The Balance Sheet and Notes to the Financial Statements

2  Describe the specific elements of the balance sheet (assets, liabilities, and owners’ equity) and prepare a balance sheet with assets and liabilities properly classified into current and noncurrent categories.  Identify the different formats used to present balance sheet data. Learning Objectives

3  Analyze a company’s performance and financial position through the computation of financial ratios.  Recognize the importance of the notes to the financial statements, and outline the types of disclosures made in the notes.  Understand the major limitations of the balance sheet.

4 Usefulness of the Balance Sheet Reports the resources (assets), obligations (liabilities), and residual ownership claims (equity) of a company. Facilitates analysis of the company’s ability to: –meet short-term obligations (liquidity). –pay all debts as due (solvency). Provides information about the company’s financial flexibility.

5 Elements of the Balance Sheet Assets Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events Assets Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events The inclusion of “probable” acknowledges that accounting is not an exact science.

6 Elements of the Balance Sheet The primary purpose of the balance sheet is to help forecast the future. Assets Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events Assets Probable future economic benefit obtained or controlled by a particular entity as a result of past transactions or events

7 Elements of the Balance Sheet Typical assets found on a balance sheet are cash, supplies, accounts receivable, land, buildings, and equipment.

8 Elements of the Balance Sheet Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. “Obligation” includes legal, moral, social, and implied commitments. Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

9 Elements of the Balance Sheet Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liability Probable future sacrifice of economical benefit arising from a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. An obligation to provide services is a liability.

10 Typical liabilities include accounts payable, notes payable, and advances from customers. Elements of the Balance Sheet

11 Elements of the Balance Sheet Equity Residual interest in the assets of an entity that remains after deducting its liabilities. Equity Residual interest in the assets of an entity that remains after deducting its liabilities. Capital Stock Retained Earnings Paid-in Capital in Excess of Par

12 How to Classify Items on the Balance Sheet Current (one year or less) Noncurrent (more than 1 year)

13 Current Assets Cash and resources expected to be converted to cash during the entity’s normal operating cycle or one year, whichever is longer, are current assets. Cash Accounts and notes receivable Inventories Prepaid items

14 Operating Cycle Receivables Cash Inventories Purchases Collections Sale s

15 Noncurrent Assets Investments Property, plant, and equipment Deferred income taxes

16 Property, Plant, and Equipment Property, plant, and equipment are properties of a tangible and relatively permanent nature that are used in the normal business operations.

17 Intangible Assets Intangible assets are long-term rights and privileges of a nonphysical nature acquired for use in business operations.

18 Current Liabilities Current liabilities are obligations expected to be paid within one year or the normal operating cycle. Accounts and notes payable Accrued expenses Current portion of long-term obligations Unearned revenues

19 Current Liabilities If the terms of the agreement for a callable obligation is due on demand or will become due on demand within one year from the balance sheet date, the obligation should be classified as current.

20 Noncurrent Liabilities The current liability classification generally does not include the following items:  Debts to be liquidated from a noncurrent sinking fund.  Short-term obligations to be refinanced.

21 Noncurrent Liabilities Long-term debt Long-term lease obligations Deferred income tax liability Pension obligations

22 Noncurrent Liabilities Long-term debt is reported at its discounted present value.

23 Contingent Liabilities Past activities or circumstances may give rise to possible future liabilities. Potential obligations that do not exist on the balance sheet date are known as contingent liabilities.

24 Contingent Liabilities An estimated liability is a definite liability, so it is not a contingent liability.

25 Owners’ Equity Contributed Capital:  Capital stock  Additional paid-in capital Capital stock usually is the number of shares issued multiplied by the par or stated value.

26 Owners’ Equity Contributed Capital:  Capital stock  Additional paid-in capital The two types of capital stock are preferred and common.

27 Owners’ Equity Contributed Capital:  Capital stock  Additional paid-in capital Additional paid-in capital is the excess invested above par or stated value of the capital stock.

28 Owners’ Equity Retained earnings is the amount of undistributed earnings of past periods.

29 Evaluating Liquidity  Current Ratio: current assets divided by current liabilities.  Quick Ratio: quick assets divided by current liabilities (Acid-Test Ratio).

30 Liquidity Ratios Example Cash $ 30 Net Accounts Receivable 70 Inventory100 Current Assets$200 Current Liabilities$100 Cash $ 30 Net Accounts Receivable 70 Inventory100 Current Assets$200 Current Liabilities$100 Current Assets Current Liabilities Current Assets Current Liabilities $200$100$200$100 = 2:1 Current Ratio

31 Liquidity Ratios Example Quick Assets Current Liabilities Quick Assets Current Liabilities $100$100$100$100 = 1:1 Cash $ 30 Net Accounts Receivable 70 Inventory100 Current Assets$200 Current Liabilities$100 Cash $ 30 Net Accounts Receivable 70 Inventory100 Current Assets$200 Current Liabilities$100 Cash $ 30 Net Accounts Receivable 70 Inventory100 Current Assets$200 Current Liabilities$100 Cash $ 30 Net Accounts Receivable 70 Inventory100 Current Assets$200 Current Liabilities$100 Quick Ratio

32 Current Ratio McDonald’s 0.5 Microsoft2.8 Disney1.2 Coca-Cola0.7 Yahoo!5.8 Coke

33 Overall Leverage Debt Ratio: total liabilities divided by total assets. Total Assets$400 Total Liabilities300 Debt Ratio: total liabilities divided by total assets. Total Assets$400 Total Liabilities300 Total Liabilities Total Assets Total Liabilities Total Assets $300$400$300$400 = 75%

34 Debt Ratio McDonald’s 52.2% Microsoft25.6% Disney53.1% Coca-Cola56.1% Yahoo!13.8% Coke

35 Asset Mix The proportion of total assets in each asset category. Property, Plant, and Equipment$ 50 Total Assets400 The proportion of total assets in each asset category. Property, Plant, and Equipment$ 50 Total Assets400 Asset Group Total Assets Asset Group Total Assets $50$400$50$400 = 12.5%

36 Efficiency “Asset Turnover” is a financial ratio measuring how efficiently a company uses its assets to generate sales. Sales$200 Total Assets400 “Asset Turnover” is a financial ratio measuring how efficiently a company uses its assets to generate sales. Sales$200 Total Assets400 Sales Total Assets Sales $200$400$200$400 = 0.50

37 Asset Turnover McDonald’s 0.63 Microsoft0.65 Disney0.56 Coca-Cola0.98 Yahoo!0.33 Coke

38 Overall Profitability Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Net Income Total Assets Net Income Total Assets $40$400$40$400 = 10.0% Return on Assets

39 Return on Assets McDonald’s 7.8% Microsoft20.2% Disney4.5% Coca-Cola18.5% Yahoo!4.1% Coke

40 Overall Profitability Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Two ratios that measure overall profitability are “Return on Assets” and “Return on Equity.” Net Income$ 40 Total Assets400 Stockholders’ Equity160 Net Income Stockholders’ Equity Net Income Stockholders’ Equity $40$160$40$160 = 0.25% Return on Equity

41 Return on Equity McDonald’s 16.4% Microsoft27.0% Disney9.5% Coca-Cola42.0% Yahoo!4.8% Coke

42 Notes to Financial Statements Summary of significant accounting policies. Additional information to support summary totals. Information about items not included in financial statements. Supplementary information required by the FASB or the SEC to fulfill the full-disclosure principle.

43 Subsequent Events Financial Statement Period Subsequent Period Balance Sheet Date Date Statements Issued Events in this period may affect the reporting of amounts in the subsequent periods

44 Types of Events Those that materially affect one or more financial statements. Those that create a need for a footnote. Subsequent Events Balance Sheet Date Date Statements Issued Financial Statement Period Subsequent Period

45 Limitations of the Balance Sheet Does not disclose actual value of the entity. Does not disclose effects of inflation. Classifications are not uniform among companies. Does not disclose all assets and liabilities.

46 The End