CHAPTER 17CHAPTER 17

The Balance Sheet andIts Analysis

OutlineOutline

• Purpose and Use of a Balance Sheet• Balance Sheet Format• Asset Valuation and Related

Problems• Balance Sheet Example• Balance Sheet Analysis• Statement of Owner Equity

ObjectivesObjectives1. To discuss the purpose of a balance

sheet2. To illustrate the format and structure of

a balance sheet3. To outline some problems when valuing

assets and the recommended valuation methods for different types of assets

4. To show the difference between a cost and market basis

5. To define owner equity or net worth and show its importance

6. To analyze solvency and liquidity7. To introduce and explain statement of

owner equity

Purpose and Use of a Balance Purpose and Use of a Balance SheetSheet

• Systematic organization of everything “owned” and “owed”

• Assets = liabilities + owner equity• Owner equity = assets − liabilities• Can be completed at any time, but

mostly prepared at end of accounting period

• Provides measures of solvency and liquidity

SolvencySolvency

Solvency measures the liabilities of the

Business relative to the amount of owner

equity invested in the business. It provides an indication of the ability

to pay off all financial obligations or

liabilities if all assets were sold.

If assets are not greater than liabilities,

the business is insolvent.

LiquidityLiquidityLiquidity measures the ability of the

businessto meet financial obligations as they come

duewithout disrupting the normal operations ofthe business. Liquidity measures the

abilityto generate cash needed to pay obligations.Liquidity is generally measured over the

next accounting period and is a short-run

concept.

Balance Sheet FormatBalance Sheet Format

• Assets shown on left or top • Liabilities are shown on right or

below assets• Owner equity shown on balance

sheet and liabilities + owner equity = assets

General Format of a Balance General Format of a Balance SheetSheet

$100 $60

400 200

$260

240

$500 $500 Total Assets

Total Liabilities

Owner's Equity

Total Liabilities andOwner's Equity

Noncurrent Assets

Current Assets Current Liabilities

Noncurrent Liabilities

Assets Liabilities

AssetsAssets

An asset has value for one of two

reasons:

1. It can be sold to generate cash, or

2. It can be used to produce other goods that in turn can be sold for cash in the future.

Current AssetsCurrent AssetsAssets that can be sold easily to

generatecash are called liquid assets.

Accounting principles require current assets,

which are the more liquid assets, to be

separated from other assets on the balance

sheet.

Current assets include: cash, marketable

stocks and bonds, accounts receivable,

and inventories of feed, grain, supplies and

feeder livestock.

Non-current AssetsNon-current Assets

• Assets that are not current assets are classified as non-current assets. They are more difficult to sell and/or their sale would be more likely to disrupt the business.

• Non-current assets include: machinery, equipment, breeding livestock, buildings, and land.

LiabilitiesLiabilities

A liability is an obligation or debt owed to

someone else. It represents an outsider’s

claim on the business.

Current LiabilitiesCurrent LiabilitiesAccounting principles require that currentliabilities be separated from other

liabilitieson the balance sheet. Current liabilities

arefinancial obligations that will become due

andpayable within one year from the date on

thebalance sheet.

Examples: accounts payable, principal and accrued interest on short-term loans, andprincipal due within one year on longer term loans.

Non-current LiabilitiesNon-current Liabilities

Any liability that is not current is

classified as a non-current liability.

These financial obligations will become due and payable some

time after one year from the date on

the balance sheet.

Owner EquityOwner EquityIf all assets were to be sold and all debts

paid on the date of the balance sheet, the

owner’s equity would be the amount left over.

Owner equity changes when: 1) the business has

a profit or loss 2) the owner invests more

capital from outside the business or withdraws

money from the business, or 3) assets change

value. Owner equity does not change when cash is used to buy other assets or a loan is taken

out to purchase an asset with value equal to the

loan.

Alternative FormatAlternative FormatCurrent assets and current liabilities are defined in the same way as previously defined.

Intermediate assets are expected to have a useful life of 1 to 10 years and intermediate liabilities are due and payable after 1 year, but before 10 years.

Fixed assets have a useful life of more than 10 years and long-term liabilities are due after 10 years.

Format of a Three-Category Format of a Three-Category Balance SheetBalance Sheet

$100 $60

120 75

280 125

$260

240

$500 $500

Current Assets Current Liabilities

Long-term Liabilities

Assets Liabilities

Total Assets

Intermediate Assets Intermediate Liabilities

Total Liabilities

Owner's Equity

Total Liabilities andOwner's Equity

Fixed Assets

Asset Valuation and Related Asset Valuation and Related ProblemsProblems

A cost-basis balance sheet has all assets

valued following the cost, cost less depreciation, or farm production costmethods. The one exception would

be inventories of grain and market

livestock.

A market-basis balance sheet has all assets valued at market value less estimated selling costs.

Which BS is best?Which BS is best?Cost-basis balance sheets conform to general accounting standards and are thus comparable to balance sheets from other

typesof businesses.

Market-basis balance sheets more accurately

reflect the actual financial position.

FFSC says both types of balance sheets are needed for proper business analysis.

Valuation Methods for Cost-Basis Valuation Methods for Cost-Basis and and

Market-Basis Balance SheetsMarket-Basis Balance SheetsCost MarketBasis Basis

Marketable securities Cost Market

Inventories of grain and 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 a Marketbase value

Machinery and Equipment Cost Market

Buildings and Improvements Cost Market

Land Cost Market

market livestock

Lower of cost or market is preferred for purchased grain and

Asset

*Market is acceptable for raised grain and market livestock

Balance Sheet for DPIM Balance Sheet for DPIM Farmer, December 31, 2007Farmer, December 31, 2007

Currrent Assets: Cost Market Current Liabilities Cost Market

Cash/checking acct. $5,000 $5,000 Account Payable 6,000 6,000Marketable securities 1,000 2,200 Notes payable within 1 year 15,000 15,000Inventories Current portion of term debt 28,000 28,000 Crops 40,000 40,000 Accured Interest 15,700 15,700 Livestock 52,000 52,000 Income taxes payable 8,000 8,000 Supplies 4,000 4,000 Current portion - deferred taxes 15,020 15,260Accounts receivable 1,200 1,200 Other accrued expenses 900 900Prepaid expenses 500 500 Total Current Liabilities $88,620 $88,860Investment in growing crops 7,600 7,600

Other current assets 0 0 Noncurrent Liabiltiies Cost Market Total Current Assets $111,300 $112,500

Notes payable Machinery 20,000 20,000

Noncurrent Assets: Cost Market Breeding Livestock 40,000 40,000Real estate debt 175,000 175,000

Machines and equipment 67,500 95,000 Noncurrent portion - deferred taxes ------ 45,000Breeding livestock (purch.) 48,000 60,000 Total Noncurrent Liabilities $235,000 $280,000Breeding livestock (raised) 12,000 24,000 Total Liabilities $323,620 $368,860Buildings and improvments 27,000 50,000Land 288,000 400,000 Owner EquityOther noncurrent assets 0 0 Total Noncurrent Assets $442,500 $629,000 Contributed capital 50,000 50,000 Total Assets $553,800 $741,500 Retained earnings 180,180 180,180

Valuation adjustment ------- 142,460

Total Equity $230,180 $372,640

Total liabilities and owner equity $553,800 $741,500

Assets Liabilities

Balance Sheet ExampleBalance Sheet Example

• Assets: most differences show up in valuation of non-current assets

• Liabilities: Little difference in liabilities sections, other than deferred taxes

• Owner equity: valuation adjustment on market-basis balance sheet accounts for change in assets’ worth over time because of changes in market conditions for items of the non-current assets

Balance Sheet AnalysisBalance Sheet Analysis

• Liquidity measures: current ratio, working capital

• Solvency measures: debt/asset ratio, equity/asset ratio, debt/equity ratio, net capital ratio

• Other measure: debt structure ratio

Current RatioCurrent Ratio

Computation

valueliability currentvalue asset current

ratio current =

( )value market 27.1$88,800

$112,500ratio current ==

Working CapitalWorking Capital

Computation

liability current-asset currentcapital working =

$23,640$88,860-$112,500capital working ==

Debt/Asset RatioDebt/Asset Ratio

Computation

assets Totalsliabilitie Total

ratio asset/Debt =

( )valuemarket50.0$741,500$368,860

ratio asset/Debt ==

Equity/Asset RatioEquity/Asset Ratio

Computation

assets Totalequity Owner

ratio asset/Equity =

( )valuemarket50.0$741,500

$372,640ratio asset/Equity ==

Debt/Equity RatioDebt/Equity Ratio

Computation

( )valuemarket99.0$372,640$368,860

ratio equity/Debt ==

equity Ownersliabilitie Total

ratio equity/Debt =

Summary of DPIM Farmer’s Summary of DPIM Farmer’s Financial ConditionFinancial Condition

Liquidity Current ratio 1.27 Working capital $23,640

Solvency: Debt/asset ratio 0.50 Equity/asset ratio 0.50 Debt/equity ratio 0.99

Measure Market Ratio

Net Capital RatioNet Capital Ratio

Computation

sliabilitie Totalassets Total

ratio capital Net =

( )valuemarket01.2$368,860$741,500

ratio capital Net ==

Debt Structure RatioDebt Structure Ratio

Computation

( )valuemarket%24or24.0$368,860$88,860

ratio structure Debt ==

sliabilitie Totalsliabilitie Current

ratio structure Debt =

Statement of Owner EquityStatement of Owner Equity

The FFSC recommends that a statement of owner equity be

part of a complete set of financial

records.

The statement shows the sources of

change in owner equity over the accounting period.

Statement of Owner EquityStatement of Owner Equity

Owner equity, January 1, 2003 $344,490Net farm income for 2003 47,900 Less adjustment for income taxes paid and payable (8,150) Net after-tax farm income 39,750Less increase in current portion -- deferred income taxes (1,600)Owner withdrawals from farm business (36,000) Nonfarm income contributed to farm business 9,500 Net owner withdrawals from farm business (26,500)Other capital contributions to farm business 0Other capital distributions from farm business 0Increase in market value of farm assets 22,500 Less increase in noncurrent portion of deferred income taxes (6,000) Net increase in valuation equity 16,500

Owner equity, December 31, 2003 $372,640

SummarySummary

A balance sheet shows the financial position of a business at a point in

time. An important consideration is the

method used to value assets. Cost methods

reflect the original investment value. Market valuation reflects current collateral

values. The FFSC recommends listing both

cost and market values for complete information.