LITMIR.BIZ

      If Equation [1-19] isn't satisfied, the Balance Sheet isn't balanced and there is something wrong with the numbers.

      Following the model used when analyzing the Basic Income Statement, an inspection of the Balance Sheet in Table 1-3 results in a number of equations that describe the relationships between the various accounts.

      Current Assets consists of Cash, Accounts Receivable (money customers owe the company), and Inventory. Therefore:

      Similarly, Fixed Assets consists of Property, Plant, and Equipment (PP&E), which represent the fixed assets the Company needs to produce its deliverable, and Accumulated Depreciation, which represents how much of these assets have been expensed through the Income Statement as they wear out.

      For example, if a hard asset is purchased for $5,000,000 and has an estimated useful life of 10 years, then the amount the asset would be depreciated each year would be $500,000 ($5,000,000/10)12 and after two years the accumulated depreciation for this asset would be $1,000,000 ($500,000 * 2).

      All of this can be expressed as

      Intangible Assets includes such things as Goodwill, which is created when an Asset is purchased at a price in excess of its book value. Other Intangible Assets are such things as patents, non-competes, and customer lists if acquired as part of an M&A transaction.13

      Again an example may be helpful. If a patent acquired as part of an acquisition of a company was valued at $3,000,000 and had 10 years remaining before expiring, it would be amortized at a rate of $300,000 ($3,000,000/10) per year for 10 years and at such time the accumulated amortization associated with the patent would be $3,000,000, leaving a net tangible value for this asset of zero.

      Net Intangible Assets can be defined by Equation [1-24]:

      Applying the same process to the Liability side of the Balance sheet:

      Current Liabilities consists of Accounts Payable,14 which is money the company owes its suppliers, Taxes Payable, and Short-Term Debt, which is interest-bearing debt that has to be repaid in less than one year.

      Long-Term Debt is interest-bearing debt and has a tenor of more than one year before it has to be repaid or rolled over.

      Total Shareholders' Equity is the sum of the money the company took in when it raised capital by selling shares in the Company to investors and Retained Earnings, which is the sum of all the profits and losses of the Company since inception minus any dividends that have been paid.

      Return on Capital Employed

      Management teams perform better if they are measured against some set of criteria. One of the criteria that is of interest to investors is the return provided by funds invested in the business. A measurement of this is “Return on Capital Employed.” The classical definition for Return on Capital Employed (ROCE) is:

      [1-28]

      where:

      Before Equation [1-28] can be used it's necessary to define NOPAT in terms of Income Statement terminology. The Income Statement in Table 1-1 has several line items such as EBITDA, EBIT, and EBT that state income at different levels. EBITDA and EBIT are clearly operations oriented. EBT is not, because it would include the impact of any interest expense or income. Interest is a result of capital structure (Debt the company takes on to its balance sheet) or interest income generated by any excess cash and isn't operating income per se. Therefore, the income classification that states the Operating Profit is EBIT. To comply with the definition it has to be tax affected, hence the expression for ROCE becomes

      [1-29]

      or

      [1-30]

      In a general sense, managers are tasked with two key objectives: (1) Find attractive investments, and (2) deliver attractive returns. Since ROCE compares what management delivers (Net Operating Profit after Tax) to what has been invested in the company (Capital Employed), ROCE is a key measure of how well management is performing and is often used in the annual evaluation process of management teams.

      Capital Employed

      Capital Employed (CE) can be defined with the assistance of the Balance Sheet (Table 1-3).

      By definition, the Capital Employed in a business is the capital provided by equity holders and holders of equity-like instruments, earnings retained in the business, and interest-bearing debt (such as bank loans, bonds, private placements, and so on).

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