5-1 Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display. PowerPoint Presentation Materials For Financial Accounting: A New Perspective by Dr. Joseph Otto

CHAPTER 5 Using the Balance Sheet to Make Decisions

5-3 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

5-4 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 $75,000

5-5 WHY DISTINGUISH BETWEEN CURRENT, NONCURRENT? To allocate resources to meet needs Timing influences decisions

5-6 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

5-7 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

5-8 LIQUIDITY Measure of availability of cash How quickly noncash assets can be turned into cash Sign of financial health

5-9 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

5-10 USING BALANCE SHEET RATIOS Ratios Show percentage relationship between 2 numbers Summarize information Easily understood, interpreted, compared Example: Return on equity Measures performance

5-11 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

5-12 LIQUIDITY RATIOS Current ratio Acid test (Quick) ratio Bank ratios

5-13 CURRENT RATIO Measures relative ability to meet maturing current debts (solvency) High ratio desirable Current Asset Current Liabilities

5-14 ACID TEST RATIO Measures relative ability to meet maturing current debts (solvency) High ratio desirable Current assets – (Inventories + prepaid Assets) Current Liabilities

5-15 BANK RATIOS Approving Susan’s Loan Banker’s measure of loan risk To protect lender Loan to value Loan to liquidation value

5-16 LOAN TO VALUE Lower is better Maximum Loan Liability Market value of collateral

5-17 LOAN TO LIQUIDATION VALUE Lower is better Maximum Loan Liability Liquidation Value of Asset

5-18 LEVERAGE RATIOS Evaluate financial risk Debt to Assets Ratio Debt to Equity Ratio

5-19 DEBT TO ASSETS RATIO Indicates long-run solvency of business Describes relative amount of financial risk Total Liabilities Total Assets

5-20 DEBT TO EQUITY RATIO Indicates long-run solvency of business Describes relative amount of financial risk Total Liabilities Total Owners’ Equity

5-21 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

5-22 USING INFORMATION TO MAKE DECISIONS: MD&A Outside balance sheet Management’s Discussion and Analysis of Operations (MD&A) Relates to balance sheet Liquidity and Capital Resources

5-23 USING INFORMATION TO MAKE DECISIONS: 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

5-24 USING INFORMATION TO MAKE DECISIONS: Commitments Executory contract Example: noncancelable lease arrangements Contingency May never materialize Potential future obligation

5-25 Executory Contract Promise to perform duties in future Commitment No current liability Definition: liability Probably future sacrifices of economic benefits arising from present obligations

5-26 HOW ARE ASSETS MEASURED? Entry prices Historical cost Current cost Exit prices Fair market value (FMV) Present value of future cash flows

5-27 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

5-28 ASSET VALUATION Personal balance sheet Estimated current value or fair market value (FMV) Business balance sheet Follows GAAP

5-29 ASSET VALUATION: Current Assets Asset Category AccountMeasurement CurrentCash Marketable Sec. A/R Inventory Monetary FMV or cost FMV less allowance LCM

5-30 ASSET VALUATION: Investments Asset Category AccountMeasurement InvestmentsEquity Bonds Long term Notes Receivables FMV Present value of future cash flows

5-31 ASSET VALUATION: Property, Plant, Equipment Asset Category AccountMeasurement Property, Plant, Equipment Buildings, Equipment, etc. Cost less Accumulated Depreciation

5-32 ASSET VALUATION: Intangible Assets Asset Category AccountMeasurement IntangiblesPatents, Goodwill, etc Cost less Amortization

5-33 KEY QUALITATIVE CHARACTERISTICS Characteristics of accounting information Relevance Makes a difference in a decision Reliability Degree of confidence in information Verifiability Traceable

5-34 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

5-35 Assign #11 read chapter 6, pg , Questions 2, 8, 11, 15, 16 Assign #12 pg , Reinforcement Exercises 3, 5, 7, 12, 18, pg , Critical Thinking Problems 1, 7, 14, 17, 19 Assign #4C Custom Computer transmittals and SC.