The Balance Sheet

& Its Analysis

Kamal Ega
 Objectives
1. 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 Liabilities
Current assets $XXX Current liabilities $XXX
Noncurrent assets XXX Noncurrent liabilities XXX
Total liabilities $XXX
Total assets $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
1. 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.
1. 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: Market-basis:
• Conforms to GAAP. • More accurate
• Conservative. indication of the current
• Comparable with financial condition.
balance sheets from • Shows the current value
other types of businesses. of available collateral.**
• Changes in equity come
only from net income
that has been earned and
retained.
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?
 Balance Sheet Analysis
A. Measures of Liquidity:
1. Current Ratio
2. Working Capital:
- not a ratio (in $), so size must be considered.
B. Measures of Solvency:
1. Debt/Asset Ratio
2. Equity/Asset Ratio
3. Debt/Equity Ratio
Are others, but these recommended by
FFSC
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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 Liquidity
Working 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 = 0.4975
Multiply by 100
• Write the Debt/Asset Ratio as 49.75%
• % (share) of total assets owed to lenders.
• Lower values are preferred.
 Measures of Solvency
Equity/Asset Ratio:
Total farm equity ÷ Total farm assets
Example: $372,640 ÷ $741,500 = 0.5025
Multiply 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 Solvency
Debt/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.
 Balance Sheet Analysis
A. 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.

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 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
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.

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