Biz4theRestofUs, Keeping Small Business in Business.

Balance sheets give a more strategic view of a business. They summarize the cumulative effect of business decisions.

• Is the business viable?
• Is it solvent?

Businesses are closing and merging a faster rate in 2009. So, every day there’s a balance sheet in the news. Let’s start at the top.

A central bank has a monopoly on creating a currency to lend to a government as legal tender. The central bank generates income by charging interest on the money it lends.

The Federal Reserve, our central bank, was created in 1913 as a response to several runs on banks.  Panics occur because banks only hold a fraction of their deposits in reserve while simultaneously maintaining an obligation to redeem them on demand. The Fed is the lender of last resort; that is, it will loan money to a bank to prevent collapse. Sounds familiar. 

How does a bank collapse? Debt is a form of leverage; that is, a company incurs debt to fund growth and improvements. Hopefully, those changes will produce the additional income to make the debt payments. It doesn’t work that way for the banks.

• A bank deposit, our money, is a liability on the bank’s balance sheet because they owe money to us, the depositor. Suppose we deposit $1,500. Since we are making this simple, the net worth is $-1,500 because the only thing on the books is the bank’s debt to the depositor.
• The bank keeps a fraction of the deposit and lends the rest. Let’s say the ratio is 10:1. Now the bank creates an asset by lending $10,000 to someone else. Notice that the bank created that money with fractional reserve banking. Then they generate income from the asset by charging interest. Now the bank has a net worth of $8,500 (the $10,000 asset minus the $1,500 deposit).
• Suppose the lender defaults after paying off $2,000 of the loan. Then assets are now $2,000 in cash and the rest turns into an $8,000 loss. The bank now has a net worth of -$7,500. (Stay with me here: The bank has $2,000 in assets and debt of $1,500 plus the $8,000 default giving a net worth of -$7,500.) Few of us would lend money to someone with a negative net worth. –At least now we wouldn’t!

The Bank of America had $1,817,943 million in assets, 1,640,891 in liabilities and a $177.052 net worth. Their debt is about 9 times their net worth. This number is pretty typical of banks. Remember, they had a huge cash infusion in 3-4Q 2008. Also, remember that part of the $1 trillion in assets is loans.

Another example of negative Stockholders Equity (the net worth of a corporation) is General Motors.  In March 2007, they had $21 billion in cash, $10,000 in receivables. They had $30 billion in payables and accrued expenses of $34.5 billion. We want the receivables (next month’s income) to be about twice as much as our payables (next month’s bills). Looks like things are not so good for next month.

Other current assets (inventory, equipment and leases) were 5 billion less than current liabilities (lines of credit, etc.)  These assets could represent collateral for a loan. Looks like they are not a good candidate for a loan. But we are not done yet.

They also owed $33 billion in long-term debt (corporate bonds, etc), $49 billion in post retirement benefits and $11 billion in pensions. They wisely invited the union to the negotiating table when restructuring their debt. Things look really, really not good for post retirement benefits and pensions.

The stock is still actively traded and our government is on the case. It’s nice to have help.