5-1 Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display. PowerPoint Presentation Materials For Financial Accounting:

5-1

Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

PowerPoint Presentation Materials

For

Financial Accounting:

A New Perspective

by

Dr. Joseph Otto

CHAPTER 5

Using the Balance Sheet to Make Decisions

5-3

CLASSIFIED BALANCE SHEET

Classifies assets, liabilities into current and noncurrent categoriesCurrent categoriesAccounts expected to be

Turned into cashSoldExchangedDischarged

Within one year

5-4

CMUBalance Sheet

12/31Assets

Current assets

Investments

Property, plant,

Equipment

$56,300

2,000

16,700

Liabilities

Current

Noncurrent

Owner’s Equity

$9,000

4,000

61,900

Total assets $75,000

Total liabilities & Equity $75,000

5-5

WHY DISTINGUISH BETWEEN CURRENT, NONCURRENT?

To allocate resources to meet needs

Timing influences decisions

5-6

HOW TO DISTINGUISH BETWEEN CURRENT, NONCURRENT

Operating cycle

Related to current assets, liabilitiesAverage length of time it takes to move

through 3 phasesPurchasingSellingCollecting

5-7

CURRENT ASSETS

Current assets areCashNoncash assets that will be

Converted into cashSoldConsumed

Within 1 year or operating cycle, whichever is longer

5-8

LIQUIDITY

Measure of availability of cashHow quickly noncash assets can be

turned into cash

Sign of financial health

5-9

CURRENT LIABILITIES

Current liabilities areObligations that will be eliminated

within one year or operating cycle of business

Paid byCurrent assetsCreating other current liabilities

5-10

USING BALANCE SHEET RATIOS

RatiosShow percentage relationship

between 2 numbersSummarize informationEasily understood, interpreted,

compared

Example: Return on equityMeasures performance

5-11

HOW TO USE LIQUIDITY RATIOS

Help determine solvencyAbility to meet obligations that

come due in current period

Working capitalCurrent assets – Current liabilitiesLimitation: measures absolute

ability to meet debts

5-12

LIQUIDITY RATIOS

Current ratio

Acid test (Quick) ratio

Bank ratios

5-13

CURRENT RATIO

Measures relative ability to meet maturing current debts (solvency)

High ratio desirable

Current Asset

Current Liabilities

5-14

ACID TEST RATIO

Measures relative ability to meet maturing current debts (solvency)

High ratio desirable

Current assets – (Inventories + prepaid Assets)

Current Liabilities

5-15

BANK RATIOSApproving Susan’s Loan

Banker’s measure of loan risk

To protect lenderLoan to valueLoan to liquidation value

5-16

LOAN TO VALUE

Lower is better

Maximum Loan Liability

Market value of collateral

5-17

LOAN TO LIQUIDATION VALUE

Lower is better

Maximum Loan Liability

Liquidation Value of Asset

5-18

LEVERAGE RATIOS

Evaluate financial riskDebt to Assets RatioDebt to Equity Ratio

5-19

DEBT TO ASSETS RATIO

Indicates long-run solvency of business

Describes relative amount of financial risk

Total Liabilities

Total Assets

5-20

DEBT TO EQUITY RATIO

Indicates long-run solvency of business

Describes relative amount of financial risk

Total Liabilities

Total Owners’ Equity

5-21

Discussions of Liquidity, Leverage

Contained in Annual ReportManagement’s Discussion &

Analysis (MD&A)Provides liquidity, leverage ratiosProvides discussion/interpretation of

ratios

Example: Merck

5-22

USING INFORMATION TO MAKE DECISIONS: MD&A

Outside balance sheet

Management’s Discussion and Analysis of Operations (MD&A)Relates to balance sheetLiquidity and Capital Resources

5-23

USING INFORMATION TO MAKE DECISIONS:

Information that documents, supports, elaborates on specific items

Summary of significant accounting policiesEssential accounting principles of

business

Other notesDetail for balance sheet accounts

5-24

USING INFORMATION TO MAKE DECISIONS:

CommitmentsExecutory contractExample: noncancelable lease

arrangements

ContingencyMay never materializePotential future obligation

5-25

Executory Contract

Promise to perform duties in future

Commitment

No current liability

Definition: liabilityProbably future sacrifices of economic

benefits arising from present obligations

5-26

HOW ARE ASSETS MEASURED?

Entry prices Historical cost Current cost

Exit prices Fair market value (FMV) Present value of future cash flows

5-27

When are Valuation Methods Equivalent?

At point of exchange when recordedHistorical costs = current cost = fair

market value (FMV) = present value of future cash flows

Valuation methods differ when reported

5-28

ASSET VALUATION

Personal balance sheetEstimated current value or fair market

value (FMV)

Business balance sheetFollows GAAP

5-29

ASSET VALUATION:Current Assets

Asset

Category

Account Measurement

Current Cash

Marketable Sec.

A/R

Inventory

Monetary

FMV or cost

FMV less

allowance

LCM

5-30

ASSET VALUATION:Investments

Asset

Category

Account Measurement

Investments Equity

Bonds

Long term

Notes

Receivables

FMV

Present value of future cash

flows

5-31

ASSET VALUATION:Property, Plant, Equipment

Asset

Category

Account Measurement

Property, Plant, Equipment

Buildings, Equipment, etc.

Cost less Accumulated Depreciation

5-32

ASSET VALUATION:Intangible Assets

Asset

Category

Account Measurement

Intangibles Patents, Goodwill, etc

Cost less Amortization

5-33

KEY QUALITATIVE CHARACTERISTICS

Characteristics of accounting informationRelevance

Makes a difference in a decisionReliability

Degree of confidence in informationVerifiability

Traceable

5-34

Limitations of Balance Sheet

Not all obligations reported in liabilitiesAsset valuation not always current market valueQualitative information incompleteMoney measurement assumes stable dollar; no inflationHuman resources not reported, valued

5-35

Assign #11read chapter 6, pg. 251-252, Questions 2, 8, 11, 15, 16

Assign #12pg. 252-258, Reinforcement Exercises 3, 5, 7, 12, 18, pg. 259-265, Critical Thinking Problems 1, 7, 14, 17, 19

Assign #4CCustom Computer transmittals and SC.