The Balance Sheet

1
The Balance Sheet Its Analysis(Chapter 5)
2
Objectives

• Discuss the purpose of the balance sheet.
• Illustrate the format and structure of the
  balance sheet.
• Outline some issues related to valuing assets.
• Show the difference between a cost-basis and a
  market-basis balance sheet.
• Define owner equity or net worth.
• Analyze a firms solvency and liquidity.
• Introduce the statement of owner equity.

3
The Balance Sheet

• Summarizes the financial condition of the
  business at a point in time
• Remember the snapshot idea!
• Estimates net worth or owner equity.
• Most transactions affect the balance sheet, so it
  may change daily.

4
Purpose of a Balance Sheet

• Everything owned and owed by a business or
  individual at a given point in time.
• Asset anything of value owned.
• Liability any debt or other financial
  obligation owed to someone else.
• Owner Equity/Net worth the amount the owner has
  invested in the business.
• Balance idea
• Owner Equity Assets Liabilities

5
Preparing a Balance Sheet

• Can be completed at anytime.
• Most are prepared at the end of the accounting
  period
• Represents both end-of-the-year and
  beginning-of-the-year.
• That is, end of year 1 beginning of year 2!
• For comparison purposes and analysis.
• Should follow guidelines of some recognized
  accounting entity
• FFSC Farm Financial Standards Council used for
  farm-based businesses.

6
General Format of a Balance Sheet

• Assets
• Current assets XXX
• Noncurrent assets XXX
• Total assets XXX

• Liabilities
• Current liabilities XXX
• Noncurrent liabilities XXX
• Total liabilities XXX
• Owners equity XXX
• Total liabilities and
• owners equity XXX

7
Assets

• An asset can be sold to generate cash.
• Used to produce other goods.

8
Current Assets

• Goods that have already been produced and can be
  sold quickly without disrupting future production
  activities
• Grain.
• Feeder livestock.
• Other inventories.
• Goods that will be used up or sold within the
  next year
• Cash.
• Checking and savings account balances.
• Stocks and bonds.
• Accounts and notes receivable.
• Inventories of feed, farm supplies, etc..

9
Noncurrent Assets

• Any asset that is not a current asset.
• Assets that are owned primarily to produce
  output, that will be sold to produce revenue.
• Selling noncurrent assets to generate revenue
  would affect the firms ability to produce future
  income.
• More difficult to sell quickly and easily at
  their full market value
• Machinery and equipment.
• Breeding livestock.
• Buildings.
• Land.

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Liabilities

• An obligation or debt owed to someone else.
• An outsiders claim against one or more assets of
  the business.

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Current Liabilities

• Financial obligations that will become due and
  payable within 1 year
• Accounts payable.
• Principal and accumulated interest on short-term
  loans or notes payable (operating loans).
• Principal payments on long-term loans due within
  the next year
• Machinery, land.
• Accrued expenses
• Accumulated interest, accrued property taxes, etc.

12
Noncurrent Liabilities

• All obligations that dont have to be paid in
  full within the next year.
• The remaining balance on long-term debt.

13
Owner Equity

• The amount of money left for the owner if the
  assets were sold and all liabilities paid.
• Also called Net Worth.
• The owners current investment in the business.
• Equity Total assets - Total liabilities

14
Changes in Owner Equity

• Using assets to produce crops and livestock
• Profit is then used to purchase additional assets
  or to reduce liabilities.
• If there is a change in an assets value.
• If an inheritance is received.
• Cash or property is contributed to the business
  or withdrawn from the business.
• An asset is sold for more or less than its
  balance sheet value.
• Important to recognize that only certain things
  bring about a change in owner equity.

15
Changes in Owner Equity

• Composition of assets and liabilities may not
  cause a change in owner equity
• If 10,000 cash is used to purchase a new
  machine?
• If 10,000 is borrowed to purchase a new machine?
• Until depreciation, no impact!
• Using 10,000 from cash to make an early
  principal payment on a loan?
• Owner equity changes only when
• The owner invests personal capital from outside
  the business.
• The owner withdraws personal capital.
• The business shows a profit or loss.
• Changes in asset values because of changes in
  market prices.

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Intermediate Assets

• Dividing noncurrent assets into two categories
  (allowed by FFSC)
• Intermediate assets have a life greater than 1
  year but less than 10 years
• Machinery, equipment, perennial crops, breeding
  livestock
• Fixed assets have a life greater than 10 years
• Land, buildings

17
Intermediate Liabilities

• Dividing noncurrent liabilities into two
  categories.
• Intermediate liabilities debt obligations
  where repayment of principal occurs over a
  period of more than 1 year and as long as 10
  years
• Loans used to purchase machinery, breeding
  livestock, and other intermediate assets.
• Fixed liabilities debt obligations where the
  repayment period is longer than 10 years
• Farm mortgages, land purchases.
• Additional division is recognized by FFSC, but
  not encouraged.

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Asset Valuation

• Cost-basis
• Values all assets using the cost, cost less
  depreciation, or farm production cost method.
• Inventories of grain and market livestock can be
  valued at market value less selling costs.
• Market-basis
• Values all assets at market value less selling
  cost
• Inflation and fast depreciation methods can cause
  market values to be higher than book values.
• Market-basis usually has higher asset values
  implying higher equity.

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Advantages of Cost-basis or Market-basis Balance
Sheets

• Cost-basis
• Conform to GAAP.
• Conservative.
• Comparable with balance sheets from other types
  of businesses.
• Changes in equity come only from net income that
  has been earned and retained.

• Market-basis
• More accurate indication of the current financial
  condition.
• Shows the current value of available collateral.

20
Use Cost or Market Basis for Balance Sheet?

• Both are important and have value.
• Recommended by FFSC
• Market-based with full documentation.
• Two column format with both.
• Recommend following specified procedure for
  valuing assets

21
Valuation Methods for Cost-basis Market-basis
Balance Sheets

• Asset Cost Basis Market Basis
• Marketable securities Cost Market
• Inventories of grain market livestock Market Ma
  rket
• Accounts receivable Cost Cost
• Prepaid expenses Cost Cost
• Investment in growing crops Cost Cost
• Purchased breeding livestock Cost Market
• Raised breeding livestock Cost or base
  value Market
• Machinery equipment Cost Market
• Buildings Improvements Cost Market
• Land Cost Market

22
Balance Sheet Analysis

• Used to measure the financial condition of the
  business (management tool)
• Compare to other, but similar businesses.
• Compare to the same business over time.
• Lenders use balance sheet analysis to make
  lending decisions and to monitor the financial
  progress of their customers.
• To deal with relative size issue, use what?

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Balance Sheet Analysis

• Measures of Liquidity
• Current Ratio
• Working Capital
• - not a ratio (in ), so size must be considered.
• Measures of Solvency
• Debt/Asset Ratio
• Equity/Asset Ratio
• Debt/Equity Ratio

24
The Concept of Liquidity

• Short-term measure.
• Measures the ability to meet financial
  obligations
• As they come due.
• Without disturbing normal revenue generating
  activities.
• Ability of the business to generate cash.

25
Measures of Liquidity

• Current Ratio
• Total current farm assets Total current farm
  liabilities
• Example from text 112,500 88,860 1.27
• Write the Current Ratio as 1.271
• Current assets compared to current liabilities.
• Values gt 1 are preferred (safety margin).
• Larger ratios imply more liquid.

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Measures of Liquidity

• Working Capital
• Total current farm assets - Total current farm
  liabilities
• Example 112,500 - 88,860 23,640
• Write the Working Capital as 23,640
• left after selling all current assets and
  paying off all current liabilities.
• Margin of safety in a value.
• Compare to similar sized operations.

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The Concept of Solvency

• Measures the degree to which liabilities are
  backed up by assets.
• Measures liabilities relative to owner equity.
• Ability to pay off all liabilities if all assets
  were sold.

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Measures of Solvency

• Debt/Asset Ratio
• Total farm liabilities Total farm assets
• Example 368,860 741,500 0.4975
• - share of total assets owed to lenders.
• Can write the Debt/Asset Ratio as a percent
• Multiply by 100 (example 49.75)
• of total assets owed to lenders.

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Measures of Solvency

• Equity/Asset Ratio
• Total farm equity Total farm assets
• Example 372,640 741,500 0.5025
• - share of assets financed by owner capital.
• Can write the Equity/Asset Ratio as percent
• Multiply by 100 (example 50.25).
• of total assets financed by owners equity
  capital.
• Higher values are preferred.

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Measures of Solvency

• Debt/Equity Ratio (leverage ratio)
• Total farm liabilities Total farm equity
• Example 368,860 372,640 0.99
• Write the Debt to Equity Ratio as 0.991
• Lender financing compared to owner financing.
• Smaller values are preferred??

31
Solvency and Liquidity based on valuation method

• Our examples used market basis
• 1. Liquidity differences if used cost- basis?
• - looked at how relevant assets are valued.

32
Valuation Methods for Cost-basis Market-basis
Balance Sheets

• Asset Cost Basis Market Basis
• Marketable securities Cost Market
• Inventories of grain market livestock Market Ma
  rket
• Accounts receivable Cost Cost
• Prepaid expenses Cost Cost
• Investment in growing crops Cost Cost
• Purchased breeding livestock Cost Market
• Raised breeding livestock Cost or base
  value Market
• Machinery equipment Cost Market
• Buildings Improvements Cost Market
• Land Cost Market

Current Assets
33
Solvency and Liquidity based on valuation method

• Our examples used market basis
• 1. Liquidity differences if used cost- basis?
• - looked at how relevant assets are valued.
• 2. Solvency differences if used cost- basis?
• - lower values for assets lower
  solvency measures.

34
Valuation Methods for Cost-basis Market-basis
Balance Sheets

• Asset Cost Basis Market Basis
• Marketable securities Cost Market
• Inventories of grain market livestock Market Ma
  rket
• Accounts receivable Cost Cost
• Prepaid expenses Cost Cost
• Investment in growing crops Cost Cost
• Purchased breeding livestock Cost Market
• Raised breeding livestock Cost or base
  value Market
• Machinery equipment Cost Market
• Buildings Improvements Cost Market
• Land Cost Market

Noncurrent Assets
35
Statement of Owner Equity

• Shows the source of changes in owner equity and
  the amount that came from each source.
• Where growth (or lack of growth) is coming from
• Reconciles beginning and ending owner equity.

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Summary

• A balance sheet shows the financial position of a
  business at a point in time.
• Assets can be valued using cost methods or
  current market valuations.
• Liquidity measures the ability of the business to
  meet financial obligations as they come due and
  without disturbing normal production.
• Solvency measures the degree to which the
  liabilities of the business are backed up by its
  assets.

37
Measuring the Financial Position of the Business

• Liquidity measures the ability of the business
  to meet financial obligations as they come due
  without disrupting the normal operations of the
  business.
• Measures the ability to generate cash in the
  amounts needed at the time it is needed.
• Liquidity is a short-run concept.

38
Measuring the Financial Position of the Business

• Solvency measures the liabilities of the
  business relative to the amount of owner equity
  invested in the business
• An indication of the ability to pay off all
  financial obligations if all assets were sold.
• The degree to which assets are greater than
  liabilities.
• If assets are not greater than liabilities, the
  business is a candidate for bankruptcy.
• Longer term issue??