Balance Sheet Analysis

The Balance Sheet & Its Analysis

(Chapter 5)

Objectives1. 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

Current assets $XXX

Noncurrent assets XXX

Total assets $XXX

Liabilities

Current liabilities $XXX

Noncurrent liabilities XXX

Total liabilities $XXX

Owner’s equity XXX

Total liabilities and

owner’s equity $XXX

Assets

• An asset can be sold to generate additional 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 ordinarily be used up or sold within the next year:

• Cash.• Checking and savings account balances.• Marketable investments.• 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 the

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 income:

– 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.

• This 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:• Conforms to GAAP.

• Conservative.

• Comparable with balance sheets from other types of businesses.

• Changes in equity come only from net income that has been earned and retained.

Market-basis:• More accurate

indication of the current financial condition.

• Shows the current value of available collateral.**

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 current

Prepaid expenses Cost Cost assets

Investment in growing crops Cost Cost

Purchased breeding livestock Cost Market

Raised breeding livestock Cost or base value Market

Machinery & equipment Cost Market noncurrent

Buildings & Improvements Cost Market assets

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?

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Balance Sheet AnalysisA. Measures of Liquidity:

1. Current Ratio2. Working Capital:

- not a ratio (in $), so size must be considered.

B. Measures of Solvency:1. Debt/Asset Ratio2. Equity/Asset Ratio3. Debt/Equity Ratio

Are others, but these recommended by FFSC

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 firm to generate cash for running the business.

Measures of Liquidity

Current Ratio:

Total current farm assets ÷ Total current farm liabilities or CA/CL:

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 liquidity.

Measures of LiquidityWorking 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 = 0.4975Multiply by 100

• Write the Debt/Asset Ratio as 49.75%• % (share) of total assets owed to lenders.• Lower values are preferred.

Measures of SolvencyEquity/Asset Ratio:

Total farm equity ÷ Total farm assets

Example: $372,640 ÷ $741,500 = 0.5025Multiply by 100

• Write the Equity/Asset Ratio as 50.25%• % of total assets financed by owner’s equity

capital.• Higher values are preferred.

Measures of SolvencyDebt/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.

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Balance Sheet AnalysisA. Concept of Liquidity:

1. Ability of the firm to generate cash for running the business.

B. Concept of Solvency:

1. Ability to pay off all liabilities if assets are sold.

Solvency and Liquidity based on valuation method

Our examples used market basis:

1. Liquidity differences if used cost-basis?

- look at how relevant assets are valued.

- likely no (or small) difference.

2. Solvency differences if used cost-basis?

- lower values for assets = less desirable 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 current

Prepaid expenses Cost Cost assets

Investment in growing crops Cost Cost

Purchased breeding livestock Cost Market

Raised breeding livestock Cost or base value Market

Machinery & equipment Cost Market noncurrent

Buildings & Improvements Cost Market assets

Land Cost Market

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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.

• See example from book (handout).

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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.