Making Business Decisions with the Balance Sheet

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					                                    Chapter 5

      Using the Balance Sheet To Make Decisions
This chapter introduces liquidity and leverage ratios as a means to make business
decisions. Ratios included in this presentation are the current and quick ratios for
liquidity and the debt to assets and debt to equity ratios for leverage. The author then
discusses the importance of the Management’s Discussion and Analysis of Operations
(MD&A) section and the notes to the financial statements in the annual report. The
focus is on how non-balance sheet sections of an annual report can contain crucial
information related to using the balance sheet. The concepts of different asset
valuations and how they are used are considered and refined. These valuations
include historical cost, fair market value, replacement cost, and the present value of
future cash flows. In addition, the concepts of going concern, relevance and reliability
are discussed as related to these measurement issues. The chapter ends with a
discussion of the limitations of the balance sheet.

Chapter Notes
Introduction: A Review of the Classified Balance Sheet
In the introduction to this chapter Ken Ledeit, a bank loan analyst, discusses the
importance of this accounting course to business students.

Using a Classified Balance Sheet to Make Better Decisions

A classified balance sheet contains information that can be used to make business
decisions, such as whether to loan money or lease property to an entity.

Why Distinguish between Current and Noncurrent?

In Chapter 3 students learned that the basic distinction between current and noncurrent
assets and between current and noncurrent liabilities is one year. In Chapter 4, current
was further refined to describe all accounts a company expects will be turned into cash,
sold, exchanged, or discharged within one year. Decisions can often be directly
influenced by whether an item is current or noncurrent. For example, knowing that a
particular liability is current helps decision makers because it alerts them to accounts
whose prompt payment is a priority.

How to Distinguish between Current and Noncurrent

The definitions of both current assets and current liabilities involve the concept of the
operating cycle. The operating cycle is the average length of time it takes a business to
move or cycle through three phases of operations: purchasing, selling, and collecting.


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Since this cycle is initiated with the payment of cash (purchasing) and completed with
the receipt of cash (collecting), it is said that the operating cycle is the average length of
time it takes to go from “cash back to cash”.

Current Assets

Current assets are cash and non-cash assets that are expected to be converted into
cash, sold, or consumed within one year or the operating cycle of the business,
whichever is longer. On a balance sheet current and noncurrent assets are listed in
order of their liquidity. Liquidity is a measure of the availability of cash, that is, how
quickly a noncash asset can be turned into cash.

Current Liabilities

Current liabilities are obligations that will be eliminated within one year, or the operating
cycle of the business, whichever is longer. These liabilities are generally settled either
by payment from current assets, such as cash, or by the creation of other current
liabilities. As with assets, both current and noncurrent liabilities appear in the balance
sheet in order of liquidity or scheduled payment date.

Using Balance Sheet Ratios To Make Better Decisions

A ratio is a percentage or decimal that shows the relationship of one number to another.
Ratios are useful decision making tools because they conveniently summarize
information in a form that is more easily understood, interpreted, and compared. In
Chapter 3, students used a profitability ratio, ROE, to measure performance. Now they
look at two additional types of ratios derived from the balance sheet and frequently
used by decision makers, the liquidity ratio and the leverage ratio.

How Are Liquidity Ratios Used to Determine Solvency?

Solvency describes a company’s ability to meet obligations that mature or come due in
the current period. Working capital is simply current assets minus current liabilities.
Although easy to calculate, working capital has limitations. One such limitation is that
working capital only measures a company’s absolute ability to meet its maturing debts.
Another limitation of working capital in evaluating solvency is its failure to consider the
liquidity of an entity’s current assets, how easily they can be converted to cash.

A more useful measure of solvency is the liquidity ratio. A liquidity ratio measures a
company’s relative ability to meet its maturing current debts, that is, its solvency. Two
of the more commonly used liquidity ratios are the current ratio and the acid test or
quick ratio. The current ratio is a relatively optimistic measure whereas the acid test
ratio is a more conservative measure.

Current Ratio



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       Current Ratio   =    Current Assets
                           Current Liabilities

A high ratio is a ratio in which the numerator, current assets, is significantly higher than
the denominator, current liabilities. In general, a high ratio is desirable because it
indicates that creditors will be paid in full and on time; but too high a ratio might indicate
that the company is holding excessive amounts of cash, accounts receivable, and
inventory. So how do you know when a current ratio amount is neither too high nor too
low? A rule of thumb is that a current ratio should be 2.0 or greater.

No matter what kind of ratio student’s use, they should always compare it to the
industry average and to the corresponding ratios of similar companies in the same
industry. Likewise, they should also determine if the company’s ratio has changed
much when compared to its ratios of past years.

Acid Test or Quick Ratio

       Acid Test Ratio     =Current Assets – (Inventories + Prepaid Assets)
                                           Current Liabilities
The acid test or quick ratio has the same denominator as does the current ratio –
current liabilities. Its numerator, however, differs from the current ratio numerator by
eliminating any current assets that are not near cash (liquid) in nature, such as
inventories and prepayments. Thus, its numerator is a more conservative measure of
liquidity than that used in the current ratio.

Bank Ratios Used in Approving Susan's Loan Application

When Ken LeDeit received Susan’s completed loan application, he discovered that he
was unable to use the standard business ratios he normally used. This was because
Susan’s business was not yet in operation, and so Ken was limited to evaluating her
financial condition as an individual.

Ultimately, Ken calculated two ratios often used by banks. The first was an optimistic
ratio called loan to value that involved dividing the maximum loan liability by the market
value of the collateral. Just to be safe, however, he also calculated a loan to liquidation
value to reflect two facts – first, the bank might initially recover less than market value
because of market fluctuations; and second, the bank would definitely net less than
market value, because of unavoidable selling costs. Although Ken’s ratios appear
different than the current and acid test ratios, all of these ratios compare a measure of
cash to a measure of liabilities.

How Is a Leverage Ratio Used to Evaluate Financial Risk?

Resources or assets can be acquired by incurring liabilities (debt financing) or by
issuing shares of capital stock (equity financing). The U.S. tax system encourages the




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use of debt financing because corporations can deduct interest expense but not
dividends.

As a company increases its use of debt financing, it also increases the probability of
encountering financial distress, because it must make principal and interest payments
at specific dates. This relationship between an increase in a corporation’s
indebtedness and the increase in its probability of financial distress is referred to as
financial risk. Equity financing does not entail financial risk because dividends require
no specific repayment. Debt financing is advantageous because of the deductibility of
interest payments but disadvantageous because of financial risk. A leverage ratio
measures the extent to which an entity has been financed by debt.

Debt to Assets Ratio

The debt to assets ratio is a leverage ratio that indicates the long-run solvency of the
business. It describes the relative amount of financial risk incurred by the entity.

           Debt to Assets = Total Liabilities
                                Total Assets
Debt to Equity Ratio
A variation of the debt to assets ratio is the debt to equity ratio.

           Debt to Equity =      Total Liabilities
                               Total Owners’ Equity

Using Information Not Found in the Balance Sheet to Make Better Balance Sheet
Decisions

Some valuable information about the balance sheet is found in the Management’s
Discussion and Analysis of Operations (MD&A), and the notes to the financial
statements.

How You Can Use the MD&A to Enhance Your Analysis of the Balance Sheet

The MD&A generally begins with a relatively lengthy discussion about the results found
on the income statement. The next section of the MD&A relates directly to the balance
sheet and is usually called Liquidity and Capital Resources. The liquidity discussion
focuses on current assets. In contrast, the capital resources section focus on
noncurrent assets and various types of liabilities used to finance asset purchases. In
recent years, companies have expanded the MD&A to include additional discussions
deemed important. For example, many 1999 annual reports contained a discussion
about the company’s Y2K preparations in the MD&A section.

How You Can Use the Notes to the Financial Statements to Enhance Your
Analysis of the Balance Sheet




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Notes, or footnotes, contain information that documents, supports, or elaborates on
specific items within the financial statements. Generally, the first few notes, such as the
Summary of Significant Accounting Policies, are somewhat general in nature. Then,
notes relating directly to the balance sheet are shown. Finally, information about the
income statement is generally provided in the last part of the notes section.

Summary of Significant Accounting Policies

The Summary of Significant Accounting Policies includes the essential accounting
principles used by a particular business. Some examples include the principles of
consolidation, the definition of cash equivalents, and the particular methods or
principles used to account for both inventories and depreciation. Often, this particular
note is two to three pages in length and covers a wide range of information about the
nature of the particular business you are studying.

Notes Providing Underlying Detail for Balance Sheet Accounts

Figure 5-8 shows notes describing four balance sheet accounts -- a partial presentation
of Nordstrom’s accounts receivable, Cisco’s inventories, ADP’s long-term debt, and
Microsoft’s common stock. In each case, notice how much more detailed the
information presented is than the corresponding balance sheet presentation of those
same accounts. Looking at these and similar notes is a must if you want to have more
than just a superficial look at the balance sheet.

Commitments and Contingencies

A critical balance sheet disclosure usually found only in the Notes is Commitments and
Contingencies. A commitment is a transaction in which a business signs a contract
promising to pay certain amounts in the future in return for future benefits. Such an
obligation involves what is called an executory contract. A common form of
commitment is cash payments that must be made under the terms of noncancelable
lease arrangements. Essentially, these leases are future obligations arising out of
executory contracts. Since these obligations are not customarily reported as balance
sheet liabilities, they represent a popular form of off-balance sheet financing.

Like commitments, contingencies are special types of liabilities that are rarely reported
on the balance sheet itself, but might be disclosed in the notes to the financial
statements. A contingent liability is a potential future obligation arising from past
events, that is contingent on the outcome of a future event, such as a lawsuit. The
uncertainty of such a liability ever occurring prevents it from normally being disclosed on
the balance sheet.

How Are Assets on a Balance Sheet Measured?

A broad interpretation of the entity concept introduced in Chapter 2 is that a business
balance sheet accounts for the affairs of the business, whereas a personal balance



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sheet accounts for the nonbusiness affairs of the owner(s). Since a business entity and
a personal entity are so different, it follows that some of their assets are not measured
in the same way.

Alternative Ways to Measure Assets

Accounting scholars often use the concepts of entry and exit prices to consider the
appropriate measure of an asset’s value. For example, when goods and services are
acquired, they are said to enter the business and their purchase prices are called entry
prices. When those same goods and services are sold or otherwise disposed of, they
are said to exit the business and their selling or liquidation prices are called exit prices.
This perspective creates at least four ways to measure assets: historical cost, a past
entry price; replacement cost or current cost, a current entry price; fair market value, a
current exit price; and the present value of future cash flows, a calculation involving
future exit prices. Let’s take a closer look at each of these entry and exit prices.

Entry Prices

Historical cost is a past entry price measurement and is also called original cost or
acquisition cost. The historical cost concept states that assets are ordinarily recorded
in the accounting records at cost, and later reported in the balance sheet at cost.
Replacement cost, or current cost, is the cost you would pay to replace an asset at a
later date.

Exit Prices

Individuals who are unfamiliar with business financial statements often assume that
assets are reported on the balance sheet at a current exit price measure called fair
market value, the expected selling price of those assets. This assumption is not
unreasonable if you consider when people inquire about personal assets, such as cars
or homes, they ask questions like "What’s it worth"? or "How much could you sell that
for now"? Accounting educators and theoreticians often focus on the future economic
benefits portion of the asset definition to argue that many assets should be reported on
the balance sheet at a future exit price measure called the present value of future cash
flows. This measure is calculated by converting a set of estimated future dollar
amounts into a single present value amount that can be recorded by the company.

Asset Valuation: Personal Balance Sheet

In the personal balance sheet, the term estimated current value, or fair market value,
has been the basis used to measure personal assets since 1983, when GAAP required
it to replace historical cost. The fair market value of an asset is defined as the amount
derived from an exchange of an asset between buyer and seller known as an arm’s
length bargaining transaction.

Asset Valuation: Business Balance Sheet


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Business balance sheets employ a variety of ways to measure assets. For example,
cash is reported at its current monetary value, inventories at replacement cost,
accounts receivable at the selling price of goods or services and marketable securities
at fair market value. Nevertheless, it is safe to say the majority of assets are valued at
historical cost.

Key Qualitative Characteristics of Accounting Information

An important qualitative characteristic of accounting information is relevance, the ability
of accounting information to make a difference in a decision. You just learned fair
market value is considered more relevant than historical cost for making personal
balance sheet decisions. Why, then, is historical cost the primary basis of
measurement for business assets? At least three arguments have been used to justify
its use for decision making in a business:

1.       Market values are difficult to estimate; they are too subjective. Market values do
         not generally meet the test of reliability, one of the most important qualitative
         characteristics of accounting information. A primary ingredient of reliability is
         verifiability, a condition in which the amount recorded for an asset is traceable to
         an underlying business document. It is argued, therefore, that the historical cost
         of an asset, unlike its market value, is relatively easy to measure accurately and
         is subject to independent or objective verification.
2.       The reporting of market values is too costly. Measuring assets at fair market
         value requires revaluation each time a balance sheet is prepared, rather than the
         single measurement required by historical cost.
         Market value information about most assets is irrelevant, because assets are
         acquired to be used rather than sold. If you accept the going concern concept
         you will not need to measure asset market values because there is no interest in
         selling prices.

        Current accounting principles do not require reporting all obligations in the
         liability section of a balance sheet.
        The current market value of most purchased assets is not reported on the
         balance sheet.
        The balance sheet reports quantitative rather than qualitative information. For
         example, information that the president’s health is failing, that a strike might be
         about to begin, or that the company is about to sign a very profitable contract are
         not captured in the balance sheet.
        The balance sheet does not report the effects of general price level changes.
        The balance sheet does not report the value of human resources as an asset.




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