Rick Makoujy - How to Read a Balance Sheet

Rick J. Makoujy, Jr.

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Dont be afraid of this book. My intention is to explain financial statements and related concepts in easy-to-understand language, not confusing industry jargon as is found in every other finance-related work Ive seen. The goal is to impart solid comprehension. If you cant do so already, after carefully reading this book you will be able to understand the business section of any newspaper, including my favorite, The Wall Street Journal. You will also find that while that the skills and knowledge described herein are business oriented, there are also parallels throughout this book to ones personal financial well-being.

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The genesis of this book is, as Paul McCartney and John Lennon (mostly McCartney), so eloquently put it, a Long and Winding Road, but which may be succinctly summarized as accounting is taught wrong. While I scraped by with a B in Accounting 101 as an undergraduate at Vanderbilt University, I walked away from the course feeling slightly less educated than I was before the class started. It seemed as though the professor received satisfaction from tricking the students. Sooo, she would say while pointing to the board wearing a Cheshire cat grin, Is it a debit or a credit? Most of the class would sheepishly state in nervous whispers, Debit? No! she would thunder. Its a credit! Ha, ha, ha!

I learned much later that she was, in effect, teaching us a little bit of brain surgery. Unless her students were likely to be accounting professionals in some capacity, general ledger entries and debits and credits only serve to confuse the bigger picture (which, frankly, is all that most people will ever need but few will ever properly understand).

After college, I landed a job with Price Waterhouses (PW) Restructuring Practice in New York City. We helped those who were owed money (i.e., creditors) from companies in bankruptcy (i.e., debtors) figure out what they might ultimately recover as a percentage of what they were owed. As a junior professional, my job was to input data and create many spreadsheets. (I became a Lotus 123 wiz.) Despite PWs status of being a premier Big Six accounting firm (alongside Coopers & Lybrand, which later merged with PW; Arthur Anderson, which later imploded during the Enron document shredding scandal; Deloitte & Touche; Ernst & Young; and KPMG Peat Marwick), I really wasnt close to being proficient in accounting, even after a couple of years. My salary seemed generous on the surface until I moved New York City, absorbed the much higher cost of living, and divided my income by the hours worked.

Two years later, anxious to move past paycheck-to-paycheck living, I solicited various Wall Street firms for open positions. Fortunately, the Price Waterhouse name on my rsum opened interview doors; I landed a job as a securities analyst for a distressed securities brokerage firm that had broken off from Bear Stearns. (Remember them?) The firm was relatively small and had no formal training program but assumed that my skills were far more advanced than they were. I was asked on my first day to create projected balance sheets for a company in bankruptcy protection. I had no clue as to what to do. Fearful of losing the job I so badly needed, I sat down with an annual report and my trusty Lotus 123 spreadsheets.

Starting with the relatively straightforward income statement, I figured out the simple subtraction to get from revenue to net income. However, the interaction between the statements proved to be more of a challenge. If net income increased, shouldnt cash on the balance sheet go up by the same amount? After some contemplation, it occurred to me that, for example, if a company had recorded a sale but had not yet gotten paid, its receivables (money owed by customers) would go up. This increase in receivables, while still counted as part of net income, would not increase cash until the customers paid their bills. Making similar adjustments for increases in equipment purchases and borrowings, I finally got the result I so desperately sought: the balance sheet balanced. In other words, the companys assets equaled its liabilities plus net worth. My first reaction was relief and joy. My second was: Why hadnt anyone ever explained financial statements to me like this before? Career lightbulb no.1 went on.