Abstract
In its application, finance relies on financial statements, the balance sheet and the income statement. This chapter introduces a basic understanding of financial statements and some applications, especially in mergers.
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Notes
- 1.
A weak inverse correlation used to exist. Consider the time before modern security interests in personal property through recordation or filing, i.e., before Article 9 of the Uniform Commercial Code, when security interests in personal property were possessory. Then, such a correlation did exist. Because, to create a security interest in a chattel, one had to deliver possession of the chattel to the lender (the pawnshop), businesses could not use their chattels for secured borrowing. Then, the secured obligations tended to be long-term mortgage loans, and those encumbered real estate. Both the corresponding asset and the liability that it secured, tended to appear at the bottom of each side of the balance sheet. On the asset side, real estate appears at the bottom. On the side of liabilities and equity, long-term loans appear at the bottom of liabilities, however, still above equity, which is junior to all liabilities. So, even then, the liabilities and equity side was not arranged coherently from the perspective of seniority. Now, when with a filing, security interests can be created encumbering even the most liquid assets, such as receivables or cash, any relation between seniority and location on the balance sheet has disappeared.
- 2.
Neither the assets nor the liabilities would correspond exactly to what appears on the balance sheet. Most importantly, a viable business would be valued as a multiple of its earnings, typically much more than the value of its assets. Even if the business could not be sold as a going concern, assets that lose value over time, like machines or vehicles, do not tend to lose exactly as much value as depreciation removes (moreover, some may remain useful even after they are fully depreciated, in which case they are worth more than the zero to which they would correspond on the balance sheet). Appreciating assets, like real estate, may be worth more than their representation on the balance sheet, which may also be the case with some intellectual property. On the liabilities side, again, some liabilities may have prepayment penalties, making them costlier to repay than what appears on the balance sheet. Long-term liabilities that have fixed interest rate payments and trade in an exchange, like bonds, may produce one more discrepancy. Bonds could be bought instead of being repaid. They could be cheaper to buy than what appears on the balance sheet if interest rates have dropped.
- 3.
See Exercises 5–8.
- 4.
Market capitalization is the total value of all outstanding shares of a publicly traded business.
- 5.
This type of insolvency is also called bankruptcy insolvency or balance-sheet insolvency. These terms distinguish it from inability to service debts, which is also called equity insolvency or cash-flow insolvency.
- 6.
Do not confuse preferred and common stock with the two classes of stock that MSO has outstanding, class A and class B. It appears that both classes of MSO stock have the same seniority, whereas if one were senior to the other, meaning that in liquidation it would need to be paid in full before any value would go to the other class, then the senior class would correspond to preferred stock. Presumably, the reason that MSO has two classes is to give one class greater voting power, for the founder to maintain control of the board of directors with less than a majority of the stock.
- 7.
1 Moody’s Manual of Railroad and Corporation Securities 1632–33, 1764–65 (1921).
- 8.
The balance sheet is dated December 31st but is issued on March 4th. For the market price to match the balance sheet, the MSO balance sheet would have to experience an increase in its assets of about $263 million, a virtual doubling of MSO’s assets, from December 31st to March 4th, which has not happened.
- 9.
For example, Facebook on July 26, 2017, had a market capitalization of $479 billion, about eight times its equity of $59 billion (according to the Wall Street Journal, overview: perma.cc/ER3V-GZTH; balance sheet: perma.cc/R7NQ-FWSE); similarly, Google (Alphabet) had market capitalization of $664 billion, about four-and-a-half times its equity of $140 billion (overview: perma.cc/X5FJ-X6YP; balance sheet: perma.cc/6AG3-MGGM).
- 10.
See, e.g., In re O’Day Corp., 126 B.R. 370, 403 (Bankr. D. Mass., 1991) (“[I]f reasonable projections would have shown losses in the years after the LBO, … a balance sheet approach is appropriate [as opposed to valuing the going concern]” with very detailed analysis and numerous further citations).
- 11.
This stands in contrast to outstanding shares of the acquirer. Those likely already trade at a price significantly higher than their book value, but that does not trigger any obligation to update the balance sheet. In a sense, this treatment of the newly issued shares is not a result of the treatment of the acquirer’s balance sheet but of the marking to market of the target’s balance sheet. The target’s equity gets revalued at the value of the consideration that the acquirer gives. Then, because the consideration is equity, it appears as such on the acquirer’s balance sheet.
- 12.
It turns out that a couple of years later, MSO was bought out at a 20% premium over its market price at that time. However, in the meanwhile Martha Stewart was convicted and spent some time in jail and MSO itself had not done well so that its market price was quite a bit lower. See, Michael J. de la Merced, Martha Stewart’s Empire Sold for Fraction of Its Former Value, N.Y. Times June 22, 2015, at B6 https://www.nytimes.com/2015/06/23/business/dealbook/martha-stewarts-media-empire-sold-for-fraction-of-its-former-value.html [perma.cc/5R5A-CWN5] (announcing MSO being bought by Sequential Brands for $6.15 per share for a total price of $353 million suggesting the outstanding shares were about 57.4 million).
- 13.
These terms have some similarities to the deal between MSO and Sequential Brands, which was a 50% cash deal based on the average price of Sequential on the last few days before the merger but gave each shareholder the option to elect away from the 50–50 split subject to proration; was for a 20% premium over the pre-announcement price (but the resulting price was $6.15 per share); was to be paid with loan proceeds; at a time when Sequential had about $295.5 million of long-term debt and about 30 million shares outstanding but they had par value of $0.01 per share but traded in the $12–$15 range. See generally Martha Stewart Living Omnimedia, Inc., Proxy Statement (Schedule 14A) (Oct. 27, 2015) www.sec.gov/Archives/edgar/data/1091801/000114420415060980/v422845_defm14a.htm [perma.cc/68ES-H5F7].
- 14.
This figure is approximately the price of Sequential Brands stock in March of 2013.
- 15.
This is new goodwill as opposed to potentially existing old goodwill due to prior acquisitions of Sequential Brands. The assumption, however, is that no old goodwill exists.
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Georgakopoulos, N.L. (2018). Financial Statements and Mergers. In: Illustrating Finance Policy with Mathematica. Quantitative Perspectives on Behavioral Economics and Finance. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-95372-4_9
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