"The Balance Sheet A balance sheet is one of"
The Balance Sheet A balance sheet is one of four financial statements that a producer needs to complete and analyze each year. The balance sheet is a snapshot of an operation on a given date, usually at the end of the year (December 31). It defines three things: 1. It outlines the assets (what is owned). 2. It summarizes the liabilities (what is owned to somebody else). 3. It establishes equity (what is owned free and clear once the liabilities have been paid). Once the assets and liabilities are clearly defined and listed, owner equity can be calculated by subtracting the liabilities from the assets. If equity is positive, then the operator and not the creditors own more of business. If equity is negative, your creditors own more of your business than you do. Creditors would not let this situation last long before they foreclosed on your business. What does a balance sheet look like? The balance sheet lists the assets, liabilities and equity. Assets and liabilities are broken into current and noncurrent. Current assets are those items that can be turned into cash rapidly (within the next twelve months) such as a checking account, feed inventories, feeder livestock, or raised crop inventories. Noncurrent assets (sometimes referred to as intermediate and long term assets) are those items that are used for production and cannot be readily sold. They include breeding livestock, machinery and equipment, buildings and real estate. Current liabilities are debts that must be paid within twelve months. These could include accounts payable such as a feed bill at the feed store. In addition, the current portion of noncurrent liabilities should be included in the current liability section. This would include any payments on noncurrent debt that is due during the next twelve months. Noncurrent liabilities are debts that do not come due within the next twelve months. These would include land payments, mortgages, etc. Once the total assets and liabilities have been detailed, the producer can determine his net equity. Remember that equity is calculated as total assets minus total liabilities. Duckworth, Brenda, Stan Bevers, Rob Borchardt, and Blake Bennett. Department of Ag Economics, Texas Cooperative Extension, Texas A&M University. May 2003. Why do you need one? Having a balance sheet is just good business management. Every good producer should know where the business is financially. The balance sheet is the place to start determining the financial health of the business. Comparing balance sheets over time gives the producer the information to know whether his decisions are moving the operation in the right direction to fulfill his goals. In addition, most lenders will want a balance sheet to determine repayment ability. How do I value my assets? There are two methods used to value the assets of an operation. The first method is based on “historical cost”, or purchase price of the asset. The second method bases valuation on fair market value, or the price that would be paid for the asset if it were sold today. Although lenders will want to see a balance sheet based on fair market value, the producer should always keep the balance sheet based on historical cost. When a lender requests a balance sheet, the producer will simply add a column to the right of historical cost and fill in the fair market value. Historical cost balance sheet assets should be presented “net of accumulated depreciation”. The accumulated depreciation account is presented as a negative number, thereby reducing the assets to their “basis” (cost less accumulated depreciation.) Likewise, assets should be broken down into categories representing similar groups of assets. The cost base balance sheet assets will look like this: Example of Fixed Assets Section of Balance Sheet. Vehicles $7,000 (Accumulated Depreciation) ($4,550) $2,450 Machinery & Equipment $47,750 (Accumulated Depreciation) ($13,569) $34,181 Land * $44,000 $44,000 Total $80,631 * No Accumulated Depreciation account because land is not depreciable Some assets are raised such as breeding livestock. In this case, the cost value utilizes a base value approach, which approximates the accumulated expenses during the development of the livestock. Only costs incurred to get the asset in place (mature enough to breed) should be included. Annual operating expenses, such as feed, repairs, etc., after the asset is able to produce are included in the annual business expenses for the period. Both methods have advantages and disadvantages. The cost basis is typically the lower value of the two methods; however, not all assets are purchased, as with the case of raised replacement L8.2 stock. Using the cost value will raise some financial ratios compared to the market value approach. The market approach accurately reflects the current value of the business if deferred taxes are included (which they should be). Deferred taxes are taxes that would have to be paid on the gain of the sale of the asset. However, the market approach can be subject to guessing. The Farm Financial Standards Council recommends that balance sheets have both values. A word about depreciation Depreciation is a portion of the total cost of an asset allocated over the useful life of the asset. When an asset is purchased, it is presumed that it will be used over a given span of time (useful life). The asset is not completely spent in the first production cycle used; rather, small “pieces” are used over the years. These “pieces” of the spent asset are called depreciation. There are several methods of calculating depreciation. Tax laws allow agricultural businesses to accelerate depreciation, or take bigger pieces per year. Producers generally like the idea of accelerating depreciation because greater expenses reduce taxable income, thereby reducing income tax expense. For income tax-reducing purposes, expenses are good and income is bad. Conversely, from a management perspective, expense is bad and income is good. Among other key differences, depreciation should be calculated differently for tax purposes and management purposes. Management depreciation should be a true representation of the use of an asset. The “straight- line” method, which is determined based on useful life, is a better choice for management depreciation. Consult an accounting professional for help with depreciation and tax issues. Tax professionals usually have the capability of calculating straight-line and tax depreciation at the same time. How is the balance sheet constructed? This curriculum provides a “flow” of information into a useful format. One piece of the financial information puzzle includes the balance sheet, which is built on prior year’s data. Although the initial balance sheet can be challenging to construct, the future years are relatively simple if the steps presented in this curriculum are consistently followed. It is recommended that the producer seek professional expertise for the initial balance sheet. Remember to value assets on historical costs (original purchase price). Liabilities should be the remaining balance of the liability as of the balance sheet date. After the balance sheet has been created, additions and subtractions are recorded on the Transaction Log for cash transactions and to the Balance Sheet Worksheet for non-cash transactions. At the end of the year, all cash transactions are added to the Balance Sheet Worksheet and totals on the worksheet are moved to the ending balance sheet. L8.3 What do I do with the balance sheet once I have it? A balance sheet can be a valuable tool for the manager to evaluate how the business is progressing toward its goals. By comparing balance sheets over a number of years, equity can be seen either increasing or deceasing. In addition, the manager will want to use ratios to calculate the financial strength of the operation. (See the Financial Analysis section of this curriculum.) L8.4 Balance Sheet (What an operation has vs. what it owes) Lesson Plan I. Goals A. Define the balance sheet. B. Explain uses of the balance sheet. C. Teach methods of compiling balance sheets. II. Highlights/ descriptions A. What is a balance sheet? A balance sheet is a report that tells the story of what an operation owns vs. what it owes. The amounts reported are a running balance of transactions from the beginning of the operation up to the date specified. For example, an operation has purchased $10,000 of equipment, but still owes $4,000 on that equipment. In the top section of the balance sheet, the total amount purchased is reported in the assets section ($10,000) and the amount owed is reported in the liabilities section ($4,000) at the bottom. The “net” amount would be what the business owns or $6,000. The business has “equity” in the business of $6,000. B. Who needs a balance sheet and why? Lenders are very interested in the balance sheet. They primarily want a business to repay the loan, but if there is an instance when repayment is not made, the lender wants substitute compensation- collateral. When a business is “over- leveraged,” its equity is small. The percentage of ownership in the business is too small, and therefore the loan is more risky. The lender may deny the loan or may increase the interest rate as compensation for accepting more risk. Management uses the balance sheet to analyze the financial health of a business. Ratios can tell the story of financial health from differing viewpoints. By using ratios to determine strengths and weaknesses, managers become more aware (ahead of time) of the financial health of the business. Most importantly, producers are likely to sleep better at night knowing the condition of the business and having a plan. L8.5 C. How to compile a balance sheet. The transaction log contains balance sheet cash inflows and outflows. If cash is received from the sale of an asset, it should be recorded on the “Cash Inflows (Balance Sheet)” form. The same would be true for the receipt of cash from loan proceeds. If cash is used to purchase an asset (or to make a loan payment), the transaction should be recorded on the “Cash Outflows (Balance Sheet)” form. Any non-cash balance sheet transactions are recorded directly to the “Balance Sheet Worksheets”. Once all cash & non-cash transactions (including the increase in accumulated depreciation) are recorded, totals from the Balance Sheet Worksheets can be taken to the final Balance Sheet. There is no need for enterprise breakdown on the balance sheet because it has no analysis relevance. D. Since a balance sheet is cumulative (running balance), the balance sheet at the end of year 1 becomes the beginning balance sheet for year 2. III. Potential Speakers A. Extension Agents B. Extension Specialists IV. Review Questions A. The balance sheet tells a producer his net income. (True or False) False. The Income Statement tells a producer about the net income. The balance sheet tells the producer about his % ownership of the business. B. The entire purchase price of a tractor should be reflected as an expense (in the income statement). (True or False) False. The cost of the asset (tractor) is reflected as an expense over the useful life of the asset as depreciation expense. L8.6 C. What is the difference in a Market-Based balance sheet and a Cost- Based balance sheet? Balance sheet information should always be internally presented (to management) using the Cost Basis for consistency when analyzing ratios. Market-Based balance sheets are typically required by lenders to determine collateral value. L8.7 Balance Sheet Overheads Introduction √ Balance Sheet tells the reader what an operation owns vs. what it owes as a running balance (year-to-date.) √ Lenders are especially interested in a producer’s balance sheet because it indicates unused collateral (market-based balance sheet.) √ Managers use the balance sheet to analyze the financial health of the business. They use ratios to help determine specific strengths and weakness (and to measure them.) Internally used balance sheets should be based on historical or actual amounts, not market values. √ The order of class presentation begins with assets, then liabilities, and finally equity. Current assets are those resources that can be converted to cash within one year. Examples of current assets include cash, checking account balance, inventories, prepaid inputs (insurance), and accounts receivable. Non-current assets are those resources that have an economic life of greater than one year. Examples of non- current assets include land, machinery, vehicles, buildings, and breeding livestock. Current liabilities are obligations expected to be fulfilled within one year. Examples of current liabilities include L8.8 account payable, deferred taxes, operating notes, and other loans with a maturity of less than one year. Non-current liabilities are obligations expected to mature in more than one year. Examples of non-current liabilities include long-term notes for resources like machinery, vehicles, and land. √ Assets minus liabilities equals equity. Equity is the amount of the business actually owned by the producer. L8.9 Balance Sheet Case Application The beginning and ending balance sheets for the Doe operation are listed below. The beginning balance sheet is as of January 1, 2002, while the ending balance sheet is as of January 1, 2003. Overall, the balance sheet information shows the Doe operation as a stable operation that is solvent (assets are greater than liabilities). The cost-based net worth increased approximately $700 from the beginning to the ending. The beginning balance sheet shows total assets at cost of $98,216.81. This includes $12,361 of current assets, $5,225 of raised livestock, $36,632 of machinery and $44,000 for the land and buildings (each net of accumulated depreciation.) Liabilities include the two notes for equipment and land. The Does’ were able to make their current payments for both notes. Net worth was $70,114 at cost value. The ending balance sheet shows an increase in the current assets, namely the cash and checking on hand. The raised livestock value decreased $400 representing the sale of a cull cow. Machinery and equipment decreased due to the annual depreciation expense. The land and buildings value stayed the same. The liabilities decreased due to the family making the annual payments on the equipment and land note. The family did not assume any new debt during the 2002 year. The cost basis equity increased from the previous year by $700. L8.10