NEW HIRES

Under this apprenticeship model, there is a tremendous information gap between those with actual business experience and outsiders: The only people who truly understand what happens on a trading floor are the ones who are already working there. How, then, are potential candidates to know whether a career in sales and trading would be interesting to them? The glamorized and greatly exaggerated image of Wall Street offered by Hollywood, or found in the gossipy, tabloid-style memoirs of some former industry employees, while certainly entertaining, does not accurately depict the day-to-day realities of a typical trader or salesperson in the equities division of an investment bank. The surprising fact is that the majority of applicants seeking jobs on Wall Street do so with as much, or more, misinfor mation about what they think the role will entail than concrete knowledge of what actually awaits them.

The information gap also makes the recruiting and hiring process inefficient. It is difficult to effectively interview someone who, in practice, does not speak your language and knows almost nothing about the job he is applying for. One of the reasons why Wall Street job interviews contain such notoriously obscure and seemingly random questions and requests as “Tell me how many ping-pong balls would fit inside a 747.” or “Let me hear you shout.” is that, if you cannot ask candidates questions specifically related to the role, then it is only possible to get a sense for their skills and qualifications in very roundabout ways.

Unfortunately, until now, even if new candidates have made a correct choice and the sales and trading business is the place for them, there is no way they can prepare in advance. Ask any trader or salesperson and you will get a similar response: The Harvard MBA, the Princeton economics major, the MIT physicist and every one of the other exceptionally bright, hardworking, and talented young people that come to Wall Street are, upon arrival on their first day of work, pretty much useless. It is not that they are not capable; they have simply studied the wrong things, and for the most part, lack applicable knowledge.

Without taking anything away from the enormous value of formal education, the fact is that the standard academic treatment of finance specifically removes from consideration most of the contribution provided by the sales and trading division. In order to model the complexities of real-world finance, certain simplifying assumptions are made: investors are assumed to be perfectly rational and markets are modelled as “efficient,” meaning that the price of a stock incorporates all available information about the prospects for that company. If that were the case, there would be very little that a salesperson or trader could contribute to the investment process. What is more, the first assumption of virtually any stock valuation or derivative pricing model is that there are no trading frictions of execution costs. However, it is precisely these frictions that are the primary sources of revenue for the trading floor. The details academia excludes are actually the bread and butter of Wall Street.¹ While in recent years many universities have taken steps to give a more “real world” focus to their curriculum, this is still, in most cases, a nascent effort.

Perhaps the most glaring example of the inefficiency caused by outsiders’ lack of basic trading floor knowledge comes from the experience of Wall Street’s summer student interns. Summer internship programs are considered to be the highest-probability route to a Wall Street job for undergraduates and MBAs and admission is extremely competitive, with acceptance rates at tier-one institutions of as low as 2 to 3 percent. Students prepare intensely for their 10-week programs, during which they rotate through various desks on the trading floor, sitting beside the traders and salespeople, doing small jobs, and learning about the business in the hope of making a good enough impression to receive a job offer for the coming year. For students interested in a career in financial markets, there is really no better learning opportunity than to sit on the “front lines” of finance at a top tier investment bank and watch firsthand how the institutional traders and salespeople actually make it all happen.

Unfortunately, for many students, this opportunity is largely wasted. On arrival, the typical summer intern has so little idea of what happens on the trading floor that they spend most of their summer just trying to orient themselves. Their time with traders is squandered asking very basic questions that could be easily learned from a book, much to the frustration of busy front-office employees. Many interns finish their summer rotations with little more than some vague notions of what they have been told, a few notes or handouts, and the sense that something very important was going on, but that it was beyond their reach.

The logic behind the Wall Street apprenticeship model is that the subtleties and nuances of real-world finance can only be learned through experience. The inefficiency in the model is that, without an organized presentation to guide them, new hires and summer interns spend a great deal of time and effort learning basic concepts, and it is only after many months of working that the more refined understanding begins to develop.

In many ways, mastering the skills necessary for success in sales or trading is like learning to drive a car: there is simply no other option than to get behind the wheel and do it—slowly at first, and then gradually building up confidence, picking up speed, and taking on greater challenges. Where the problem lies, and what this book endeavors to solve, is that, if working in institutional trading and sales is like driving a car, historically there has been no driver’s education course or handbook of road rules. New hires have been arriving on the job without knowing what the gas pedal, brake, or steering wheel are for and having never seen a street sign in their lives. What few books have been available were designed for experts and were as useful as a physics text on the thermodynamics of engine combustion would be to someone learning to drive.

EXPERIENCED PROFESSIONALS

Many firms provide employees with opportunities for additional professional development, though for the most part, beyond the initial training programs, learning is done on an ad hoc basis and in a fairly disorganized manner. Some traders and salespeople take it upon themselves to be a student of the business, and extend the breadth and depth of their understanding as far as possible. Most, however, assemble what can best be described as a “mosaic” understanding of the sales and trading business: based on the combination of a number of small pieces of information picked up from various places over time, they put together a broad picture of the activities on a trading floor which is fairly complete, but only from a certain distance. Drill down more closely and you will find that there are often significant holes in their comprehension and many areas are lacking in detail.

So long as a trader’s or salesperson’s activities remain limited to his or her primary area of expertise, this lack of a more granular understanding of other products is generally not a problem. In recent years, however, many of the traditional distinctions between groups within the equities division have been blurred or outright eliminated. Traders and salespeople whose experience had been limited to one area have to contend with the full spectrum of equity and derivative products including single stocks, portfolio trades, ETFs, futures, swaps, and options. This challenge is even more exaggerated for new transfers into the equities division from other asset classes who face a steep learning curve but lack a formal process by which to ascend it.

Buy-side traders working at hedge funds, mutual funds, pension funds, endowments, retail brokers, and investment advisors face a similar challenge. While many have ample experience and product knowledge, often obtained during previous careers as Wall Street traders or through a construction of their own mosaic, there are others who lack a detailed understanding of how the sales and trading business works. The lack of opportunity to obtain the “Wall Street Education” that comes from working on a trading floor means they often work at a significant informational disadvantage to their brokers, which can be a source of friction. Of particular importance are the cases where this lack of understanding manifests itself in a disagreement over how to calculate a fair price or what are reasonable expectations of the broker: It can be extremely difficult for parties with conflicting economic interests to come to an agreement without an independent reference.

WHY DO WE NEED ANOTHER FINANCE BOOK?

So clearly the way traders and salespeople acquire this large, unstructured body of knowledge is inefficient, but why do we need a new book? Don’t the hundreds of existing finance books already explain everything a trader or salesperson needs to know? The answer is, strangely enough, no. While there exist books covering almost every aspect of academic and applied finance, the genre of “Introductory Institutional Finance,” which best describes the contents of this book, has somehow not yet emerged.

In the existing finance literature, the words “introductory” and “institutional” have been treated as mutually exclusive. Books targeting the institutional (i.e., “professional”) investor tend to focus on sophisticated pricing and risk management concepts appropriate only to those who are already experts in their field, while introductory texts provide personal financial planning advice or trading strategies (“How to Get Rich Trading XYZ”) relevant only to the retail (“nonprofessional”) investor.

A useful illustration of the dichotomy between the retail and institutional viewpoints comes from the concept of liquidity, which measures how many shares of a stock can be bought or sold in a given period of time without significant impact on the price. Due to the large size of institutional order flow, the concept of liquidity is ubiquitous in the activities of the professional trader and salesperson; it is the most fundamental factor in the analysis of risk and the first consideration in the execution of every client or proprietary order. For retail investors, on the other hand, liquidity is almost irrelevant due to the small size of their orders. However, despite its preeminent importance in institutional finance, liquidity considerations receive scarce attention in the existing literature because these books are written for professionals who, it is assumed, are already well versed in such a basic concept.

In writing this book, I have attempted to fill this gap in the literature. My intention is to provide the introductory explanation of the fundamental workings of the trading floor that I was looking for when I began my career, and that new hires have asked for on countless occasions since then (and continue to ask for). It is also meant to serve as a reference text for more senior traders and salespeople for those situations where they find it necessary to patch over a particular crack in their knowledge. This book does not pretend to be a substitute for what is learned through an apprenticeship on Wall Street. Success as a trader or salesperson requires an understanding of the subtleties of markets, risk management, and client relationships, which can only be learned through experience. My goal is to provide a logically structured and detailed presentation of the basic terminology and concepts of equities sales and trading so as to soften and shorten the steep learning curve that new arrivals to the equities division have traditionally encountered.

OVERVIEW OF CONTENTS

This book provides an overview of the front office sales and trading business of a typical Wall Street investment bank or broker-dealer. In selecting and structuring the material to include, and the level of detail to present, the primary criterion has been the probability that the reader would find the information useful in practice, either in a front-office environment or as a buy-side client. Anything I would not expect of the trader or salesperson sitting next to me on the trading desk, or that would not significantly benefit his or her job performance, has been omitted to ensure the reader is not distracted from the relevant material. The presentation and pace of the book are based on my own experience explaining this material to both junior and more senior professionals over many years.

Throughout the book I have made an effort to introduce, wherever possible, the language and terminology used by traders and salespeople in practice. Not only is there a great deal of vocabulary that is unique to the trading floor, but the correct use of that language, down to the trading-specific interpretations of the prepositions “for” and “at” is essential for such a fast-paced environment where it can easily mean the difference between a successful trade and an expensive error.

So that the book is accessible and useful to the broadest possible audience, the prerequisites have been kept to a minimum. The reader is assumed to have no particular familiarity with finance or economics beyond what could be considered the commonsense understanding of the dynamics of supply and demand. (Specifically, that an increase in demand, or scarcity of supply, for any good, tends to drive the price of that good up, while a decrease in demand, or excess supply, leads to lower prices.) However, because modern finance is inherently mathematical, it is necessary that the reader understand some of the basic concepts from calculus, probability, and statistics. Fortunately, our interest is only at the conceptual level: The reader must understand, to use one example, that the mathematical definition of the derivative measures a rate of change and can be interpreted as the slope of a line. It will not, however, be necessary that the reader be able to actually calculate the derivative. An appendix is included with a brief overview of the relevant mathematical concepts for those readers in need of a refresher.

A final observation is that, while the book is written from a U.S.-centric perspective, the structure of the equity sales and trading business globally is quite consistent and the concepts presented here can be easily extended to international markets, making the book relevant for both U.S. and international readers.

LAYOUT

The ordering of the material across the whole book has been carefully chosen so that, to the greatest degree possible, terminology and concepts are introduced with an appropriate motivation and readers with no previous experience will be best served by reading each chapter in sequence. At the same time, the structure of each chapter is designed to be a self-contained unit and readers with more experience can go directly to the chapters that interest them.

Part One: What Is a Stock?

The book begins by analyzing the most fundamental question about equities: what is a stock and what determines its price? We look at the first of these questions in Chapter 1, where we present the basics of financial accounting and the contents and structure of the standard financial disclosures made by companies (Balance Sheet, Income Statement, and Statement of Cash Flows). In Chapter 2 we look at various valuation methods used to determine the fair price to pay for a share of stock. While both of these subjects are amply covered in many other texts, the focus here has been to narrow the scope of the material down to those concepts and terminology of greatest practical use to the average trader or salesperson.

Part Two: Products and Services

The main body of the text, consisting of Chapters 3 through 11, covers all of the major equity and equity derivatives products. Each chapter focuses on a particular product or service (with the exception of Chapter 11, which summarizes several) and the ordering has been deliberately structured as a progression from simple to more complex products. The material can be divided into four sections, each of which centers on a particular concept:

1. Single Stocks: The first section (Chapter 3) focuses on the “cash” market for single stocks and provides a considerable amount of detail about market conventions and the relationship between salespeople and traders, much of which is directly applicable to the trading in other products.

2. Multiple-Stock Products: The next three chapters look at equity products that incorporate multiple underlying stocks. This includes equity indices (Chapter 4), program trading (Chapter 5), and exchange traded funds, or ETFs (Chapter 6).

3. One-Delta Derivatives: In this section, we encounter our first true derivatives, but restrict our focus to those that directly replicate exposure to the underlier (so called, one-delta derivatives): forwards and futures are covered in Chapter 7, and equity swaps in Chapter 8.

4. Derivatives with Variable Delta: In the last section (Chapters 9 and 10), we look at options, which have a varying sensitivity to the movements of the underlying stock (delta not equal to one).

The final chapter of Part Two is Chapter 11, which contains an overview of the various other groups that are either on, or interact with, the trading floor, and the services they offer.

Part Three: Economics

In the last section, we look at the interrelationships between economic data, market movements, and investor behavior from the point of view of the trader. Chapter 12 presents an overview of the structure of the economy and introduces some of the important terminology and concepts from macroeconomics. This then allows us to focus in Chapter 13 on what are some of the most important, market-moving data announcements—the daily economic data releases. We present an overview of all the major U.S. releases, their source, and what they tell us about the economy and an analysis of some of the factors that determine the market’s reaction to these announcements. We then present a brief overview of the most salient data points for the rest of the globe. We end the chapter by reversing the direction of the inference to look at how certain market indicators can provide useful insights into the current state of the economy.

Appendix: Mathematical Review

The Appendix provides a brief review of the mathematical concepts necessary to understand the material in the book and relate intelligently to others on the trading floor. There is a common misperception, particularly among students, about the level of mathematical understanding relevant to a job on Wall Street. Because many of the most recent areas of development in finance have been mathematically complex, many applicants have the mistaken impression that by studying concepts such as stochastic calculus or probability theory, they will dramatically improve their chances of being hired. While more mathematics is never a bad thing—like speaking more languages or knowing more history—the effort expended to learn more esoteric concepts provides rapidly diminishing returns to the vast majority of trading and sales roles. In practice, the most useful mathematical skill is a facility with mental arithmetic: the ability to think clearly about numbers and quickly compute accurate approximations particularly under pressure. The job of a trader or salesperson much more often requires that they provide an “on the spot” estimate of, for example, how much 69,000 shares of an $84.10 stock is worth, or how much a 0.15 percent move equates to on an index level of 641.21, than virtually any other type of calculation.

Note: Throughout the text I use the terms investment bank and broker-dealer to refer to the financial services firms that provide equity and equity derivative sales and trading services to clients. In light of the sweeping changes in the industry that occurred in the latter part of 2008, many of these companies should be properly called “banks.” Readers should interpret the words “investment bank” and “broker-dealer” as referring to those parts of banks that provide these services.

AN IMPORTANT CLARIFICATION: The contents of this book represent my own views of generally accepted market practices in the pricing, trading, and risk management of a variety of equity and equity derivative products, in the context of the institutional client’s business. The information is a blend of objectively verifiable facts and subjective opinions that, while undoubtedly influenced by my professional experience, are entirely my own and should not be interpreted as representing the policies or practices of any of my employers, past or present.

I welcome any questions, comments, or feedback on the book. Readers can contact me at matthew.tagliani@gmail.com.

A Comment on the Events of 2008

The changes that have occurred in the global financial markets while this book was being written were unlike anything experienced since the Great Depression. The loss of confidence triggered by the deflation of a speculative housing bubble brought the market for short-term lending to a standstill, jeopardizing the solvency of financial institutions globally. Governments and central banks around the world took unprecedented actions including bailouts, nationalizations, and stimulus packages worth trillions of dollars. The consequences of these interventions will not be fully understood or appreciated for many years.

This uncertainty has raised many questions about the future of the financial services industry with gloom-and-doom prognostications of the end of Wall Street. While perhaps representative of the sentiment of the moment, these concerns are greatly exaggerated. The painful lessons learned about credit risk, leverage, and speculation will undoubtedly change the industry, but the recent market conditions are no more an indication of the end of financial services than the imploding of the technology bubble in 2000 spelled the end of the Internet. The industry will evolve and improve, but the trading, pricing, and risk management of the products described in this book will remain largely the same.

MATTHEW TAGLIANI, CFA
November 2008

Acknowledgments

There are countless individuals who have assisted me throughout my career and to whom I hold tremendous gratitude. While they have not been directly involved in the making of this book, which has been a rather solitary effort, they have helped to make it possible either by directly enhancing my understanding of the business or simply making the environment where I have worked and learned more enjoyable. Particular thanks go to Geoff Craig, Sam Kellie-Smith, David Russell, Craig Verdon, and Ben Walker, who provide me with my current opportunities to continue developing professionally, and to Guy Weyns, who kindly reviewed several chapters and made many helpful recommendations. Special thanks also go to Bill Gerace and Bill Leonard, who were instrumental in the development of my critical thinking skills.

I am greatly indebted to all the people at John Wiley & Sons who made this book possible, particularly Bill Falloon, Stacey Fischkelta, Emilie Herman, Joan O’Neil, Todd Tedesco, and Laura Walsh.

The writing of this book consumed most of my evenings, weekends, vacation time, and holidays over a period of slightly more than two years—the time and effort required to bring it to completion having far exceeded any of my initial estimates, which I now see were wildly overoptimistic. That I should, for so long, voluntarily sacrifice what little free time I am afforded outside of my day-to-day work as a trader to pursue this project could be considered somewhat deranged, certainly masochistic and, at the very least, a bit imbalanced.

However, that my wife Nati should not only tolerate such an extended period of my virtual nonexistence, but actively encourage, support, and motivate me along the way is simply beyond explanation. While I spent my time reclused in intellectual La-La Land, she brilliantly managed the very real-world responsibilities of raising a family and managing a home, while keeping me free from the distracting realities of daily life. This was no small feat, considering that between starting and finishing this book, we relocated to the United Kingdom and added a second child to our family roster. Hers has been a truly superhuman effort which, quite frankly, I haven’t the vaguest idea how to repay.

I must also thank my daughter Sof’a, who has accepted lame “Daddy can’t play, he has to work.” excuses on far too many sunny Saturday afternoons and yet somehow has still not given up on me, and my son Cosmo, who had the bad luck of arriving just as I immersed myself in the final intense push to complete this book. You have both given me far more than I ever had the right to ask of you.

PART One

What Is a Stock?

CHAPTER 1

Equity Fundamentals (Part 1) Introduction to Financial Statements

INTRODUCTION

In this chapter and the next we lay out a general framework for answering the most fundamental question for anyone working in equities or equity derivatives: “What is a share of stock and how much is it worth?” The goal is to develop sufficient understanding of the relevant concepts and terminology from financial accounting to ensure that the reader can understand, participate in, and benefit from, the sort of general stock analysis and valuation discussions that are held on a trading floor.

The presentation of the material is deliberately of a general character—the focus is on developing a clear conceptual understanding without getting bogged down in the details that, while essential to the work of an equity research analyst, are unnecessary for our purposes. Readers interested in a more detailed presentation can consult any of the many well-written books available on equity analysis or financial accounting.

It is worth clarifying that while the material in the first two chapters is basic, that does not mean it is easy. Readers with no previous exposure to financial accounting or valuation may find the writing rather dense—many of new concepts are introduced in a small number of pages. Because the material is conceptually fundamental, it is presented at the beginning of the book. It is not, however, a prerequisite for understanding the contents of subsequent chapters and readers who find this first section challenging can jump straight to Chapter 3 and come back to these first two chapters either as a reference or for more careful study at a later time.

EQUITY AND CORPORATION

By definition, a share of stock is a unit of ownership in a corporation. This definition does not help us much unless we understand what a corporation is.¹ A corporation is actually a rather curious concept: It is an independent legal entity, with its own rights and responsibilities, but distinctly independent from the people who run and own it. In many ways a newly established corporation is like a new citizen born into the state in which it is incorporated. Like people, corporations have rights and responsibilities, and can be held legally liable for their actions. Whether the question is over the purchase of a piece of property, the payment of a tax, or the pollution of a river, the answers “Archibald Gricklegrass did it” or “XYZ Incorporated did it,” while not identical, are similarly valid.

Although businesses may adopt any one of many different legal structures, there are two very important characteristics of corporations that make it by far the most popular option. The first is that a corporation can be divided into fractional units (shares) that can be owned by multiple parties and purchased or sold freely between them. These shares give ownership of the “equity” in the corporation—that is, the benefits that remain after paying off all debts, taxes, and other obligations, both now and for the indefinite future. They also give the holders a fractional say in the decisions of the corporation (voting rights). The holder of even one share of stock has the right to attend the annual shareholders’ meeting and ask whatever questions they choose of the management and, if enough other shareholders agree, to replace the management or even dissolve the corporation and liquidate its assets. It is, in the truest sense, ownership of the corporation in fractional percentage with the number of shares held and the number of shares outstanding.

The second important concept is that the fractional owners—the shareholders—have limited liability in the event of financial or legal challenge to the corporation. While the holder of a share of stock is, in fact, a partial owner of the company, the most that he or she can lose in the event the company were sued or faced financial hardship is the value of the stock he holds. This makes stock ownership a remarkable concept: the holder of stock gets all the benefits of owning the company with no more risk than the invested capital. Once a stock’s price has gone to zero, there is nothing more that can be done to reclaim additional responsibility from the shareholder—a stock price can never go below zero. Were this not the case, stock ownership would be significantly more risky and trading on the stock market would be considerably less active as investors would have to assess much more carefully the potential risks of association with the activities and management of the company in question.

While the owners of the corporation are actually the shareholders, the actual day-to-day running of the business is left in the hands of the officers of the corporation (from the President on down) whose actions are then supervised by an executive board whose job it is to insure that the actions of the corporation are in the best interest of the shareholders.

INTRODUCTION TO FINANCIAL STATEMENTS

For a potential investor to make an informed decision as to whether to purchase shares of a company, he or she needs some information about its internal operation and financial status. What does the company own? What does it owe to others? How much money is it making? How is it using that money? In the United States, publicly traded companies are required to publish, and make available to investors, a quarterly report summarizing all the financial details of the company. To ensure that this report is accurate and understandable to investors and can be compared with the equivalent disclosures by other firms, there is a set of generally accepted accounting principles (GAAP) that specify the definitions and conventions that must be adhered to in presenting the information. Because these quarterly public disclosures are generally the only information the public has about the internal operations of the company, they must be verified by an external independent auditor who verifies that the information is accurate and that there is no attempt by the management to deceive investors by manipulating the data.

There are three statements that provide the majority of the information in the quarterly financial disclosures, which we will examine in more detail here:

1. Balance sheet: Summarizes the assets (things owned) and liabilities (things owed) of the company and how they are financed through a mixture of debt (borrowed money) and equity (funds contributed by the shareholder owners).

2. Income statement: Summarizes the revenue, expenses, and resulting income in the period.

3. Statement of cash flows: Summarizes the sources and uses of cash.

In this chapter, samples of each of these three financial statements are presented, along with definitions and explanations of their contents.

Because all publicly traded companies in the United States must adhere to GAAP, the structure of the financial statements, and the definitions of the various components are deliberately general. This “one size fits all” approach facilitates the comparison of different companies but in doing so, removes a great deal of important detail. In practice, companies usually provide many clarifications and additional insights through footnotes to the statements and supplementary disclosures.

To maximize the comprehension and retention of the material, I would strongly recommend that readers choose a simple small business with which they feel comfortable and think about what the definition of each new concept would mean in this specific context. (Personally, I find a bakery a particularly useful example.) I have deliberately not provided my own example because it is the act of thinking about the meaning of each concept and applying it to the tangible example that actually leads to understanding and retention. Readers who make the effort should find that these first two chapters provide sufficient foundation in financial accounting and fundamental analysis (the subject of the next chapter) to be able to understand a typical analyst’s research report or discuss investment ideas with coworkers.

THE BALANCE SHEET

The balance sheet summarizes the assets and liabilities of the company at the time of publication. Unlike the income statement and statement of cash flows, the balance sheet is a freeze-frame snapshot of the company, rather than an analysis of the performance over the period. The changes in the mix of assets and liabilities of the company can be seen by comparing the current composition of the balance sheet with that of previous periods. While these changes are not explicitly shown on the balance sheet, the previous quarter and one-year ago data are usually presented alongside for comparison.

The contents of a sample balance sheet for a hypothetical company, XYZ Inc., are shown in Exhibit 1.1. While our example is deliberately simple, the structure and layout of the balance sheet of even a large multinational corporation would be quite similar (which emphasizes the need for additional disclosures). To make the example as clear as possible, the formatting and notation are somewhat nonstandard and the potentially distracting previous period values have been excluded.

Balance Sheet Fundamentals

The balance sheet is structured with assets on the left-hand side and liabilities and shareholders’ equity on the right. For an item to be considered an asset, it must have been acquired in the past and have the potential to generate a quantifiable economic benefit in the future. Liabilities are obligations acquired in the past that require economic sacrifices in the future. The difference between the assets and liabilities of the company is what is left over for the owners (shareholders) of the company. This is called shareholders’ equity. This leads us to one of the fundamental identities of accounting:

EXHIBIT 1.1 Balance Sheet for XYZ Inc.

That is, the things a company has (assets) are either paid for with borrowed money (liabilities) or belong to the owners (shareholders’ equity). This identity means that the sum of the items on each side of the balance sheet must be the same—that’s why it’s called the “balance” sheet.

In order for the two sides of the balance sheet to remain equal, the assets and liabilities of the company must be recorded using a process called double-entry bookkeeping. A single item cannot be added to the balance sheet in isolation—there must always be an equal and offsetting adjustment somewhere else to keep things balanced. This offsetting entry can be an equivalent addition to the other side of the balance sheet, or a reduction in another item on the same side.

This is best illustrated by an example. Consider a brand new company that has yet to begin operation and whose only asset is $1,000 of cash invested by the founders. The company’s balance sheet looks quite simple:

The company now purchases a piece of equipment for $600. The management has three ways to pay for it: they can spend the cash they have, they can buy it on credit (get a loan), or the owners of the company can contribute more capital to pay for it. The three approaches are recognized differently on the balance sheet, but each one requires two entries:

• Pay with cash: Two equal and offsetting adjustments are made to the left-hand side of the balance sheet. The Equipment line is increased by $600 while the Cash line is reduced by an equivalent amount. The assets of the company have simply changed shape from cash to machines.

• Pay with borrowed funds: If the machine is purchased with borrowed funds (credit), then the offsetting adjustment to the addition of $600 to the equipment line on the left-hand side would be an increase in the liabilities of the company (the borrowed funds) on the right-hand side. This has the additional effect of increasing the total size of the balance sheet from $1,000 on each side to $1,600. (The balance sheet is now leveraged by the addition of borrowed funds.)

• Owners contribute more capital: The third option is that the owners of the company contribute additional capital to pay for the machine. In this case, the offsetting adjustment to the $600 addition to the equipment line is an addition of $600 to the shareholders’ equity. The balance sheet increases in size from $1,000 to $1,600 but there is no leverage.

In all cases, there are two entries to the balance sheet—one to record the change in assets, the other to record how it was paid for—or alternatively, to whom it belongs (the owners of the company or the creditors).

Of the four items in this very simple balance sheet, three can be objectively measured: the cash holdings, the value of the equipment, and the amount of money the company owes. Shareholders’ equity is effectively defined as everything that is left over. Suppose, for example, that during installation the newly purchased machinery is damaged and its value is reduced from $600 to $400. The asset side of the balance sheet is now reduced by $200 and there must be an equal and offsetting adjustment to the right-hand side. If the machine was paid for on credit, the debt does not change just because the machine is worth less than before. The only place where the loss of $200 on the asset side can be reflected is in the shareholders’ equity line. The owners of the company take the loss, not the creditors.

In general, the shareholders’ equity line is calculated as a “plug.” That is, once all the assets and liabilities have been added up, the shareholders’ equity is defined to be whatever value makes the two sides of the balance sheet equal.

Balance Sheet Contents

On both the asset and liability sides of the balance sheet, the contents are categorized as either current, consisting of liquid assets and short-term liabilities that will be used or paid off within one year, and long term, which includes everything else.

Left-Hand Side Beginning on the asset side of the balance sheet, some of the standard items and their definitions are presented here. (Note: Not all items are included in the sample balance sheet in Exhibit 1.1.)

Current Assets

• Cash and marketable securities: Liquid short-term bank deposits and securities tradable in the market such as bonds or stocks. (Things that either are cash or could become cash quickly.)

• Accounts receivable: Money owed to the company for products or services that have been delivered but for which the company has not yet received payment.

• Inventory: Completed items ready for sale as well as the raw materials for production.

• Prepaid expenses: Cash that is “stored” in the form of prepayment of future obligations.

Long-Term Assets (also called Fixed Assets)

• Plant, property and equipment: The physical resources used in the running of the business.

• Long-term investments: Assets owned by the company that are not directly related to the functioning of the business (e.g., a piece of unused land).

• Intangible assets: Money paid by the company for rights, patents, trademarks, and the like, which can produce value but do not have a physical presence.

One particular intangible asset that is often given its own line on the balance sheet is goodwill. This is a slightly slippery accounting concept that requires a bit of explaining.

We first need to introduce the concept of book value. This is the simplest measure of the value of a company and is computed as the sum of the company’s assets less its liabilities. The book value is the accounting-based measure of what the company is worth. Because of the way in which accounting standards require certain items to be recognized on the balance sheet, the book value is very different from the liquidation value of the company, which uses the market value of all assets and liabilities to determine what would be left if an investor bought the company, broke it up, and sold off all the buildings, inventory, and other “stuff” and paid off all the bills. In reality, however, the market value of a company, as determined by the total value of all outstanding shares, is many times (i.e., 10 to 20 times) both its book value and its liquidation value. The reason for this is because the benefit of owning shares of a company is not just the ownership of the equipment, inventory, and other “stuff,” but the right to a proportional share of all the benefits that can be produced with those assets for the life of the company.

The concept of goodwill arises when one company acquires another for more than its book value. Let us assume Company X pays $10 billion in cash to acquire Company Y, which has $8 billion in assets and $5 billion in liabilities, for a book value of $3 billion. When Company X recognizes the purchase of Company Y on its balance sheet it will reflect both the cost—a decrease in cash assets of $10 billion—as well as what it has acquired for that price: $8 billion in assets and $5 billion in liabilities. The net effect will be a decrease in assets of $2 billion and an increase in liabilities of $5 billion for a net “loss” of $7 billion in shareholders’ equity.

goodwill impairment