Transcript Farm Management Chapter 5 The Balance Sheet and Its Analysis © Mcgraw-Hill Companies, 2008

Farm Management
Chapter 5
The Balance Sheet and
Its Analysis
© Mcgraw-Hill Companies, 2008
Chapter Outline
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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 Objectives
1. Discuss the purpose of a balance sheet
2. Illustrate the format and structure of a balance
sheet
3. Outline some problems when valuing assets, and
the recommended valuation methods for different
types of assets
4. Show the difference between a cost and market
basis
5. Define owner equity or net worth and show its
importance
6. Analyze solvency and liquidity
7. 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 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.
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Liquidity
Liquidity measures the ability of the business
to meet financial obligations as they come due
without disrupting the normal operations of
the business. Liquidity measures the ability
to 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
Assets
Current Assets
$100
Noncurrent Assets
Total Assets
Liabilities
400
$500
Current Liabilities
$60
Noncurrent Liabilities
200
Total Liabilities
$260
Owner's Equity
240
Total Liabilities and
Owner Equity
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$500
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 generate
cash 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’s
claim on the business.
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Current Liabilities
Accounting principles require that current
liabilities be separated from other liabilities
on the balance sheet. Current liabilities are
financial obligations that will become due and
payable within one year from the date on the
balance sheet.
Examples: accounts payable, principal and
accrued interest on short-term loans, and
principal due within one year on longer
term loans.
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Noncurrent Liabilities
Any liability that is not current is classified as
a noncurrent liability. These financial
obligations will become due and payable
some time after one year from the date
on the balance sheet.
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Owner Equity
If 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
Assets
Current Assets
Liabilities
$100
Current Liabilities
Intermediate Assets
120
Intermediate Liabilities
Fixed Assets
280
Long-term Liabilities
Total Assets
$500
$60
75
125
Total Liabilities
$260
Owner's Equity
240
Total Liabilities and
Owner Equity
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$500
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 types
of 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.
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Table 5-3
Valuation Methods for Cost-Basis and
Market-Basis Balance Sheets
Asset
Cost
Basis
Market
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
base value
Market
Machinery and Equipment
Cost
Market
Buildings and Improvements
Cost
Market
Land
Cost
Market
*Market is acceptable for raised grain and market livestock
Lower of cost or market is preferred for purchased grain and
market livestock
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Table 5-4 Balance Sheet for I. M. Farmer,
December 31, 2010
Assets
Currrent Assets:
Cash/checking acct.
Marketable securities
Inventories
Crops
Livestock
Supplies
Accounts receivable
Prepaid expenses
Investment in growing crops
Other current assets
Total Current Assets
Noncurrent Assets:
Machines and equipment
Breeding livestock (purch.)
Breeding livestock (raised)
Buildings and improvments
Land
Other noncurrent assets
Total Noncurrent Assets
Total Assets
Liabilities
Cost
Market
$5,000
1,000
$5,000
2,200
40,000
52,000
4,000
1,200
500
7,600
0
$111,300
40,000
52,000
4,000
1,200
500
7,600
0
$112,500
Cost
Market
67,500
48,000
12,000
27,000
288,000
0
$442,500
$553,800
95,000
60,000
24,000
50,000
400,000
0
$629,000
$741,500
Current Liabilities
Account Payable
Notes payable within 1 year
Current portion of term debt
Accured Interest
Income taxes payable
Current portion - deferred taxes
Other accrued expenses
Total Current Liabilities
Noncurrent Liabiltiies
Notes payable
Machinery
Breeding Livestock
Real estate debt
Noncurrent portion - deferred taxes
Total Noncurrent Liabilities
Total Liabilities
Cost
Market
6,000
15,000
28,000
15,700
8,000
15,020
900
$88,620
6,000
15,000
28,000
15,700
8,000
15,260
900
$88,860
Cost
Market
20,000
40,000
175,000
-----$235,000
$323,620
20,000
40,000
175,000
45,000
$280,000
$368,860
50,000
180,180
------$230,180
$553,800
50,000
180,180
142,460
$372,640
$741,500
Owner Equity
Contributed capital
Retained earnings
Valuation adjustment
Total Equity
Total liabilities and owner equity
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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 value
Current ratio =
Current liability value
$112,500
Current 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 liabilities
Debt/asset ratio =
Total assets
$368,860
Debt/asset ratio =
= 0.50
$741,500
(market value)
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Equity/Asset Ratio
Owner equity
Equity/asset ratio =
Total assets
$372,640
Equity/asset ratio =
= 0.50
$741,500
(market value)
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Debt/Equity Ratio
Total liabilities
Debt/equity ratio =
Owner equity
$368,860
Debt/equity ratio =
= 0.99
$372,640
(market value)
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Table 5-5
Summary of I. M. Farmer’s Financial Condition
Measure
Liquidity
Current ratio
Working capital
Market Ratio
1.27
$23,640
Solvency:
Debt/asset ratio
Equity/asset ratio
Debt/equity ratio
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0.50
0.50
0.99
Net Capital Ratio
Total assets
Net capital ratio =
Total liabilities
$741,500
Net capital ratio =
= 2.01
$368,860
(market value)
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Debt Structure Ratio
Current liabilities
Debt structure ratio =
Total liabilities
$88,860
Debt structure ratio =
= .24 or 24%
$368,860
(market value)
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Statement 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.
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Table 5-6
Statement of Owner Equity
Owner equity, January 1, 2010
Net farm income for 2010
Less adjustment for income taxes paid and payable
Net after-tax farm income
Less increase in current portion -- deferred income taxes
Owner withdrawals from farm business
Nonfarm income contributed to farm business
Net owner withdrawals from farm business
Other capital contributions to farm business
Other capital distributions from farm business
Increase in market value of farm assets
Less increase in noncurrent portion of deferred income taxes
Net increase in valuation equity
$344,490
47,900
(8,150)
39,750
(1,600)
(36,000)
9,500
(26,500)
0
0
22,500
(6,000)
Owner equity, December 31, 2010
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16,500
$372,640
Summary
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.
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