Balance sheet structure in service and manufacturing companies

Balance Sheet

Financial analysis is critical to determining the intrinsic value of a company. Analysts, hedge funds, institutional investors and retail investors alike all use various forms of information to determine a fair price to pay for a security. This information is generally acquired through the financial statements of the particular company being researched. In addition to the many forms of information gathering within the market, there are also many philosophies that determine the underlying characteristics of individual investors. First, there is a value philosophy predicated on locating stocks well below their intrinsic value with a predetermined margin of safety to account for errors of judgment. This philosophy attempts to identify undervalued securities. Likewise, there is a growth philosophy which is focused primarily on the future growth trends within a particular industry. There are many philosophies that govern investment behavior with these two constituting the vast majority. No matter what the philosophy is of an investor, he or she will undoubtedly glance at the annual report of a company to help determine its value. The balance sheet is a great indicator of company value and management expertise. The composition of a manufacturing company will be somewhat different then that of a service company. In many instances, the balance sheets may often look completely different depending on the industry in which the manufacturing and service company operate in. Through this document, I aim to discuss the differing components of these respective balance sheets, why these components are important, and identify the optimal capital structure of both (Williams, 2008).

To begin, the balance provides information regarding the assets, liabilities and owners equity of a particular business at one point and time. In many instances its backwards looking as the composition of the balance sheet can change within a week or two depending on acquisitions, or capital expenditures. Assets are listed first in order of liquidity or ease of a readily available market. This section is followed by liabilities, which is then followed by shareholders equity.

The balance sheet structure of a manufacturing company will have a large amount of fixes assets on its balance sheets. Manufacturing institutions, particularly those in the metal industry, have high fixed costs as compared to service companies. These fixed costs are usually the result of increased property, plant and equipment expenditures. Manufacturing companies are often in a commodity type business. As such, these companies must constantly innovate, or renovate existing equipment to provide cheaper and more efficient products. These innovative products have high initial costs but low variable costs. Many manufacturing companies therefore have a higher degree of fixed assets relative to their service company counterparts. Due to the fact manufacturing companies have higher fixed costs; they usually have higher depreciation expense as well. Fixed assets are usually depreciated on an accelerated or fixed basis. These expenses will be higher simply by virtue of having more fixed assets than a service company would. Furthermore, manufacturing companies will often have higher inventory assets as compared to service companies. Manufacturing companies hold higher amounts of inventory as they often create physical products. These products may include cars, shirts, computers, or cell phones. These inventory levels are higher as many service companies sell intangible products such as "expertise" or "product knowledge." As such, service companies are required to have high inventory levels. Manufacturing companies will have distinct asset accounts such as "Raw materials inventory" of "Finished goods inventory." Higher inventory levels create distinct differences as to the many of the account payable to a manufacturing and service company. For example, a manufacturing company will usually have a "standing accounts payable" section listed on the balance sheet. This section is usually designated for the purchase of wholesale products. Likewise service companies would have a "service revenue received" which is usually reserved for expected payments of a particular service (Daniels, 1980).

Service companies have profound differences relative to their manufacturing counterparts. For one, service companies often sell products which are intangible in nature. There isn't a "customer service" journal entry in regards to assets. As such, service companies have very little inventory as compared with their manufacturing counterparts who often sell physical products. In contrast, manufacturing companies are more complex as they must produce their goods as well as market them. Due primarily to the fact that service companies sell intangible products, they usually only have expenses related to daily operations. Also, many service companies are predicated on the use of intellectual property to remain competitive. This intellectual property is listed as an asset which is also intangible. Expertise, for example is very difficult to value adequately. As such, many service companies have patents or intellectual property that is very valuable listed on the balance sheet (Epstein, 2007).