This week we will continue to look at the audited returns for Acme Combustion, the fictitious company we are analyzing. The balance sheet is a description of the owner’s equity in the company. The basic form is Assets = Liabilities + Owners equity. Assets are the investments made in land, equipment, buildings and inventory in order to operate. The liabilities and owners equity reflect how those assets are being financed. All transactions are reflected on both sides of the statement, and only transactions measurable in dollars are recorded.
Now let’s look at the asset side of Acme’s balance sheet for the years 2008 and 2007 (Table to right).
First of all, we see that assets are divided into two categories, current and long-term. Looking first at the current assets, we see each year ended with $1 million in the bank. Our Account Receivable has dropped 25% with the 17% drop in sales revenue.
The allowance is for uncollectible debt. No matter how well we screen our accounts, there will always be circumstances where a number of accounts will have to go into collection, and some will never be recovered. This will be even more likely in a down economy.
Along with our drop in sales, we have reduced inventory, but by only 9.6% compared to the 17% drop in sales. When a downturn first hits, it is not uncommon for the required inventory adjustments to catch up. But inventory must be reduced. At a cost of goods in inventory at about 61% of the sales revenue, $16.725 million in inventory represents future sales of about $27 million, or over 80% of the sales for 2008.
What are we projecting for 2009? Inventory for Acme is way too high. We have far too much cash tied up in inventory, and with the long recession looming, this could be real bad as this inventory ages and perhaps becomes obsolete or unusable. Companies will sometimes continue to make inventory as the economy drops in order to keep direct labor employed. However, this can not continue indefinitely.
On the long-term side, we have added $10 million in new machinery. We will see how that was financed on the Liabilities side. All land buildings and machinery is depreciated over set schedules of time. In our case, in 2007 we had depreciated about 25% of our assets. With the addition of the new machinery, we are now depreciating about 22%. This $10 million investment would be an "unusual investment." Generally, one tries to invest each year an amount equal to that year’s depreciation.