean?

You would have to retain $30 million in earnings to double your profits. I would have to
retain $50 million to get the same profit! That means that you could have paid out the
difference (in this case $20 million) as dividends, reinvested it in the business, paid
down debt, or bought back shares! We will talk more about this in the future.

Common, Preferred, and Convertible Shares

You'll normally see an entry for such things as "common" or "preferred" stock on the
balance sheet under the shareholder's equity section of a balance sheet. This does not
refer to the current price of all of the company's shares. Instead, these entries reflect
the par value of the company's stock, and / or, when there is no par value assigned to
the stock, the amount investors paid when the company issued shares.

The Definition of Par Value

What is par value? Par was originally created as a way to protect creditors and
shareholders by providing a "cushion" of assets that could not be damaged or impaired.
In time, it proved to be completely unsuccessful at protecting either party. This is
important because companies would take the total shares outstanding, multiply them
by the par value, and put them on the balance sheet as "paid in capital". An example: If
a business had 100,000 shares of stock outstanding and each had a par value of $1,
the company would put $100,000 under "common stock" on the shareholder equity part
of the balance sheet.

Eventually, state governments no longer required companies to establish a par value

on their stock. In cases where no par exists, a corporation must put the amount raised
when the company issued stock. If the same business had 100,000 shares and no par,
but it initially sold stock at $25 per share, it would put $2,500,000 under the common
stock section of shareholder equity on the balance sheet.

On most balance sheets, there is a list of such entries. They consist of all of the capital
that has been paid in by shareholders who have purchased either the common stock,
preferred stock, warrants, etc.

Capital Surplus and Reserves

Capital Surplus
To understand what Capital Surplus is, you must first understand the concept of
Surplus. From an accounting standpoint, surplus is the difference between the total par
value of the stock outstanding and the shareholder equity and Proprietorship Reserves.
(Don't panic! It's not as complicated as it sounds!) You already know what par value
and shareholder equity are. The only thing you haven't learned about is Proprietorship
Reserves, which we will discuss in a minute.

Almost always part of the surplus is a result of retained earnings (which would increase
the shareholder equity). There is a specific part of the surplus that comes from other
sources (such as increasing the value of fixed assets carried on the balance sheet, the
sale of stock at a premium, or the lowering of the par value on common stock). These
"other" sources are frequently called "Capital Surplus" and placed on the balance
sheet. In other words, Capital Surplus tells you how much of the company's
shareholder equity is not due to retained earnings.

Reserves & Proprietorship Reserves

Reserves deserve special attention when analyzing a company. Although we aren't
going to discuss them in depth until a later lesson, it would be wise to lightly touch on
them so you have a general understanding of their purpose. When a business creates
a "Reserve", they are essentially setting aside a certain amount of money for a specific
purpose. Often times, reserves are monies set aside to act as a buffer against future
losses. Let's look at a few examples:
 If a company had a substantial amount of their current assets in accounts
receivables, they would set charge off a percentage of the total amount they
were owed in case some of the customers didn't pay their bills. This is a reserve
for doubtful and bad accounts.
 If a business had a build up of inventories that risked losing their value,
management would create a reserve to offset losses.
 If a manufacturing corporation decided to save money to build a new widget
plant, they would put money in a reserve until they had saved enough to pay for
it. In this case, there would be no accounting entry, just a pile of cash growing on
the balance sheet.
Proprietorship Reserves are set up to alert investors that a certain part of the
shareholder equity cannot be paid out as cash dividends since they have another
purpose.

Treasury Stock
When analyzing a balance sheet, you're apt to run across an entry under Shareholder
Equity called "Treasury Stock". This refers to the shares a company has issued and
somehow reacquired either through share repurchase programs or donations.

Companies sometimes buy back their shares for a variety of reasons. In most cases, it
is a sign management believes the stock is undervalued. Depending upon its
objectives, a company can either retire the shares it purchases, or hold them with the
intention of reselling them to raise cash when the stock price rises.

When a corporation purchases its own stock, the cash on hand is reduced. This lowers
the total shareholder equity. In order for investors to know the reduced cash and equity
was a result of share repurchases and not debt or losses, management puts the cost of
the reacquired stock under "Treasury Stock" in order to clarify. This is why you will often
see a negative number besides the treasury stock entry. (You may be wondering why
the current market price of the company's treasury stock isn't listed as an asset since
the shares can be sold at any time to raise cash. There is a debate about this in the
accounting world. The premise is that all unissued stock can also be sold for cash yet it
isn't listed as an assets - treasury stock should be treated the same way.)

Many states limit the amount of treasury stock a corporation can own at any given time
since it is way of taking resources out of the business by the owners / shareholders,
which in turn, may jeopardize the legal rights of the creditors.

Treasury Stock Not Permitted In Some States

Some states don't allow companies to carry treasury stock on the balance sheet,
instead requiring them to retire shares.

Retained Earnings on the Balance Sheet

When a company generates a profit, management has one of two choices: They can
either pay it out to shareholders as a cash dividend, or retain the earnings and reinvest
them in the business.

When the executives decide that earnings should be retained, they have to account for
them on the balance sheet under shareholder equity. This allows investors to see how
much money has been put into the business over the years. Once you learn to read the
income statement, you can use the retained earnings figure to make a decision on how
wisely management is deploying and investing the shareholders' money. If you notice a
company is plowing all of its earnings back into itself and isn't experiencing
exceptionally high growth, you can be sure that the stock holders would be better
served if the board of directors declared a dividend.

Ultimately, the goal for any successful management is to create $1 in market value for
every $1 of retained earnings.

Retained Earnings Examples from Real Companies

Let's look at an example of retained earnings on the balance sheet:
 Microsoft has retained $18.9 billion in earning over the years. It has over 2.5
times that amount in stockholder equity ($47.29 billion), no debt, and earned
over 12.57% on its equity last year. Obviously, the company is using the
shareholder's money very effectively. With a market cap of $314 billion, the
software giant has done an amazing job.
 Lear Corporation is a company that creates automotive interiors and electrical
components for everyone from General Motors to BWM. As of 2001, the
company had retained over $1 billion in earnings and had a negative tangible
asset value of $1.67 billion dollars! It had a return on equity of 2.16%, which is
less than a passbook savings account. The company is astronomically priced at
79.01 times earnings and has a market cap of $2.67 billion. In other words:
Shareholders have reinvested a billion dollars of their money back into the
company and what have they gotten? They owe $1.67 billion. 1 That is a bad
investment.

The Lear example deserves a closer look. It is immediately apparent that shareholders
would have been better off had the company paid out its earnings as dividends.
Unfortunately, the economics of the company are so bad had the profits been paid out,
the business probably would have gone bankrupt. The earnings are reinvested at a sub
par rate of return. An investor would earn more on the earnings by putting them in a CD
or money market fund then by reinvesting them into the business.

Formulas and Calculations for Analyzing a Balance Sheet

Formulas & Calculations for the Balance Sheet
You've learned how to analyze a balance sheet! In Segment 2 we are going to work
through the balance sheets of a few American companies. Here is a reference guide for
all of the calculations you've learned so far. You should memorize these as soon as
possible; they are priceless investment tools for the rest of your life.

Tests of a Company's Financial Strength and Liquidity:

Working Capital: Current Assets - Current Liabilities
Working Capital per Dollar of Sales: Working Capital ÷ Total Sales1
Current Ratio: Current Assets ÷ Current Liabilities
Quick / Acid Test / Current Ratio: Current Assets minus inventory (called "Quick
Assets) ÷ Current Liabilities
Debt to Equity Ratio: Total Liabilities ÷ Shareholders' Equity
Tests of a Company's Efficiency:
Receivable Turnover: Net Credit Sales1 ÷ Average Net Receivables for the Period
Average Age of Receivables: Numbers of days in period ÷ Receivable Turnover
Inventory Turnover: Cost of Goods Sold1 ÷ Average Inventory for the Period
Number of Days for Inventory to Turn: Number of days in Period ÷ Inventory
Turnover

Putting It All Together

What the Balance Sheet Can and Cannot Tell You
Once again, congratulations. You now have the tools necessary to analyze a balance
sheet. Before you go running out wielding your new-found power of fundamental
analysis, you have to understand the limitations of the balance sheet. If I were going to
sell you the local grocery store or corner gas station, you would not make an offer
based solely on the balance sheet. Instead, you would take into consideration the profit
the business generated, the future prospects for the business, the local competition,
etc. That is precisely what you are doing when you look at a publicly traded company;
you must make a decision just as if you were purchasing a private business. The
balance sheet is just one key in making that decision; it is the theoretical value of the
enterprise if you were to purchase it, liquidate the assets, and shut its doors. The
liquidation value is not the true value of a business - what is important is how much
cash it can generate for the owners in the future. Only in exceptionally rare cases
(where a company is trading for less than its working capital, for instance) could you
make an investment decision based solely on the balance sheet.

Often times, the information you find on the balance sheet isn't valuable in and of itself;
it must be compared with something else. There were a few calculations we looked at
that required the use of the income statement, which is the focus of Lesson 4. As you
progress through these lessons, you will find that by using the three financial
statements together, you can garner nearly all of the secrets of any business.

Now, get ready to put your skills to the test. We're going to analyze a few balance
sheets together.

Analyzing a Sample Balance Sheet - Microsoft

The main purpose of balance sheet analysis is to determine if a company is financially
strong and economically efficient. The first balance sheet we are going to look at is a
perfect example of both. It can be found in Microsoft's 2001 10K statement.

A Quick Note on Microsoft's Balance Sheet

Before we begin analyzing, notice that unlike most balance sheets, the most recent
year is on the right hand side in bold. I highlighted the column so you would be sure to
look at the correct figures.
An additional point: when companies put together their balance sheet, they tend to omit
the 000's at the end of long numbers to save space. If you see on the top of a balance
sheet that numbers are stated "in thousands", add "000" to find the actual amount (i.e.,
$10 stated in thousands would be $10,000). If a balance sheet is stated in millions, you
will need to add "000,000" (i.e., $10 stated in millions would be $10,000,000).

Keep in mind we are analyzing the fiscal balance sheet as of June, 2001. This
information may be different when you go to search on Moneycentral, Yahoo!, or
TheStreet since they will use the most recent data available. The purpose of this
analysis is not to advice you on what to buy, but rather to show you the process of
analyzing a balance sheet.

Let's Begin Analyzing!

Cash Position
The first thing you will notice is that Microsoft has $31.6 billion in cash and short term
investments. This doesn't mean much unless you compare it to the company's debt to
find out if it is borrowed money. Glance down the balance sheet and look for any long-
term debt. You'll notice there isn't an entry for it. This isn't a mistake; Microsoft has no
long term debt.

Don't get too excited yet. Remember that some businesses fund day-to-day operations
with short-term loans (think back to our department store executive at Christmas in Part
10). To see if Microsoft is using short term debt to survive, look at the current liabilities.
In 2001, the entire value of Microsoft's current liabilities was $11,132. Compare that to
the $31.6 billion in cash the company has. Does it have enough money to pay off its
debt? Absolutely. Microsoft's balance sheet has 3x the cash necessary to pay off
current liabilities and long term debt. This is without calculating in receivables and other
assets. You can be sure the company is not in any danger of going bankrupt.

Working Capital
Let's calculate the company's working capital. Take the current assets ($39,637) and
subtract the current liabilities ($11,132). The answer is $28,505. Microsoft has $28.5
billion in working capital. To find the working capital per share, look at the bottom of the
balance sheet. You'll see there are 5.383 billion shares outstanding. Take the working
capital of $28.5 billion and divide it by the 5.383 billion shares outstanding. The answer,
$5.29, is the amount of working capital per-share.

If you could buy Microsoft's stock at $5.29 per share, you would be getting all of the
company's fixed assets (real estate, computers, long term investments, etc.) plus its
earnings / profit each year from now until eternity for free! The company will probably
never trade that low; but you should always keep this in mind when analyzing a
business. Sometimes, especially during serious economic downturns, you will find
companies selling close to working capital. (Note: We will discuss stock option dilution
and other advanced concepts in later lessons.)
Working Capital Per Dollar of Sales
We calculated working capital at $28.505 billion. According to Microsoft's income
statement, total revenue (the same thing as total sales) came to $25.296 billion.
Following the formula for Working Capital per Dollar of Sales, we come up with 1.12 (or
112%). This means Microsoft has more working capital than its sales last year; if you
remember from the lesson, manufacturers of heavy machinery require the most
working capital and range from 20-25%. The 112% figure is excessive by anyone's
standard. The main concern should not be financial safety, but efficiency. Why isn't
Microsoft putting this money to work?

Current Ratio
The current ratio should be at least 1.5 but probably not over 3 or 4. Taking Microsoft's
current assets and dividing them by the current liabilities, we find the software company
has a current ratio of 3.56. Unless the business is saving resources to launch new
products, build new production facilities, pay down debt, or pay a dividend to
shareholders, a current ratio this high usually signals that management is not using
cash very efficiently.

Quick Ratio
To calculate the quick ratio, we have to take the quick assets and divide them by
current liabilities. If you've studied Microsoft's current assets, you will notice there is no
entry for inventory. You know that Microsoft sells software; meaning its products consist
of information It doesn't need to carry inventory. As soon as a customer places an
order, the company can load its program onto a CD-ROM or DVD and ship it out the
same day. Because there is no inventory, there is no risk of spoilage or obsolesce.

Inventory is what causes the biggest difference between the current and quick ratio.
The quick ratio was designed to measure the immediate resources of a company
against its current liabilities. Almost all of Microsoft's resources are already liquid. The
only things that aren't are the $1.949 billion in deferred income taxes (how are you
going to use it to raise cash?) and the $2.417 billion attributed to "other" current assets.
Subtract these from the $39,637 billion in current assets and you get $35.271 billion.
This $35 billion in quick assets represents the things the company can turn in to cash
almost immediately. Divide it by the current liabilities ($35.271 divided by $11,132) and
you get 3.168. Even under the most stringent test of financial strength, Microsoft has
$3.168 in current assets for every $1 in liabilities.

Microsoft's Financial Sheet Excerpts

Microsoft's Balance Sheet

- January 31, 2001
In Millions
2000 2001
Cash and equivalents $4,846 $3,922
Short-term investments $18,952 $27,678
Total cash and short-term investments $23,798 $31,600
Accounts receivable $3,250 $3,671
Deferred income taxes $1,708 $1,949
Other $1,552 $2,417
Total current assets $30,308 $39,637
Property, Plant and Equipment, Net $1,903 $2,309
Equity and other investments $17,726 $14,141
Other assets $2,213 $3,170
Total assets $52,150 $59,257

Accounts payable $1,083 $1,188

Accrued compensation $557 $742
Income taxes $558 $1,468
Unearned revenue $4,816 $5,614
Other liabilities $2,714 $2,120
Total current liabilities $9,755 $11,132
Deferred income taxes $1,027 $836

Common stock and paid-in capital $23,195 $28,390

Retained earnings, accumulated other comprehensive income of
$18,173 $18,899
$1,527 and $587
Total stockholders' equity $41,368 $47,289
Total liabilities and stockholders' equity $52,150 $59,257

Microsoft's Income Statement

- January 31, 2001
In Millions, except earnings per share
Year Ended June 30
1999 2000 2001
Revenue
$19,747 $22,956 $25,296
Cost of Goods Sold
 $2,814 $3,002 $3,455

Analyzing a Sample Balance Sheet Part II - Microsoft

Inventory Turn & Average Age of Inventory
We already discovered that Microsoft carries no inventory. It is absolutely efficient. Its
products are already sold before they are manufactured.

Receivable Turn and Age of Receivables

You'll notice that on the income statement excerpt, credit sales is not listed as a
separate item. Instead, we have to use the less accurate total sales or revenue figure
to calculate receivable turn. Take the $25.296 billion in revenues and divide it by the
average receivables, $3.4605 billion ($3250 + 3671 divided by 2). You will end up with
7.30 turns. To calculate the number of days this translate into, take 365 divided by 7.3.
In Microsoft's case, the answer is 50 days.*

Debt to Equity Ratio

Microsoft is debt free. It has no long or short term debt. If you take $0 (the amount of
the company's debt) and divide it by the shareholder equity ($47.289 billion) you will
get 0. This means that 0% of the company's equity consists of debt; the shareholders
own it all.

Final Thoughts
All of our calculations have shown one thing; the company has virtually no risk of
bankruptcy. Microsoft has 3x the cash it needs to survive, no long term debt, no
inventory to worry about, and extremely strong current and quick ratios. Its working
capital per dollar of sales is 112%, excessive by any standard (especially compared to
its competitors. Adobe Software had a ratio of 36%, while Oracle Systems came in at
46.5%). The main question an investor should ask when looking at the balance sheet
is, "why so much cash?". None of the company's top management has given any clues
as to the plans for the growing pile of greenbacks.
Microsoft's Financial Statement Excerpts
Year Ended June 30 1999 2000 2001
Revenue $19,747 $22,956 $25,296
Cost of Goods Sold $2,814 $3,002 $3,455

Simon Transportation Services

Now that we've looked at an outstanding balance sheet, let's look at one that signals
the company may be running into trouble. Simon Transportation is a trucking company
that specializes in temperature-controlled transportation for major corporations such as
Anheuser Busch, Campbell's Soup, Coors, Kraft, M&M Mars, Nestle, Pillsbury, and
Wal-Mart. If you look closely, you will start to see problems develop in 2000 that foretell
of future financial difficulties.

Simon Transportation Services filed for Chapter 11 bankruptcy in the early part of 2002.
The company's balance sheet showed signs of strain almost two years prior. We are
going to focus most of our attention on the 2000 part of the balance sheet to
demonstrate that an intelligent investor could have seen warning signs before the
company went under. Note: Since we are going to be focusing on 2000's numbers, we
will not average in 2001's numbers to calculate inventory and receivable turn.

Cash Position
Simon had $3,331,119 in cash in September of 2000. It also had $3,437,120 in short
term loans. This is the first sign the company was using borrowed money to operate.
Almost all of the company's current assets are tied up in receivables, which is a real
concern that customers may not be paying on time.

Working Capital
In 2000, the company had working capital of $15,970,104.

Working Capital per Dollar of Sales

In 2000, the company had total sales / revenues of $231,396,894. With working capital
of $15,970,104, the company had a total Working Capital per Dollar of Sales
percentage of 6.9%. Simon operates in the trucking industry, so most of its assets are
fixed (in the form of diesels, trucks, semis, etc.)

Current Ratio
The current ratio should be at least 1.5 but probably not over 3 or 4. Simon had a
current ratio of 1.631 in 2000. This is mediocre. The quick ratio will be a much better
indication of the company's financial health.

Quick Ratio
The company's quick assets come out to around 1.487.

Inventory Turn & Average Age of Inventory

The company's inventory turn for 2000 only is 122.97 (meaning the company clears its
inventory around every 3 days). In most situations, this would mean the company
would have smaller working capital needs. However, if you look at the current assets,
you notice they consist almost entirely of accounts receivable. Although the business
sells its inventory frequently, it isn't converting those sales into cash immediately. Thus,
the receivable turn is going to be very important to the success of this business.

Receivable Turn and Age of Receivables

Credit Sales are not carried individually. Thus, we will have to use the total sales /
revenues of $231,396,894 with receivables of $34,265,075 in 2000. The receivable turn
comes out to 6.75 times per year, or once every 54 days. So, although the company is
clearing its inventory every 3 days, it is only getting paid every 54 days. Since the
inventory turns aren't being converted to cash, the business needs more working
capital. The 6% of working capital per dollar of sales we calculated earlier is
dangerously low.

Debt to Equity Ratio

Combine Simon's short and long term debt, and you'll come up with $19,813,911.
Divide the $44,844,132 in shareholder equity by this amount and you'll see that 44.18%
of the company's equity is made up of debt. This would be acceptable if Simon enjoyed
high enough return on equity to justify such a high borrowing level. A glance at the
company's income statement shows that this is not the case; Simon lost money in
2000. Not only is the company not making money, it is losing money altogether.
Common sense tells you that a business that is heavily in debt and is losing money
probably isn't financially secure.

A quick look into the company's 10k and 10q statements reveals that the short term
loans are secured by the receivables. In plain English, if Simon Transportation fails to
pay its short term loans on time, the bank can go to court and take control of the
receivables. If this were to happen, the business may not have enough cash on hand to
pay its long term debt, which makes up a sizable part of the balance sheet. If Simon
ran into a bump in the road, it probably wouldn't be able to survive because of cash
flow issues.

Final Thoughts
Here's what we've observed: In 2000, a full year before declaring bankruptcy, Simon
Transportation had very little working capital, barely acceptable current and quick
ratios, a high percentage of debt to equity, and inventory that was quickly sold but
slowly collected for. The company may be able to survive as long as it doesn't run into
any problems. An increase in fuel prices, a driver strike, or some other unfavorable
event that increased losses would quicken the company's financial demise. An item of
particular concern is found in the company's 10k, "The Company's top 5, 10, and 25
customers accounted for 24%, 39%, and 57% of revenue, respectively, during fiscal
2000. No single customer accounted for more than 10% of revenue during the fiscal
year."

According to these numbers, each of the top five customers accounted for nearly 5% of
Simon's business. If just one of these switched to another trucking company, five
percent of the business' revenues would have been lost. If the company had profitable
with little or no debt, this would not be a concern. When you're counting on things going
smoothly and you're playing with money that's not your own, you're almost always
headed for disaster.

The bottom line: This is not a company you would invest in if you were looking for
something long term and considerably safe.

Simon Transportation Financial Statements

 Simon Transportation Services, Inc.
Consolidated Balance Sheet - September 30, 2001
Current Assets Sep 30, 2001 Sep 30, 2000
Cash & Equivalents N/A $3,331,119
Short Term Investments N/A N/A
Receivables $36,495,339 $34,265,075
Inventories $1,302,067 $1,330,462
Pre-Paid Expenses $2,528,675 $2,325,199
Total Current Assets $40,326,081 $41,251,855

Long Term Assets N/A N/A

Property, Plant, & Equipment $83,795,541 $49,403,534
Goodwill N/A N/A
Other Assets $5,574,182 $451,603
Total Assets $129,695,804 $91,106,992

Current Liabilities
Accounts Payable $46,031,558 $21,844,631
Short Term Debt $74,537,820 $3,437,120
Total Current Liabilities $120,569,408 $25,281,751

Long-Term Liabilities
Long-Term Debt $835,000,000 $16,376,791
Other Liabilities $1,004,000,000 $902,000,000
Deferred Long Term Liability Charges N/A $4,604,318
Total Liabilities $120,569,408 $46,262,860

Shareholders' Equity
Preferred Stock $5,195,434 N/A
Common Stock $62,917 $62,877
Retained Earnings ($50,503,733) ($2,451,176)
Treasury Stock ($1,053,147) ($1,053,147)
 Capital Surplus $51,865,007 $48,285,578
Other Stockholder Equity $3,559,918
Total Stockholder Equity $9,126,396 $44,844,132

Total Revenue $278,818,242 $231,396,894

Cost of Goods Sold $253,268,462 $163,611,569

Epilogue for Simon Transportation

On December 14, 2000, Simon issued a press release. It had run into a bump in the
road. Here's an excerpt:

"In addition to the change in accounting method, during the quarter, Simon experienced
the highest driver turnover in its history. Turnover exacerbated recruiting costs and
contributed to increased claims and repair expense, and low tractor utilization. In
addition, high fuel prices continued to affect the truckload industry, including Simon."

To correct this problem, Simon's management increased driver pay by 2¢ per mile, an
increased cost the company could hardly afford. Perhaps most disturbing of all, the
company openly acknowledged in its 10k around the same time that it was in violation
of its long term debt agreements.

"The Company's secured line of credit agreement contains various restrictive

covenants including a minimum tangible net worth requirement and a fixed charge
coverage covenant. As of September 30, 2000, the Company was in violation of the
minimum tangible net worth requirement. The Company obtained a waiver of the
violation and as discussed in Note 10 has amended the covenant subsequent to
September 30, 2000."

In February of 2002, the company filed for Chapter 11 bankruptcy protection. Had an
investor been able to analyze a balance sheet, they would have been warned in
advance of the company's problems and possibly avoided huge losses to their portfolio.