farm management chapter 5 the balance sheet and its analysis

Farm Management

Chapter 5

The Balance Sheet and

Its Analysis

farm management chapter 5

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Chapter Outline

• 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


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Chapter Objectives1. To discuss the purpose of a balance sheet

2. To illustrate the format and structure of a balance sheet

3. 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 liquidity

7. To introduce and explain statement of owner equity


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Purpose and Use of a Balance Sheet

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

• Assets = liabilities + owner equity

• Owner equity = assets liabilities

• Can complete at any time, but most prepared at end of accounting period

• Provides measures of solvency and liquidity


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Solvency

Solvency measures the liabilities of the businessrelative to the amount of owner equity invested in the business. It provides an indication of theability to pay off all financial obligations or liabilities if all assets were sold. If assets arenot greater than liabilities, the business isinsolvent.


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Liquidity

Liquidity 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.


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Balance 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


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Table 5-1 General Format of a Balance Sheet

$100 $60

400 200

$260

240

$500 $500

Assets Liabilities

Noncurrent Assets

Current Assets Current Liabilities

Noncurrent Liabilities

Total Assets

Total Liabilities

Owner's Equity

Total Liabilities andOwner's Equity


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Assets

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.


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Current Assets

Assets 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.


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Noncurrent Assets

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

Noncurrent assets include: machinery, equipment, breeding livestock, buildings, and land.


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Liabilities

A liability is an obligation or debt owed to someone else. It represents an outsider’sclaim on the business.


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Current 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.


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Noncurrent Liabilities

Any liability that is not current is classified asa noncurrent liability. These financial obligations will become due and payable some time after one year from the dateon the balance sheet.


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Owner 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.


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Alternative Format

• Current assets and liabilities are defined in the same way as previously

• Intermediate assets are expected to have a 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


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Table 5-2 Format of a Three-Category Balance Sheet

$100 $60

120 75

280 125

$260

240

$500 $500 Total Assets

Intermediate Assets Intermediate Liabilities

Total Liabilities

Owner's Equity

Total Liabilities andOwner's Equity

Fixed Assets

Current Assets Current Liabilities

Long-term Liabilities

Assets Liabilities


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Asset Valuation and Related Problems

A cost-basis balance sheet has all assets valued following the cost, cost less depreciation, or farm production cost methods. 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.


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Which 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 accuratelyreflect the actual financial position.

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


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Table 5-3 Valuation Methods for Cost-Basis and

Market-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

Table 5-4 Balance Sheet for I.M. Farmer, December 31, 20XX

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


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Balance Sheet Example

• Assets: most differences show up in valuation of noncurrent 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 item


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Balance 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


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Current Ratio

Current asset valueCurrent ratio =

Current liability value

$112,500Current ratio = = 1.27 (market value)

$88,860


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Working Capital

Working capital =

Current assets current liability

Working capital = $112,500 $88,860 = $23,640

(market value)


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Debt/Asset Ratio

Total liabilitiesDebt/asset ratio =

Total assets

$368,860Debt/asset ratio = = 0.50

$741,500

(market value)


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Equity/Asset Ratio

Owner equityEquity/asset ratio =

Total assets

$372,640Equity/asset ratio = = 0.50

$741,500

(market value)


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Debt/Equity Ratio

Total liabilitiesDebt/equity ratio =

Owner equity

$368,860Debt/equity ratio = = 0.99

$372,640

(market value)


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Table 5-5 Summary of I.M. Farmer’s Financial 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


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Net Capital Ratio

Total assetsNet capital ratio =

Total liabilities

$741,500Net capital ratio = = 2.01

$368,860

(market value)


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Debt Structure Ratio

Current liabilitiesDebt structure ratio =

Total liabilities

$88,860Debt structure ratio = = .24 or 24%

$368,860

(market value)


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Statement of Owner Equity

The FFSC recommends that a statement ofowner equity be part of a complete set offinancial records. The statement shows thesources of change in owner equity over the accounting period.


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Table 5-6 Statement 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


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Summary

A balance sheet shows the financial positionof a business at a point in time. An importantconsideration is the method used to valueassets. Cost methods reflect the original investment value. Market valuation reflectscurrent collateral values. The FFSCrecommends listing both cost and marketvalues for complete information.

farm management chapter 5 the balance sheet and its analysis

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