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CHAPTER 5

ANSWERS TO END OF CHAPTER QUESTIONS

1. True or false. If the debt/equity ratio increases, the debt/asset ratio will also increase. Why?

True. If additional debt is incurred, there should be a corresponding increase in total assets but owner equity will
remain the same. The debt-equity ratio will increase and, since debt has increased proportionally more than assets,
the debt/asset ratio will also increase.

2. True or false. A business with a higher working capital will also have a higher current ratio. Why?

False. It is important to not confuse changes in a ratio with changes in an absolute number such as working capital.
A business with current assets of \$50 and current liabilities of \$20 has the same current ratio as a business with
current assets of \$500,000 and current liabilities of \$200,000. However, the latter business obviously has the higher
working capital but their liquidity relative to the size of their current assets and liabilities is the same.

3. Use your knowledge of balance sheets and ratio analysis to complete the following abbreviated a balance sheet.
The current ratio = 2.0 and the debt/equity ratio = 1.0.

Assets                                               Liabilities
Current assets               \$80,000                    Current liab.                          \$40,000
Noncurrent assets            120,000                    Noncurrent liab.                        60,000
Total liabilities                      100,000
Owner equity                           100,000
Total liabilities
Total assets                \$200,000                     plus equity                          \$200,000

Solution: A current ratio of 2.0 means current assets are twice current liabilities so the latter must be \$40,000. With
a debt/equity ratio of 1.0, total liabilities must be the same as equity or \$100,000. Noncurrent liabilities are found by
subtracting current from total liabilities. Next, total liabilities plus equity can be found by addition. Total assets
must equal the same value or \$200,000. Finally, noncurrent assets can be found by subtracting current from total
assets.

4. Can a business be solvent but not liquid? Liquid but not solvent? How?

A business can be solvent but not liquid. This can happen when much of the total asset value is in assets with the
least liquidity such as land and buildings and most of the liabilities are current. Since farm and ranch businesses
often have a large proportion of their assets in land, buildings and other noncurrent assets, this is a common situation.

Conceptually, a business can be liquid but not solvent. The business would need to have a large current asset value
relative to its current liabilities and noncurrent liabilities considerably greater than noncurrent assets. The latter
might happen, for example, given a sharp decrease in the market value of noncurrent assets such as land. However,
since the current portion of any noncurrent debt is included as a current liability, it would be difficult to find a farm
or ranch business which is liquid but not solvent.

5. Does a balance sheet show the annual net farm income for a farm business? Why or why not?

No. A balance sheet is not intended nor designed to show net farm income, only the financial condition of the
business at a point in time. However, as will be shown in the next chapter, net farm income does have an effect on
the balance sheet values even though it does not show up directly on the balance sheet.

6. True or false. Assets + Liabilities = Equity.

False. The correct accounting equation is: Assets = Liabilities + Equity
7. Assume you are an agricultural loan officer for a bank and a customer requests a loan based on the following
balance sheet. Conduct a ratio analysis and give your reasons for granting or denying an additional loan. What is
the weakest part of this customer's financial position?

Assets                                            Liabilities
Current assets                      \$ 40,000                    Current liabilities                           \$ 60,000
Noncurrent assets                    240,000                    Noncurrent liabilities                          50,000
Total liabilities                            110,000
Owner equity                                 170,000
Total assets                       \$280,000                     Total liab. plus equity                      \$280,000

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Current ratio:                            0.67                     Debt/asset ratio:                                 0.39
Working capital:                     \$-20,000                      Debt/equity ratio:                                0.65
Debt structure:                  0.55 or 55%                       Equity/asset ratio:                               0.61

This customer has a poor liquidity position (the weakest part of the customer's financial condition) but a relatively
strong solvency position. Whether or not the loan should be made is a judgment call. However, if it is made, it
should be a new noncurrent loan rather than a current. As one possibility, assume the bank grants a new \$60,000
noncurrent loan with the proceeds to be used to pay off all current liabilities. If the balance sheet values are adjusted
to reflect this situation, you will find the liquidity problem has been greatly reduced if not eliminated and solvency is
still strong. (Note that the current portion of the new loan would become a current liability so current liabilities
would not be zero.) A new current loan only compounds the liquidity problem.

8. Why is there no noncurrent deferred income taxes on a cost basis balance sheet?

All noncurrent assets on a cost basis balance sheet are valued using one of the cost related valuation methods. If sold
for this amount, there would be no income tax due so no deferred income tax is shown. On a market basis balance
sheet, noncurrent assets would be valued at market prices (assumed to be higher than cost). If this higher value is
realized by selling the assets, income tax would be due on any gain. It is therefore misleading to show market values
without also showing any income tax that would be due as a result of selling the assets for this amount.

9. Assume a mistake was made and the value of market livestock on a balance sheet is \$10,000 higher than it should
be. How does this error affect measures of liquidity and solvency? Would the same results occur if land had been
over valued by \$10,000?

Over valuing market livestock by \$10,000 means current assets, total assets and owner's equity are all \$10,000 higher
than they should be. Liabilities are not affected. Therefore, all liquidity and solvency measures will appear to be
better than they actually are.

If land is over valued by \$10,000, the results are different. Current asset value is correct but noncurrent assets, total
assets, and owner equity are higher than they should be. Since liquidity measures involve only current assets, they
are correct. However, solvency measures will be overstated.

10. Would the following entries to a farm balance sheet be classified as an asset or liability? As current or
noncurrent?

a) machine shed - noncurrent asset
b) feed bill at local feed store - current liability
c) a 20-year farm mortgage - noncurrent liability (but payments due during next year are a current liability)
d) a 36-month certificate of deposit - noncurrent asset
e) newborn calves - current asset

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Description: Debt to Equity Ratio document sample