Long-Term Investments on the Balance Sheet
Understanding the Differences Between Long-Term and Short-Term Investments
For many new investors, opening a company's 10-K and reading the balance sheet is no easy feat. Thankfully, once you start to pull apart the puzzle, it becomes easier to understand how the pieces fit together. In turn, this allows you to begin formulating your own estimates of value. In the past, I've covered current assets and current liabilities, but now let's turn our attention to the long-term assets and long-term investments found on the balance sheet.
Simply stated, long-term investments and long-term assets, in contrast to current assets and current liabilities, are things a business owns but can't be converted into cash quickly to fund day-to-day operations.
[Note that what we are discussing in the context of balance sheet analysis is different from my usual discussion about what constitutes a long-term investment from the perspective of an individual investor acquiring stocks, bonds, mutual funds, real estate, and other securities. The distinction is important.]
The Definition of Long-Term Investments on a Balance Sheet
When you pick up an annual report or Form 10-K filing for a publicly traded business, the long-term investments shown on the balance sheet represent assets that a company intends to hold for more than one year. They can consist of stocks and bonds of other companies, real estate holdings, and cash that has been set aside for a specific purpose or project.
In addition to investments a company plans to hold for an extended period of time, long-term investments also consist of the stock in a company's affiliates and subsidiaries.
For balance sheet classification purposes, the difference between short-term investments and long-term investments lies in a company's motive for owning the asset.
Short-term investments consist of stocks, bonds, and other holdings the company plans on selling shortly. An investment bank engaging in proprietary trading for its own account might very well classify a lot of its positions as short-term on the balance sheet. The investments classified under long-term investments may never be sold. An excellent example of the latter would be Berkshire Hathaway's relationship with Coca-Cola. Berkshire owns 400,000,000 shares of the soft-drink giant, and will most likely continue to hold them forever regardless of the price they are selling for in the open market. As of mid-2017, those shares represent a 9.4% ownership stake in the Atlanta-based beverage giant. Even though it doesn't control Coke, in a lot of ways, Berkshire Hathaway thinks of Coca-Cola as a permanent part of its asset base the same way it does subsidiaries such as GEICO and Precision Castparts.
The Classification Between Short-Term Investments and Long-Term Investments Has Important Balance Sheet Implications As It Changes the Way Assets Must Be Valued In Some Cases
When a holding company or other firm purchases bonds or shares of common stock as an investment, the decision about whether to classify it as short-term or long-term has some fairly important implications for the way those assets are valued on the balance sheet.
To provide an illustration, consider an insurance company. Imagine that it buys $10,000,000 worth of corporate bonds that it intends to sell at some point in the next twelve months; a trade made as part of a larger, complex transaction. In this situation, the bonds will be classified as short-term and subject to rules requiring them to be "marked to market". This means if the bonds decline in value to $9,000,000 in a quarter, the $1,000,000 loss must be run through the company's income statement even though the loss hasn't been realized, existing entirely on paper.
Now, imagine an alternative scenario. In this case, the bonds were acquired for $10,000,000 and the insurance company plans on holding them until maturity as a long-term investment. In this situation, the bonds could be accounted for under the "amortized cost method".
The fluctuations in the value of bonds between now and maturity don't influence the figures reported on the income statement in the same way. Instead, any premium or discount to par value is amortized. This results in greater stability in reported net income. In some periods, especially following major changes in the interest rate environment, this can mean the financial statements of a business with a lot of long-term investment assets may or may not fully reflect economic reality at first glance. You're going to have to dig into the annual report and Form 10-K filing to get a better idea of intrinsic value.