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Balance Sheet Analysis

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Balance Sheet Analysis

  1. 1. The Balance Sheet & Its Analysis (Chapter 5)
  2. 2. Objectives <ul><li>Discuss the purpose of the balance sheet. </li></ul><ul><li>Illustrate the format and structure of the balance sheet. </li></ul><ul><li>Outline some issues related to valuing assets . </li></ul><ul><li>Show the difference between a cost-basis and a market-basis balance sheet . </li></ul><ul><li>Define owner equity or net worth. </li></ul><ul><li>Analyze a firm’s solvency and liquidity . </li></ul><ul><li>Introduce the statement of owner equity . </li></ul>
  3. 3. The Balance Sheet <ul><li>Summarizes the financial condition of the business at a point in time: </li></ul><ul><ul><li>Remember - the “snapshot” idea! </li></ul></ul><ul><li>Estimates net worth or owner equity. </li></ul><ul><li>Most transactions affect the balance sheet, so it may change daily. </li></ul>
  4. 4. Purpose of a Balance Sheet <ul><li>Everything “owned” and “owed” by a business or individual at a given point in time. </li></ul><ul><li>Asset – anything of value owned. </li></ul><ul><li>Liability – any debt or other financial obligation owed to someone else. </li></ul><ul><li>Owner Equity/Net worth – the amount the owner has invested in the business. </li></ul><ul><li>“ Balance” idea: </li></ul><ul><ul><li>Owner Equity = Assets – Liabilities </li></ul></ul>
  5. 5. Preparing a Balance Sheet <ul><li>Can be completed at anytime. </li></ul><ul><li>Most are prepared at the end of the accounting period </li></ul><ul><ul><li>Represents both end-of-the-year and beginning-of-the-year. </li></ul></ul><ul><ul><ul><li>That is, end of year 1 = beginning of year 2! </li></ul></ul></ul><ul><ul><li>For comparison purposes and analysis. </li></ul></ul><ul><li>Should follow guidelines of some recognized accounting entity: </li></ul><ul><ul><li>FFSC = Farm Financial Standards Council used for farm-based businesses. </li></ul></ul>
  6. 6. General Format of a Balance Sheet <ul><li>Assets </li></ul><ul><li>Current assets $XXX </li></ul><ul><li>Noncurrent assets XXX </li></ul><ul><li>Total assets $XXX </li></ul><ul><li>Liabilities </li></ul><ul><li>Current liabilities $XXX </li></ul><ul><li>Noncurrent liabilities XXX </li></ul><ul><li>Total liabilities $XXX </li></ul><ul><li>Owner’s equity XXX </li></ul><ul><li>Total liabilities and </li></ul><ul><li>owner’s equity $XXX </li></ul>
  7. 7. Assets <ul><li>An asset can be sold to generate additional cash. </li></ul><ul><li>Used to produce other goods. </li></ul>
  8. 8. Current Assets <ul><li>Goods that have already been produced and can be sold quickly without disrupting future production activities: </li></ul><ul><ul><ul><li>Grain. </li></ul></ul></ul><ul><ul><ul><li>Feeder livestock. </li></ul></ul></ul><ul><ul><ul><li>Other inventories. </li></ul></ul></ul><ul><li>Goods that will ordinarily be used up or sold within the next year: </li></ul><ul><ul><ul><li>Cash. </li></ul></ul></ul><ul><ul><ul><li>Checking and savings account balances. </li></ul></ul></ul><ul><ul><ul><li>Marketable investments. </li></ul></ul></ul><ul><ul><ul><li>Accounts and notes receivable. </li></ul></ul></ul><ul><ul><ul><li>Inventories of feed, farm supplies, etc.. </li></ul></ul></ul>
  9. 9. Noncurrent Assets <ul><li>Any asset that is not a current asset. </li></ul><ul><li>Assets that are owned primarily to produce the output that will be sold to produce revenue. </li></ul><ul><li>Selling noncurrent assets to generate revenue would affect the firm’s ability to produce future income. </li></ul><ul><li>More difficult to sell quickly and easily at their full market value: </li></ul><ul><ul><ul><li>Machinery and equipment. </li></ul></ul></ul><ul><ul><ul><li>Breeding livestock. </li></ul></ul></ul><ul><ul><ul><li>Buildings. </li></ul></ul></ul><ul><ul><ul><li>Land. </li></ul></ul></ul>
  10. 10. Liabilities <ul><li>An obligation or debt owed to someone else. </li></ul><ul><li>An outsider’s claim against one or more assets of the business. </li></ul>
  11. 11. Current Liabilities <ul><li>Financial obligations that will become due and payable within 1 year </li></ul><ul><ul><ul><li>Accounts payable. </li></ul></ul></ul><ul><ul><ul><li>Principal and accumulated interest on short-term loans or notes payable (operating loans). </li></ul></ul></ul><ul><ul><ul><li>Principal payments on long-term loans due within the next year: </li></ul></ul></ul><ul><ul><ul><ul><li>Machinery, land. </li></ul></ul></ul></ul><ul><ul><ul><li>Accrued expenses : </li></ul></ul></ul><ul><ul><ul><ul><li>Accumulated interest, accrued property taxes, etc. </li></ul></ul></ul></ul>
  12. 12. Noncurrent Liabilities <ul><li>All obligations that don’t have to be paid in full within the next year. </li></ul><ul><ul><li>The remaining balance on long-term debt. </li></ul></ul>
  13. 13. Owner Equity <ul><li>The amount of money left for the owner if the assets were sold and all liabilities paid. </li></ul><ul><li>Also called Net Worth. </li></ul><ul><li>The owners current investment in the business. </li></ul><ul><li>Equity = Total assets - Total liabilities </li></ul>
  14. 14. Changes in Owner Equity <ul><li>Using assets to produce income: </li></ul><ul><ul><li>Profit is then used to purchase additional assets or to reduce liabilities. </li></ul></ul><ul><li>If there is a change in an assets value. </li></ul><ul><li>If an inheritance is received. </li></ul><ul><li>Cash or property is contributed to the business or withdrawn from the business. </li></ul><ul><li>An asset is sold for more or less than its balance sheet value. </li></ul><ul><li>Important to recognize that only certain things bring about a change in owner equity. </li></ul>
  15. 15. Changes in Owner Equity <ul><li>Composition of assets and liabilities may not cause a change in owner equity: </li></ul><ul><ul><li>If $10,000 cash is used to purchase a new machine? </li></ul></ul><ul><ul><li>If $10,000 is borrowed to purchase a new machine? </li></ul></ul><ul><ul><ul><li>Until depreciation, no impact! </li></ul></ul></ul><ul><ul><li>Using $10,000 from cash to make an early principal payment on a loan? </li></ul></ul><ul><li>Owner equity changes only when: </li></ul><ul><ul><li>The owner invests personal capital from outside the business. </li></ul></ul><ul><ul><li>The owner withdraws personal capital. </li></ul></ul><ul><ul><li>The business shows a profit or loss. </li></ul></ul><ul><ul><li>Changes in asset values because of changes in market prices. </li></ul></ul>
  16. 16. Intermediate Assets <ul><li>Dividing noncurrent assets into two categories (allowed by FFSC): </li></ul><ul><ul><li>Intermediate assets – have a life greater than 1 year but less than 10 years: </li></ul></ul><ul><ul><ul><ul><li>Machinery, equipment, perennial crops, breeding livestock </li></ul></ul></ul></ul><ul><ul><li>Fixed assets – have a life greater than 10 years: </li></ul></ul><ul><ul><ul><ul><li>Land, buildings </li></ul></ul></ul></ul>
  17. 17. Intermediate Liabilities <ul><li>Dividing noncurrent liabilities into two categories. </li></ul><ul><ul><li>Intermediate liabilities – debt obligations where repayment of principal occurs over a period of more than 1 year and as long as 10 years: </li></ul></ul><ul><ul><ul><ul><li>Loans used to purchase machinery, breeding livestock, and other intermediate assets. </li></ul></ul></ul></ul><ul><ul><li>Fixed liabilities – debt obligations where the repayment period is longer than 10 years: </li></ul></ul><ul><ul><ul><ul><li>Farm mortgages, land purchases . </li></ul></ul></ul></ul><ul><li>This additional division is recognized by FFSC, but not encouraged . </li></ul>
  18. 18. Asset Valuation <ul><li>Cost-basis: </li></ul><ul><ul><li>Values all assets using the cost, cost less depreciation, or farm production cost method. </li></ul></ul><ul><ul><ul><li>Inventories of grain and market livestock can be valued at market value less selling costs. </li></ul></ul></ul><ul><li>Market-basis: </li></ul><ul><ul><li>Values all assets at market value less selling cost: </li></ul></ul><ul><ul><ul><li>Inflation and fast depreciation methods can cause market values to be higher than book values. </li></ul></ul></ul><ul><ul><ul><li>Market-basis usually has higher asset values implying higher equity. </li></ul></ul></ul>
  19. 19. Advantages of Cost-basis or Market-basis Balance Sheets <ul><li>Cost-basis: </li></ul><ul><li>Conforms to GAAP. </li></ul><ul><li>Conservative. </li></ul><ul><li>Comparable with balance sheets from other types of businesses. </li></ul><ul><li>Changes in equity come only from net income that has been earned and retained. </li></ul><ul><li>Market-basis: </li></ul><ul><li>More accurate indication of the current financial condition. </li></ul><ul><li>Shows the current value of available collateral.** </li></ul>
  20. 20. Use Cost or Market Basis for Balance Sheet? <ul><li>Both are important and have value. </li></ul><ul><li>Recommended by FFSC: </li></ul><ul><ul><li>Market-based with full documentation. </li></ul></ul><ul><ul><li>Two column format with both. </li></ul></ul><ul><li>Recommend following specified procedure for valuing assets: </li></ul>
  21. 21. Valuation Methods for Cost-basis & Market-basis Balance Sheets <ul><li>Asset Cost Basis Market Basis </li></ul><ul><li>Marketable securities Cost Market </li></ul><ul><li>Inventories of grain & market livestock Market Market </li></ul><ul><li>Accounts receivable Cost Cost current </li></ul><ul><li>Prepaid expenses Cost Cost assets </li></ul><ul><li>Investment in growing crops Cost Cost </li></ul><ul><li>Purchased breeding livestock Cost Market </li></ul><ul><li>Raised breeding livestock Cost or base value Market </li></ul><ul><li>Machinery & equipment Cost Market noncurrent </li></ul><ul><li>Buildings & Improvements Cost Market assets </li></ul><ul><li>Land Cost Market </li></ul>
  22. 22. Balance Sheet Analysis <ul><li>Used to measure the financial condition of the business (management tool): </li></ul><ul><ul><ul><li>Compare to other, but similar businesses. </li></ul></ul></ul><ul><ul><ul><li>Compare to the same business over time. </li></ul></ul></ul><ul><li>Lenders use balance sheet analysis to make lending decisions and to monitor the financial progress of their customers. </li></ul><ul><li>To deal with relative size issue, use what? </li></ul>
  23. 23. Balance Sheet Analysis <ul><li>A. Measures of Liquidity: </li></ul><ul><ul><li>Current Ratio </li></ul></ul><ul><ul><li>Working Capital: </li></ul></ul><ul><ul><ul><li>- not a ratio (in $), so size must be considered. </li></ul></ul></ul><ul><li>B. Measures of Solvency: </li></ul><ul><ul><li>Debt/Asset Ratio </li></ul></ul><ul><ul><li>Equity/Asset Ratio </li></ul></ul><ul><ul><li>Debt/Equity Ratio </li></ul></ul><ul><li>Are others, but these recommended by FFSC </li></ul>
  24. 24. The Concept of Liquidity <ul><li>Short-term measure. </li></ul><ul><li>Measures the ability to meet financial obligations: </li></ul><ul><ul><li>As they come due. </li></ul></ul><ul><ul><li>Without disturbing normal revenue generating activities. </li></ul></ul><ul><li>Ability of the firm to generate cash for running the business. </li></ul>
  25. 25. Measures of Liquidity <ul><li>Current Ratio: </li></ul><ul><li>Total current farm assets ÷ Total current farm liabilities or CA/CL: </li></ul><ul><li>Example from text: 112,500 ÷ 88,860 = 1.27 </li></ul><ul><li>Write the Current Ratio as 1.27:1 </li></ul><ul><li>Current assets compared to current liabilities. </li></ul><ul><li>Values > 1 are preferred (safety margin). </li></ul><ul><li>Larger ratios imply more liquidity. </li></ul>
  26. 26. Measures of Liquidity <ul><li>Working Capital: </li></ul><ul><li>Total current farm assets - Total current farm liabilities: </li></ul><ul><li>Example: $112,500 - $88,860 = $23,640 </li></ul><ul><li>Write the Working Capital as $23,640 </li></ul><ul><li>$ left after selling all current assets and paying off all current liabilities. </li></ul><ul><li>Margin of safety in a $ value. </li></ul><ul><li>Compare to similar sized operations. </li></ul>
  27. 27. The Concept of Solvency <ul><li>Measures the degree to which liabilities are backed up by assets. </li></ul><ul><li>Measures liabilities relative to owner equity. </li></ul><ul><li>Ability to pay off all liabilities if all assets were sold. </li></ul>
  28. 28. Measures of Solvency <ul><li>Debt/Asset Ratio: </li></ul><ul><li>Total farm liabilities ÷ Total farm assets </li></ul><ul><li>Example: $368,860 ÷ $741,500 = 0.4975 </li></ul><ul><li>Multiply by 100 </li></ul><ul><li>Write the Debt/Asset Ratio as 49.75% </li></ul><ul><li>% (share) of total assets owed to lenders. </li></ul><ul><li>Lower values are preferred. </li></ul>
  29. 29. Measures of Solvency <ul><li>Equity/Asset Ratio: </li></ul><ul><li>Total farm equity ÷ Total farm assets </li></ul><ul><li>Example: $372,640 ÷ $741,500 = 0.5025 </li></ul><ul><li>Multiply by 100 </li></ul><ul><li>Write the Equity/Asset Ratio as 50.25% </li></ul><ul><li>% of total assets financed by owner’s equity capital. </li></ul><ul><li>Higher values are preferred. </li></ul>
  30. 30. Measures of Solvency <ul><li>Debt/Equity Ratio (leverage ratio): </li></ul><ul><li>Total farm liabilities ÷ Total farm equity </li></ul><ul><li>Example: $368,860 ÷ $372,640 = 0.99 </li></ul><ul><li>Write the Debt to Equity Ratio as 0.99:1 </li></ul><ul><li>Lender financing compared to owner financing. </li></ul><ul><li>Smaller values are preferred. </li></ul>
  31. 31. Balance Sheet Analysis <ul><li>A. Concept of Liquidity: </li></ul><ul><ul><li>Ability of the firm to generate cash for running the business. </li></ul></ul><ul><li>B. Concept of Solvency: </li></ul><ul><ul><li>Ability to pay off all liabilities if assets are sold. </li></ul></ul>
  32. 32. Solvency and Liquidity based on valuation method <ul><li>Our examples used market basis: </li></ul><ul><li>1. Liquidity differences if used cost-basis ? </li></ul><ul><li>- look at how relevant assets are valued. </li></ul><ul><li>- likely no (or small) difference. </li></ul><ul><li>2. Solvency differences if used cost-basis ? </li></ul><ul><li>- lower values for assets = less desirable solvency measures. </li></ul>
  33. 33. Valuation Methods for Cost-basis & Market-basis Balance Sheets <ul><li>Asset Cost Basis Market Basis </li></ul><ul><li>Marketable securities Cost Market </li></ul><ul><li>Inventories of grain & market livestock Market Market </li></ul><ul><li>Accounts receivable Cost Cost current </li></ul><ul><li>Prepaid expenses Cost Cost assets </li></ul><ul><li>Investment in growing crops Cost Cost </li></ul><ul><li>Purchased breeding livestock Cost Market </li></ul><ul><li>Raised breeding livestock Cost or base value Market </li></ul><ul><li>Machinery & equipment Cost Market noncurrent </li></ul><ul><li>Buildings & Improvements Cost Market assets </li></ul><ul><li>Land Cost Market </li></ul>
  34. 34. Statement of Owner Equity <ul><li>Shows the source of changes in owner equity and the amount that came from each source. </li></ul><ul><li>Where growth (or lack of growth) is coming from: </li></ul><ul><ul><li>Reconciles beginning and ending owner equity. </li></ul></ul><ul><li>See example from book (handout). </li></ul>
  35. 35. Summary <ul><li>A balance sheet shows the financial position of a business at a point in time. </li></ul><ul><li>Assets can be valued using cost methods or current market valuations. </li></ul><ul><li>Liquidity measures the ability of the business to meet financial obligations as they come due and without disturbing normal production. </li></ul><ul><li>Solvency measures the degree to which the liabilities of the business are backed up by its assets. </li></ul>