Introduction to Accounting: What you need to know about equity and debt in order to understand the concept of dividends

In this blog post we shall analyse the balance sheet and talk a bit about ratios like p/e and p/b. It´s super important that you understand the red line between equity, debt and dividends (I´ll write the norwegian terminology in brackets) , and this blog post will teach you exactly that!

The investment side of the balance sheet

A company’s balance sheet can be divided into two parts, the investment part and the financial part. On the left side, you will find two sections: Fixed assets (anleggsmidler) and Current assets (omløpsmidler). Let´s dig deeper:


  1. Fixed assets:
    1. Here you will find the following:
      1. Intangible assets (immaterie eiendeler) ->
        1. Example: Sales- and production rights.
      2. Tangible assets (materielle eidendeler)
        1. Example: Rental appartments, ships, machines…
  • Financial fixed assets (finansielle anleggsmidler)
    1. Example: Long term stock investments

According to norwegian law, RL § 5-1, fixed assets are defined as assets which are supposed to be lasting ownership and useable. Example of this could be stuff like houses, apartments, assets, long-term stock holdings to name a few.


  1. Current assets:
    1. Merchandise (varer)
    2. Receivables (fordringer)
      1. Example: Customer who needs to pay money to the business because they bought it on credit.
    3. Investments (financials)
      1. Example: Short term stock ownership (trading)
    4. Bank deposit and cash

According to Norwegian law, RL §5-1, Current assets are other stuff than fixed assets. The point is that these assets are way easier to trade than the fixed ones.

As you see, the left side of the balance sheet is about what the company owns. When a company earns more money, they can choose to invest more into the left side of the balance sheet, which again could result in even bigger profit in the future.

 

The funding side

On the right side of the balance sheet, we have the financial aspect of our business. There are also two main sections here, namely Equity (Egenkapital) and Debt (Gjeld). It looks like this:


  1. Equity
    1. Deposited equity (Innskudd egenkapital)
    2. Earned equity (Opptjent egenkapital)
  2. Debt
    1. Commitments (Erstatningsansvar etter ulykke, utsatt skattegjeld)
    2. Other long-term debt (langsiktige banklån)
    3. Short term debt (Kortsiktige banklån, leverandørgjeld, utbytte, betalbar skatt)

 

Very often, a company needs debt in order to be able to buy the assets that they want. The guys that give companies debt is the banks. However, these guys aren´t willing to just give anyone a loan. No sir! Often, the company needs to have a certain amount if equity in order to get approved from the bank. This is to make sure that the company are able to pay the debt without any problems. The normal ratio in Norway here is 40% equity and 60 % debt.

Example

Let´s say you are the bank. Mr mister comes to your bank and wants to buy a house. You say, fine, how much do you want to borrow? He says $1 000 000. You say, okay, how much equity do you have? He says none. So you say, well then Mr mister, how on earth should I know if you are able to pay back the loan that I would be offering to you. He answers that you wouldn´t know and that you should trust him because he his such a pretty lad. Well, you get the picture. The bank needs to know that you have equity.

Two major risk elements regarding debt

  • Short term debt, which are bills that needs to be paid ASAP and you need to have the money in the hand or else you will get f… As you understand, it´s critical that you have enough money to pay the short-term debt, unless you might be forced to sell some of you assets or even take another loan with very bad interests. The solution to short-term debt is that the company has enough liquidity (likvidiet) which basically is the same as a measurement for figuring out how much $ in hand.
  • Long term debt is not the same as short-term debt, because it normally has way lower interest, and the guys that have given you this loan are normally way nicer than the short-term sharks. The solution to this is to have a good solvency. Let´s explain that too:

In the long-term perspective, one uses solvency (soliditet) to figure out how much equity vs debt a company has. A good solvency can be seen as how stable and secure a company is. Again, say that Mr mister has $999 000 in his pocket, and he wants to borrow $100 000. Well, now you would say sure, why not. He can pay back the interest without any trouble.

Ooooooookey, so now we have talked about the balance sheet, WHAT WAS ALL OF THAT ABOUT STOCKLES?

So what about dividends?

Well, the thing you need to understand is this: When a company has positive earnings, those earnings goes straight to the equity part of the balance sheet. Those money can again be spent on the left side, buying more assets which can make the business even greater, which again results in an even greater return for YOU. Or, it can reduce debt, or pay dividends.

So, what happens if a high yielding company doesn´t have positive earnings, but pays out dividend anyhow? Yeeeeep, you know it. They have to take money from the “equity bag”, which again will make the banks say whooooo hey there cowboy. Are you sure about that? How much are you taking? Can you pay the loans now big fellow? Sure? …. They might say, this is crazy! If you do this, we shall decrease your credit rating! And if they do that, they are basically saying, we are less sure that this company can pay it´s obligation than we were before.

So you see, dividend payment isn´t just something magical which has 100% positive stuff along with it. It´s a fine balance, and you should always make sure you understand the risk when you invest in something!

A few short words when looking at key ratios:

  • P/E
    • Price / earnings is a ratio which we get when we divide the current share price over it´s past earnings. Here, the current share price reflects what the market values the company, and earnings (bottom line) is the what the company is left with after costs (debt, interest,…,) are subtracked from  the revenue (top line). Note: Earnings is what keeps the ship away from sinking.

NB: When looking at P/E ratios, you need to look at sector P/E. This is a much better ratio than P/E alone. Here´s why:

“One primary limitation of using P/E ratios emerges when comparing P/E ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due both to the differing ways companies earn money and to the differing timelines during which companies earn that money. As such, one should only use P/E as a comparative tool when considering companies within the same sector, as this kind of comparison is the only kind that will yield productive insight” – Investopedia

  • P/B
    • Price / book is a ratio which we get when we divide the current share price over it´s book value. The book which is referred to here is what is left if one sold all of the tangible assets ((Apartments, Rentals, ships, machines, inventory)– the liabilities that the firm has. In super easy English, P/B = If one sold everything they could sell – what they need to pay the bank. As you see, P/B works pretty well for banks and insurance, because when they sell everything they have – their debt, there aren´t much stuff left, which means it´s quite accurate. For other stuff, like gaming companies, it´s harder to sell what they have (how do you sell the great concept of Call of Duty)?

That was it. Now I hope you know a bit more about accounting, and with this in our head, we can finally analyse a few companies.

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16 comments

        1. Yeah. Do you think that it´s generic? I just don´t see how they are made up (a program which reads the topic, generatics a random comment)? Sounds like a pretty sophisticated program.

    1. Hi Tom,

      Man! That´s awesome. I´m so glad to an accounting teacher both bothers to read this post, but also find it somewhat read-worthy. I´m not an expert at all, but I believe that understanding accounting is a pretty essential part if one wants to become a real investor! Thanks for commenting!

    1. Hi Dividend Portfolio,

      Glad that you found the post read-worthy. I try quite hard to make difficult subjects “easy” to read. Finance doesn´t have to be difficult, but strange and compliated terms can make any man afraid of starting to learn something new. Appriciate your comment and don´t hesitate asking if you want more info!

  1. Thanks Stockles and good start to accounting intro. I do have an Intro to Accounting college text book sitting on my desk that I have read probably about half way through, but then got side tracked by a Corporate Finance text book which I’ve found to be even more interesting : )

    When I was young (in 20s), I thought accounting was probably the most boring subject in the world, even though I didn’t know anything about it, just the sound of it was so boring. But now, I find accounting and finance to be the most interesting subjects and also extremely useful when investing.

    BTW, regarding banks, they are so damn hard to figure out with all those loan provisions piled up. I would be very interested, if you get more into bank valuation or balance sheet review.
    Mr. ATM recently posted…Quick Update On TMy Profile

    1. Hi Mr. ATM,

      Haha, been there too! Also like Corp more than accounting, but you are so right: I´m not sure why accounting is seen upon as something drier than the dessert. It can be quite cool and it gives profound feeling of knowing a business.

      True! Banks are hard. I´ll see what I can do! The next subject that I will go through is the balance sheet of two norwegian industrial companies. Really looking forward to that!

      Thanks for commenting!

      1. So true! Well, hehe, that´s kind of what I ´ve been doing. 3 years engineering, then 5 years finance and accounting. Hopefully, it should provide me with some good tools in the future.

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