© Mcgraw-Hill Companies, 2008 Farm Management Chapter 5 The Balance Sheet and Its Analysis

© Mcgraw-Hill Companies, 2008 Chapter Outline Purpose and Use of a Balance Sheet Balance Sheet Format Asset Valuation and Related Problems Balance Sheet Example Balance Sheet Analysis Statement of Owner Equity

© Mcgraw-Hill Companies, 2008 Chapter Objectives 1.Discuss the purpose of a balance sheet 2.Illustrate the format and structure of a balance sheet 3.Outline some problems when valuing assets, and the recommended valuation methods for different types of assets 4.Show the difference between a cost and market basis 5.Define owner equity or net worth and show its importance 6.Analyze solvency and liquidity 7.Introduce and explain statement of owner equity

© Mcgraw-Hill Companies, 2008 Purpose and Use of a Balance Sheet Systematic organization of everything “owned” and “owed” Assets = liabilities + owner equity Owner equity = assets  liabilities Can complete at any time, but most prepared at end of accounting period Provides measures of solvency and liquidity

© Mcgraw-Hill Companies, 2008 Solvency Solvency measures the liabilities of the business relative to the amount of owner equity invested in the business. It provides an indication of the ability to pay off all financial obligations or liabilities if all assets were sold. If assets are not greater than liabilities, the business is insolvent.

© Mcgraw-Hill Companies, 2008 Liquidity Liquidity measures the ability of the business to meet financial obligations as they come due without disrupting the normal operations of the business. Liquidity measures the ability to generate cash needed to pay obligations. Liquidity is generally measured over the next accounting period and is a short-run concept.

© Mcgraw-Hill Companies, 2008 Balance Sheet Format Assets shown on left or top Liabilities are shown on right or below assets Owner equity shown on balance sheet and liabilities + owner equity = assets

© Mcgraw-Hill Companies, 2008 Table 5-1 General Format of a Balance Sheet

© Mcgraw-Hill Companies, 2008 Assets An asset has value for one of two reasons: 1) It can be sold to generate cash, or 2) It can be used to produce other goods that in turn can be sold for cash in the future.

© Mcgraw-Hill Companies, 2008 Current Assets Assets that can be sold easily to generate cash are called liquid assets. Accounting principles require current assets, which are the more liquid assets, to be separated from other assets on the balance sheet. Current assets include: cash, marketable stocks and bonds, accounts receivable, and inventories of feed, grain, supplies and feeder livestock.

© Mcgraw-Hill Companies, 2008 Noncurrent Assets Assets that are not current assets are classified as noncurrent assets. They are more difficult to sell and/or their sale would be more likely to disrupt the business. Noncurrent assets include: machinery, equipment, breeding livestock, buildings, and land.

© Mcgraw-Hill Companies, 2008 Liabilities A liability is an obligation or debt owed to someone else. It represents an outsider’s claim on the business.

© Mcgraw-Hill Companies, 2008 Current Liabilities Accounting principles require that current liabilities be separated from other liabilities on the balance sheet. Current liabilities are financial obligations that will become due and payable within one year from the date on the balance sheet. Examples: accounts payable, principal and accrued interest on short-term loans, and principal due within one year on longer term loans.

© Mcgraw-Hill Companies, 2008 Noncurrent Liabilities Any liability that is not current is classified as a noncurrent liability. These financial obligations will become due and payable some time after one year from the date on the balance sheet.

© Mcgraw-Hill Companies, 2008 Owner Equity If all assets were to be sold and all debts paid on the date of the balance sheet, the owner’s equity would be the amount left over. Owner equity changes when: 1) the business has a profit or loss, 2) the owner invests more capital from outside the business or withdraws money from the business, or 3) assets change value. Owner equity does not change when cash is used to buy other assets or a loan is taken out to purchase an asset with value equal to the loan.

© Mcgraw-Hill Companies, 2008 Alternative Format Current assets and liabilities are defined in the same way as previously Intermediate assets are expected to have a life of 1 to 10 years and intermediate liabilities are due and payable after 1 year but before 10 years Fixed assets have a useful life of more than 10 years and long-term liabilities are due after 10 years

© Mcgraw-Hill Companies, 2008 Table 5-2 Format of a Three-Category Balance Sheet

© Mcgraw-Hill Companies, 2008 Asset Valuation and Related Problems A cost-basis balance sheet has all assets valued following the cost, cost less depreciation, or farm production cost methods. The one exception would be inventories of grain and market livestock. A market-basis balance sheet has all assets valued at market value less estimated selling costs.

© Mcgraw-Hill Companies, 2008 Which Is Best? Cost-basis balance sheets conform to general accounting standards and are thus comparable to balance sheets from other types of businesses. Market-basis balance sheets more accurately reflect the actual financial position. FFSC says both types of balance sheets are needed for proper business analysis.

© Mcgraw-Hill Companies, 2008 Table 5-3 Valuation Methods for Cost-Basis and Market-Basis Balance Sheets

© Mcgraw-Hill Companies, 2008 Table 5-4 Balance Sheet for I. M. Farmer, December 31, 2010

© Mcgraw-Hill Companies, 2008 Balance Sheet Example Assets: most differences show up in valuation of noncurrent assets Liabilities: Little difference in liabilities sections, other than deferred taxes Owner equity: valuation adjustment on market-basis balance sheet accounts for change in assets’ worth over time because of changes in market conditions for item

© Mcgraw-Hill Companies, 2008 Balance Sheet Analysis Liquidity measures: current ratio, working capital Solvency measures: debt/asset ratio, equity/asset ratio, debt/equity ratio, net capital ratio Other measure: debt structure ratio

© Mcgraw-Hill Companies, 2008 Current Ratio Current asset value Current ratio = Current liability value $112,500 Current ratio = = 1.27 (market value) $88,860

© Mcgraw-Hill Companies, 2008 Working Capital Working capital = Current assets  current liability Working capital = $112,500  $88,860 = $23,640 (market value)

© Mcgraw-Hill Companies, 2008 Debt/Asset Ratio Total liabilities Debt/asset ratio = Total assets $368,860 Debt/asset ratio = = 0.50 $741,500 (market value)

© Mcgraw-Hill Companies, 2008 Equity/Asset Ratio Owner equity Equity/asset ratio = Total assets $372,640 Equity/asset ratio = = 0.50 $741,500 (market value)

© Mcgraw-Hill Companies, 2008 Debt/Equity Ratio Total liabilities Debt/equity ratio = Owner equity $368,860 Debt/equity ratio = = 0.99 $372,640 (market value)

© Mcgraw-Hill Companies, 2008 Table 5-5 Summary of I. M. Farmer’s Financial Condition

© Mcgraw-Hill Companies, 2008 Net Capital Ratio Total assets Net capital ratio = Total liabilities $741,500 Net capital ratio = = 2.01 $368,860 (market value)

© Mcgraw-Hill Companies, 2008 Debt Structure Ratio Current liabilities Debt structure ratio = Total liabilities $88,860 Debt structure ratio = =.24 or 24% $368,860 (market value)

© Mcgraw-Hill Companies, 2008 Statement of Owner Equity The FFSC recommends that a statement of owner equity be part of a complete set of financial records. The statement shows the sources of change in owner equity over the accounting period.

© Mcgraw-Hill Companies, 2008 Table 5-6 Statement of Owner Equity

© Mcgraw-Hill Companies, 2008 Summary A balance sheet shows the financial position of a business at a point in time. An important consideration is the method used to value assets. Cost methods reflect the original investment value. Market valuation reflects current collateral values. The FFSC recommends listing both cost and market values for complete information.