The Balance Sheet & Its Analysis (Chapter 5) Objectives 1. Discuss the purpose of the balance sheet. 2. Illustrate the format and structure of the balance sheet. 3. Outline some issues related to valuing assets. 4. Show the difference between a cost-basis and a market-basis balance sheet. 5. Define owner equity or net worth. 6. Analyze a firm’s solvency and liquidity. 7. Introduce the statement of owner equity. The Balance Sheet • Summarizes the financial condition of the business at a point in time: – Remember the “snapshot” idea! • Estimates net worth or owner equity. • Most transactions affect the balance sheet, so it may change daily. Purpose of a Balance Sheet • Everything “owned” and “owed” by a business or individual at a given point in time. • Asset – anything of value owned. • Liability – any debt or other financial obligation owed to someone else. • Owner Equity/Net worth – the amount the owner has invested in the business. • “Balance” idea: – Owner Equity = Assets – Liabilities Preparing a Balance Sheet • Can be completed at anytime. • Most are prepared at the end of the accounting period – Represents both end-of-the-year and beginning-of- the-year. • That is, end of year 1 = beginning of year 2! – For comparison purposes and analysis. • Should follow guidelines of some recognized accounting entity: – FFSC = Farm Financial Standards Council used for farm-based businesses. General Format of a Balance Sheet Assets Liabilities Current assets $XXX Current liabilities $XXX Noncurrent assets XXX Noncurrent liabilities XXX Total liabilities $XXX Total assets $XXX Owner’s equity XXX Total liabilities and owner’s equity $XXX Assets • An asset can be sold to generate cash. • Used to produce other goods. Current Assets • Goods that have already been produced and can be sold quickly without disrupting future production activities: • Grain. • Feeder livestock. • Other inventories. • Goods that will be used up or sold within the next year: • Cash. • Checking and savings account balances. • Stocks and bonds. • Accounts and notes receivable. • Inventories of feed, farm supplies, etc.. Noncurrent Assets • Any asset that is not a current asset. • Assets that are owned primarily to produce output, that will be sold to produce revenue. • Selling noncurrent assets to generate revenue would affect the firm’s ability to produce future income. • More difficult to sell quickly and easily at their full market value: • Machinery and equipment. • Breeding livestock. • Buildings. • Land. Liabilities • An obligation or debt owed to someone else. • An outsider’s claim against one or more assets of the business. Current Liabilities • Financial obligations that will become due and payable within 1 year • Accounts payable. • Principal and accumulated interest on short-term loans or notes payable (operating loans). • Principal payments on long-term loans due within the next year: – Machinery, land. • Accrued expenses: – Accumulated interest, accrued property taxes, etc. Noncurrent Liabilities • All obligations that don’t have to be paid in full within the next year. – The remaining balance on long-term debt. Owner Equity • The amount of money left for the owner if the assets were sold and all liabilities paid. • Also called Net Worth. • The owners current investment in the business. • Equity = Total assets - Total liabilities Changes in Owner Equity • Using assets to produce crops and livestock: – Profit is then used to purchase additional assets or to reduce liabilities. • If there is a change in an assets value. • If an inheritance is received. • Cash or property is contributed to the business or withdrawn from the business. • An asset is sold for more or less than its balance sheet value. • Important to recognize that only certain things bring about a change in owner equity. Changes in Owner Equity • Composition of assets and liabilities may not cause a change in owner equity: – If $10,000 cash is used to purchase a new machine? – If $10,000 is borrowed to purchase a new machine? • Until depreciation, no impact! – Using $10,000 from cash to make an early principal payment on a loan? • Owner equity changes only when: – The owner invests personal capital from outside the business. – The owner withdraws personal capital. – The business shows a profit or loss. – Changes in asset values because of changes in market prices. Intermediate Assets • Dividing noncurrent assets into two categories (allowed by FFSC): 1. Intermediate assets – have a life greater than 1 year but less than 10 years: – Machinery, equipment, perennial crops, breeding livestock 2. Fixed assets – have a life greater than 10 years: – Land, buildings Intermediate Liabilities • Dividing noncurrent liabilities into two categories. 1. Intermediate liabilities – debt obligations where repayment of principal occurs over a period of more than 1 year and as long as 10 years: – Loans used to purchase machinery, breeding livestock, and other intermediate assets. 2. Fixed liabilities – debt obligations where the repayment period is longer than 10 years: – Farm mortgages, land purchases. • Additional division is recognized by FFSC, but not encouraged. Asset Valuation • Cost-basis: – Values all assets using the cost, cost less depreciation, or farm production cost method. • Inventories of grain and market livestock can be valued at market value less selling costs. • Market-basis: – Values all assets at market value less selling cost: • Inflation and fast depreciation methods can cause market values to be higher than book values. • Market-basis usually has higher asset values implying higher equity. Advantages of Cost-basis or Market-basis Balance Sheets Cost-basis: Market-basis: • Conform to GAAP. • More accurate indication • Conservative. of the current financial • Comparable with condition. balance sheets from • Shows the current value other types of businesses. of available collateral. • Changes in equity come only from net income that has been earned and retained. Use Cost or Market Basis for Balance Sheet? • Both are important and have value. • Recommended by FFSC: – Market-based with full documentation. – Two column format with both. • Recommend following specified procedure for valuing assets: Valuation Methods for Cost-basis & Market-basis Balance Sheets Asset Cost Basis Market Basis Marketable securities Cost Market Inventories of grain & market livestock Market Market Accounts receivable Cost Cost Prepaid expenses Cost Cost Investment in growing crops Cost Cost Purchased breeding livestock Cost Market Raised breeding livestock Cost or base value Market Machinery & equipment Cost Market Buildings & Improvements Cost Market Land Cost Market Balance Sheet Analysis • Used to measure the financial condition of the business (management tool): • Compare to other, but similar businesses. • Compare to the same business over time. • Lenders use balance sheet analysis to make lending decisions and to monitor the financial progress of their customers. • To deal with relative size issue, use what? Balance Sheet Analysis • Measures of Liquidity: 1. Current Ratio 2. Working Capital: - not a ratio (in $), so size must be considered. • Measures of Solvency: 1. Debt/Asset Ratio 2. Equity/Asset Ratio 3. Debt/Equity Ratio 23 The Concept of Liquidity • Short-term measure. • Measures the ability to meet financial obligations: – As they come due. – Without disturbing normal revenue generating activities. • Ability of the business to generate cash. Measures of Liquidity Current Ratio: Total current farm assets ÷ Total current farm liabilities: Example from text: 112,500 ÷ 88,860 = 1.27 • Write the Current Ratio as 1.27:1 • Current assets compared to current liabilities. • Values > 1 are preferred (safety margin). • Larger ratios imply more liquid. Measures of Liquidity Working Capital: Total current farm assets - Total current farm liabilities: Example: $112,500 - $88,860 = $23,640 • Write the Working Capital as $23,640 • $ left after selling all current assets and paying off all current liabilities. • Margin of safety in a $ value. • Compare to similar sized operations. The Concept of Solvency • Measures the degree to which liabilities are backed up by assets. • Measures liabilities relative to owner equity. • Ability to pay off all liabilities if all assets were sold. Measures of Solvency Debt/Asset Ratio: Total farm liabilities ÷ Total farm assets Example: $368,860 ÷ $741,500 = 0.4975 - share of total assets owed to lenders. • Can write the Debt/Asset Ratio as a percent: – Multiply by 100 (example = 49.75%) – % of total assets owed to lenders. Measures of Solvency Equity/Asset Ratio: Total farm equity ÷ Total farm assets Example: $372,640 ÷ $741,500 = 0.5025 - share of assets financed by owner capital. • Can write the Equity/Asset Ratio as percent: – Multiply by 100 (example = 50.25%). – % of total assets financed by owner’s equity capital. • Higher values are preferred. Measures of Solvency Debt/Equity Ratio (leverage ratio): Total farm liabilities ÷ Total farm equity Example: $368,860 ÷ $372,640 = 0.99 • Write the Debt to Equity Ratio as 0.99:1 • Lender financing compared to owner financing. • Smaller values are preferred?? Solvency and Liquidity based on valuation method Our examples used market basis: 1. Liquidity differences if used cost- basis? - looked at how relevant assets are valued. Valuation Methods for Cost-basis & Market-basis Balance Sheets Asset Cost Basis Market Basis Marketable securities Cost Market Inventories of grain & market livestock Market Market Current Accounts receivable Cost Cost Assets Prepaid expenses Cost Cost Investment in growing crops Cost Cost Purchased breeding livestock Cost Market Raised breeding livestock Cost or base value Market Machinery & equipment Cost Market Buildings & Improvements Cost Market Land Cost Market Solvency and Liquidity based on valuation method Our examples used market basis: 1. Liquidity differences if used cost- basis? - looked at how relevant assets are valued. 2. Solvency differences if used cost- basis? - lower values for assets = lower solvency measures. Valuation Methods for Cost-basis & Market-basis Balance Sheets Asset Cost Basis Market Basis Marketable securities Cost Market Inventories of grain & market livestock Market Market Accounts receivable Cost Cost Prepaid expenses Cost Cost Investment in growing crops Cost Cost Purchased breeding livestock Cost Market Raised breeding livestock Cost or base value Market Noncurrent Machinery & equipment Cost Market Assets Buildings & Improvements Cost Market Land Cost Market Statement of Owner Equity • Shows the source of changes in owner equity and the amount that came from each source. • Where growth (or lack of growth) is coming from: – Reconciles beginning and ending owner equity. 35 Summary • A balance sheet shows the financial position of a business at a point in time. • Assets can be valued using cost methods or current market valuations. • Liquidity measures the ability of the business to meet financial obligations as they come due and without disturbing normal production. • Solvency measures the degree to which the liabilities of the business are backed up by its assets. 36 Measuring the Financial Position of the Business • Liquidity – measures the ability of the business to meet financial obligations as they come due without disrupting the normal operations of the business. – Measures the ability to generate cash in the amounts needed at the time it is needed. – Liquidity is a short-run concept. Measuring the Financial Position of the Business • Solvency – measures the liabilities of the business relative to the amount of owner equity invested in the business: – An indication of the ability to pay off all financial obligations if all assets were sold. – The degree to which assets are greater than liabilities. – If assets are not greater than liabilities, the business is a candidate for bankruptcy. – Longer term issue??