Chestnut & Cedar Stock Report - The Balance Sheet

Introduction to Fundamental Analysis

- The Accounting Process
- Postulates and Principles
    of Accounting
* Postulates of Accounting
   * Principles of Accounting

- The Financial Statements
   * The Balance Sheet
    * The Income Statement
    * The Cash Flow Statement
    * Shareholders' Equity Statement

The Balance Sheet

The balance sheet reflects the financial position of a company, as of a particular date. It shows, in detail, the assets (resources) of an organization and the claims on those assets. The claims are normally creditors and shareholders. The difference between what a company owns and what a company owes is its net worth. A classified balance sheet is more analytical. It groups accounts with similar economic characteristics, usually, by their short-term or long-term nature. Short-term assets should be funded by short-term liabilities; while, long-term assets are preferably funded by long-term debt or equity. Categories are listed in liquidity order. Liquidity is the length of time it takes to convert an asset into cash. The purpose of a classified balance sheet is to pinpoint asset/liability mismatches. Over all, the balance sheet gives investors a wealth of information on the financial health of a company, as of a particular date.

The main categories on the balance sheet are: cash, marketable securities, accounts receivable, notes receivable, inventory, fixed assets, accounts payable, accrued expenses, loans payable, common stock, and retained earnings. While the categories appear to be straight forward and clear-cut, the supporting details and values used can be extremely complicated, and are highly regulated by accounting, legal, and various government bodies.

Balance Sheet Values

The values reported on the balance sheet are normally determined by adjusting historical cost figures downward to approximate fair value, where practical. Technically, most of the values on the balance sheet are based on methodologies such as cost, lower of cost or market, net realizable value, cost less a depreciation or amortization method, discounted cash flows or fair market value. Balance sheet values normally are not written up to market value. This results in a statement that conservatively presents the position of a company, but it’s also rather complicated.

For example, one would think that valuing marketable securities on the balance sheet is a simple process; just take the number of shares owned and multiple them by their market price, to calculate market value; charging the P&L for price swings. In fact, however, there are three different methods to value marketable securities, based on management’s intent.

They are:

1. Held-to-maturity securities – These are usually debt instruments that are valued at historical cost and adjusted for interest.

2. Trading securities – These are securities that are frequently bought and sold. They are valued at their fair market price with both realized and unrealized gains and losses being recorded in the P&L.

3. Available-for-sale securities – These are securities that management intends to sale. They are valued at their market value. Realized gains or losses are charged to the P&L, while unrealized gains or losses are charged directly to shareholders’ equity.

The investor’s dilemma is that most of the accounts on the balance sheet have similar multiple choice options. Reading the plain categories of a balance sheet is just not sufficient in today’s environment. This is why knowing the rules is important.

Regarding stock prices, a company’s market value is normally different than its accounting value. Basically, customer relationships and products add value; as such, businesses are usually valued higher then a company’s accounting book value.

Investors would love to have updated minute by minute fair market value financial statements, similar to how stock portfolios are tracked. However, intricacies and estimates used in preparing financial statements make it neither practical nor cost efficient to have such statements prepared at this point in time. Accountants have a hard enough time accurately reporting within 45 days of the end of each quarter and 75 days of year-end. Even if the raw data to produce financial statements is available, the accounting, audit, legal, and management sign-off process takes time. Now it’s time to dig into the numbers and statistics. It’s going to take 6 sections to get a grasp of fundamental analysis.

Medtronic, Inc. (“MDT”) is being used as our example.

MDT - Consolidated Balance Sheet ($ in millions, except per share data)	April 29, 2005	April 30, 2004
Assets
Current assets:
Cash	$ 2,232.2	$ 1,593.7
Short-term investments	1,159.4	333.8
Accounts receivable, net	2,292.7	1,994.3
Inventories	981.4	877.7
Deferred tax assets	385.6	197.4
Prepaid expenses	370.2	315.8
Total current assets	7,421.5	5,312.7

Property, plant and equipment	1,859.3	1,708.3
Goodwill	4,281.2	4,236.9
Other intangible assets, net	1,018.0	999.3
Long-term investments	1,565.7	1,456.3
Other assets	471.7	397.3
Total assets	$ 16,617.4 ========	$ 14,110.8 ========
Liabilities and Shareholders’ Equity
Current liabilities:
Short-term borrowings	$ 478.6	$ 2,358.2
Accounts payable	371.8	346.2
Accrued compensation	542.2	459.8
Accrued income taxes	923.3	637.6
Other accrued expenses	1,064.1	438.8
Total current liabilities	3,380.0	4,240.6

Long-term debt	1,973.2	1.1
Deferred tax liabilities, net	478.1	408.2
Long-term accrued compensation	157.9	123.7
Other long-term liabilities	178.7	260.2
Total Liabilities	6,167.9	5,033.8

Shareholders’ equity:
Common stock	121.0	120.9
Retained earnings	10,178.5	8,890.9
Non-owner changes in equity	150.0	65.2
Total shareholders’ equity	10,449.5	9,077.0
Total liabilities and S/E	$ 16,617.4 ========	$ 14,110.8 ========

Medtronic, Inc. Balance Sheet Statistics	April 29, 2005	April 30, 2004
Book Value – per share:
Total Assets	$ 16,617.4	$ 14,110.8
Less: Total liabilities	6,167.9	5,033.8
Equals: Book value	10,449.5	9,077.0

Average Common shares O/S	1,220.8	1,225.9
Book value per share	$ 8.56	$ 7.40

Tangible Net Worth – per share:
Book value	$ 10,449.5	$ 9,077.0
Less: Prepaid expenses	370.2	315.8
Less: Goodwill	4,281.2	4,236.9
Less: Other intangible assets, net	1,018.0	999.3
Tangible net worth	4,780.1	3,525.0

Average common shares outstanding	1,220.8	1,225.9
Tangible net worth – per share	$ 3.92	$ 2.88

Air – per share:
Tangible net worth – per share	$ 3.92	$ 2.88
Year-end price – per share	52.70	50.46
Air – per share	$ 48.78	$ 47.58

Working Capital:
Current assets	7,421.5	5,312.7
Less: Current liabilities	3,380.0	4,240.6
Equals: Working capital	4,041.5	1,072.1

Current Ratio:	2.20 to 1	1.25 to 1

Debt to Equity:
Total liabilities	6,167.9	5,033.8
Total stockholders’ equity	10,449.5	9,077.0
Debt to equity	59 %	55 %

Next review The Income Statement