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					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??

				
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