Financial Accounting: Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display. PowerPoint Presentation Materials For Financial Accounting: A New Perspective by Paul Solomon

Using the Balance Sheet to Make Decisions CHAPTER 5 Using the Balance Sheet to Make Decisions

PERFORMANCE OBJECTIVES: Ratios PO3: Calculate, interpret, & discuss ratios for Liquidity Activity or turnover Financial leverage Profitability Valuation

PERFORMANCE OBJECTIVES: Valuation PO 16: Describe valuation by Distinguishing among Historical cost Replacement cost Fair market value Present value of future cash flows Identifying GAAP methods for major asset, liability accounts

PERFORMANCE OBJECTIVES: Other PO 17: Identify limitations of financial statements

USER FOCUS Annual report on liquidity, leverage

INSIGHTS Executory contracts When are all valuation methods equivalent? Limitations of balance sheet

TOPICS Using classified balance sheet to make better decisions Using balance sheet ratios to make better decisions Using information not found in balance sheet to make decisions How assets are measured

CLASSIFIED BALANCE SHEET Classifies assets, liabilities into current and noncurrent categories Current categories Accounts expected to be Turned into cash Sold Exchanged Discharged Within one year

CMU Balance Sheet 12/31 Assets Current assets Investments Property, plant, Equipment $56,300 2,000 16,700 Liabilities Current Noncurrent Owner’s Equity $9,000 4,000 61,900 Total assets $75,000 Total liabilities & Equity

WHY DISTINGUISH BETWEEN CURRENT, NONCURRENT? To allocate resources to meet needs Timing influences decisions

HOW TO DISTINGUISH BETWEEN CURRENT, NONCURRENT Operating cycle Related to current assets, liabilities Average length of time it takes to move through 3 phases Purchasing Selling Collecting

CURRENT ASSETS Current assets are Cash Noncash assets that will be Converted into cash Sold Consumed Within 1 year or operating cycle, whichever is longer

LIQUIDITY Measure of availability of cash Sign of financial health How quickly noncash assets can be turned into cash Sign of financial health

CURRENT LIABILITIES Current liabilities are Obligations that will be eliminated within one year or operating cycle of business Paid by Current assets Creating other current liabilities

USING BALANCE SHEET RATIOS Show percentage relationship between 2 numbers Summarize information Easily understood, interpreted, compared Example: Return on equity Measures performance

HOW TO USE LIQUIDITY RATIOS Help determine solvency Ability to meet obligations that come due in current period Working capital Current assets – Current liabilities Limitation: measures absolute ability to meet debts

LIQUIDITY RATIOS Current ratio Acid test (Quick) ratio Bank ratios

CURRENT RATIO Measures relative ability to meet maturing current debts (solvency) High ratio desirable Current Asset Current Liabilities

Current assets – (Inventories + prepaid Assets) ACID TEST RATIO Measures relative ability to meet maturing current debts (solvency) High ratio desirable Current assets – (Inventories + prepaid Assets) Current Liabilities

BANK RATIOS Approving Susan’s Loan Banker’s measure of loan risk To protect lender Loan to value Loan to liquidation value

LOAN TO VALUE Maximum Loan Liability Market value of collateral Lower is better

LOAN TO LIQUIDATION VALUE Maximum Loan Liability Liquidation Value of Asset Lower is better

LEVERAGE RATIOS Evaluate financial risk Debt to Assets Ratio Debt to Equity Ratio

DEBT TO ASSETS RATIO Total Liabilities Total Assets Indicates long-run solvency of business Describes relative amount of financial risk Total Liabilities Total Assets

DEBT TO EQUITY RATIO Total Liabilities Total Owners’ Equity Indicates long-run solvency of business Describes relative amount of financial risk Total Liabilities Total Owners’ Equity

USER FOCUS: Discussions of Liquidity, Leverage Contained in Annual Report Management’s Discussion & Analysis (MD&A) Provides liquidity, leverage ratios Provides discussion/interpretation of ratios Example: Merck

USING INFORMATION TO MAKE DECISIONS: MD&A Outside balance sheet Management’s Discussion and Analysis of Operations (MD&A) Relates to balance Liquidity and Capital Resources

USING INFORMATION TO MAKE DECISIONS: Notes 1 Information that documents, supports, elaborates on specific items Summary of significant accounting policies Essential accounting principles of business Other notes Detail for balance sheet accounts

USING INFORMATION TO MAKE DECISIONS: Notes 2 Commitments Executory contract Example: noncancelable lease arrangements Contingency May never materialize Potential future obligation

INSIGHT 5-1: Executory Contract Promise to perform duties in future Commitment No current liability Definition: liability Probably future sacrifices of economic benefits arising from present obligations

HOW ARE ASSETS MEASURED? Entry prices Historical cost Current cost Exit prices Fair market value (FMV) Present value of future cash flows

INSIGHT 5-2: When are Valuation Methods Equivalent? At point of exchange when recorded Historical costs = current cost = fair market value (FMV) = present value of future cash flows Valuation methods differ when reported

ASSET VALUATION Personal balance sheet Business balance sheet Estimated current value or fair market value (FMV) Business balance sheet Follows GAAP

ASSET VALUATION: Current Assets Category Account Measurement Current Cash Marketable Sec. A/R Inventory Monetary FMV or cost FMV less allowance LCM

ASSET VALUATION: Investments Category Account Measurement Investments Equity Bonds Long term Notes Receivables FMV Present value of future cash flows

ASSET VALUATION: Property, Plant, Equipment Category Account Measurement Property, Plant, Equipment Buildings, Equipment, etc. Cost less Accumulated Depreciation

ASSET VALUATION: Intangible Assets Category Account Measurement Intangibles Patents, Goodwill, etc Cost less Amortization

KEY QUALITATIVE CHARACTERISTICS Characteristics of accounting information Relevance Makes a difference in a decision Reliability Degree of confidence in information Verifiability Traceable

INSIGHT 5-3: Limitations of Balance Sheet Not all obligations reported in liabilities Asset valuation not always current market value Qualitative information incomplete Money measurement assumes stable dollar; no inflation Human resources not reported, valued