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The Balance Sheet

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The Basic Elements of the

Balance Sheet The Statement of Financial Position

The balance sheet, also called the

statement of financial position, is theexpanded expression of the accountingequation.

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Balance Sheet Remember that the basic accounting

equation states that assets equal the

sum of liabilities and owners' equity.

Assets = Liabilities + Owners Equity

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Balance Sheet Another way to state the equation:

Uses of resources =Sources of resources

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Balance Sheet Liabilities and owners' equity are the

sources from which the firm has

obtained its funds.

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Balance Sheet The listing of assets shows the way

that the firm's managers have put

those funds to work.

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Balance Sheet The balance sheet is the cumulative

result of the firm's past activities.

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Assets Assets are probable future economic

benefits obtained or controlled by a

particular entity as a result of pasttransactions or events.

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Liabilities Liabilities are probable future

sacrifices of economic benefits arising

from present obligations of aparticular entity to transfer assets orprovide services to other entities in the

future as a result of past transactionsor events.

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Owners' Equity Owners' equity is the residual interest

in the assets of an entity after

deducting liabilities.

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Assets Are Either Current or

Noncurrent Current assets are those assets which

will typically become cash or be

consumed in one year or oneoperating cycle, whichever is greater.

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Assets Are Either Current or

Noncurrent Noncurrent assets are assets used in

the conduct of the business and for

which the replacement cycle is longerthan one year.

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Current Assets Current assets are listed in order of

their maturity or collectibility.

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Current Assets Liquidity reflects the ability of the

firm to generate sufficient cash to meet

its operating cash needs and to pay itsobligations as they become due.

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Current Assets Because of the liquidity focus, current

assets are generally valued at the

lower of their acquisition costs orpresent resale values.

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Current Assets Current assets include cash and cash

equivalents, accounts receivable,

inventories, and prepaid expenses.

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Cash and Cash Equivalents Cash and cash equivalents include

currency, bank deposits, and various

marketable securities that can beturned into cash on short noticemerely by contacting a bank or broker.

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Cash and Cash Equivalents Cash is often considered to be any

item which a bank will accept at face

value for deposit.

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Cash and Cash Equivalents Cash equivalents are only securities

purchased within ninety days of their

maturity dates.

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Current Assets If you receive a pig in a bartering

transaction, then the pig is not

considered cash. Try depositing the pig into your account

at the bank!

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Accounts Receivable Accounts receivable represent credit

sales that have not yet been collected.

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Accounts Receivable A fast turnover period for accounts

receivable is desirable.

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Accounts Receivable The longer a debt remains unpaid, the

higher the chance that it will not ever

be paid.

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Accounts Receivable Accounts receivable are listed on the

balance sheet at their net realizable

value, which is the amountmanagement thinks it will actually beable to collect.

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Inventory Inventory represents items that have

been purchased or manufactured for

resale to customers.

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Inventory Some students feel that inventory

should be reported as a noncurrent

asset, but ask yourself this question: Does a business, which earns money by

selling goods, really want its inventory toremain unsold for over one year?

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Inventory Remember that stores have sales in

order to move out slowly moving

inventory.

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InventoryJust as is true for accounts receivable,

a fast turnover period for inventory is

very desirable.

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Inventory At times it is necessary for reporting

purposes to reduce the historical cost

of the inventory to a lower value.

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Current Assets Regardless of the type of asset, all

assets have a common characteristic in

representing probable futureeconomic benefits to the firm.

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The Operating Cycle and

Liquidity The operating cycle of a business is

the time which elapses from the

purchase of inventory, to the exchangeof inventory for accounts receivable,to the collection of that receivable.

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Liquidity It is sometimes called the cash-to-cash

cycle because it is the time which

elapses from the time a companyspends money to purchase inventoryto the time it receives cash for that

inventory.

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Liquidity Some businesses have a very short

operating cycle, a week or two.

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Liquidity Others have operating cycles which

take years.

Examples include companies in the forestproducts industry or the distilled spiritsindustry.

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Liquidity

Cash

Inventory

AccountsReceivable

Purchases

Cash

Sales

Collections

Credit Sales

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Noncurrent Assets Noncurrent assets are assets used in

the conduct of the business and for

which the replacement cycle is longerthan one year.

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Noncurrent Assets While the focus for current assets is

their liquidity, the focus for

noncurrent assets is on the operatingcapacity of the firm.

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Noncurrent Assets Property, plant, and equipment

comprises the most common type of

noncurrent assets.

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Property, Plant, and

Equipment Property usually represents the land

upon which the firm's offices,

factories, and other facilities arelocated.

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Equipment Property is valued on the balance

sheet at its historical acquisition cost.

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Equipment Because of the age of the land, it is

often the most out of date in terms of

current market values.

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Equipment Buildings or plant may include

buildings, warehouses, hospitals, and

myriad other assets.

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Equipment Equipment includes office furniture,

tools, computers, and the like.

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Equipment Buildings and equipment are the

primary productive assets of any

organization.

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Depreciation Because property, plant, and

equipment assets wear out over time,

they must be reported on the balancesheet at their net book value. This reduction in the reported value

during a period is called depreciationexpense.

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Depreciation Depreciation is a rational and

systematic allocation of an asset's cost

to expense over the asset's life.

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Depreciation It has nothing to do with writing

assets up or down to market value or

attempting to accumulate cash for thepurpose of replacing the asset.

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Accumulated Depreciation Accumulated depreciation is the total

amount of depreciation expense that

has been recognized to date. If an asset's cost is $10,000 and the

Accumulated Depreciation accountshows a balance of $2,000, then the netbook value is $8,000.

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Intangible Assets Intangible assets lack physical

substance and yet are important

resources in the regular operations ofa business.

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Intangible Assets Patents, which protect invention,

copyrights, which protect artistic

works, and goodwill are examples ofintangible assets.

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Goodwill Goodwill denotes the economic value

of an acquired firm in excess of the

value of its identifiable net assets. Pooky Company has assets of $500,000

and liabilities of $300,000.

Therefore, its net assets are $200,000. If Cassie Company pays $250,000 to buyPooky Company, then there is goodwillof $50,000 ($250,000 - $200,000).

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Goodwill

Goodwill may only be recorded whenone business buys another business.

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Goodwill

Internally generated goodwill maynot be recorded in the accounting

records.

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Goodwill

Very often the most important asset ofa business is its personnel, or human

resources, but human resources doesnot appear on the balance sheet as anasset class.

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Goodwill

There are also other assets which donot appear on the balance sheet, such

as customers and suppliers.

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Goodwill

Externally acquired goodwill ariseswhen one business buys another

business.

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Liabilities

Liabilities include any probableobligation that the firm has incurred

as a consequence of its past activities.

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Liabilities

While some liabilities involve aspecific dollar amount on a specific

date, others involve estimates.

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Liabilities

Liabilities are either current ornoncurrent.

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Liabilities

Current liabilities are short-termobligations that are expected to utilize

cash or other current assets within ayear or an operating cycle, whicheveris longer.

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Liabilities

Noncurrent liabilities representobligations that generally require

payment over periods longer than ayear.

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Current Liabilities

Current liabilities include accountspayable, notes payable, warranty

obligations and accrued expenses.

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Accounts Payable

Accounts payable represent debts thatthe firm incurs in purchasing

inventories and supplies formanufacturing or resale purposes.

Accounts payable also include

anything that a firm purchases oncredit.

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Notes Payable

Notes payable are more formalcurrent liabilities than the accounts

payable. Notes are usually written documents

which involve payment of interest.

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Warranty Obligations

Warranty obligations represent thefirm's estimated future costs to fulfill

its obligations for repair or refundguarantees.

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Warranty Obligations

Warranties are reported on estimatesbecause a company cannot know for

sure how many items will be returnedfor warranty work.

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Accrued Expenses

Accrued expenses represent liabilitiesfor services already consumed but not

yet paid for or included elsewhere inliabilities.

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Taxes Payable

Taxes payable represent unpaid taxesowed to a governmental unit and will

be paid within one year.

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Noncurrent Liabilities

Noncurrent liabilities representobligations that generally require

payment over periods longer than ayear. They are contracts to repay debt at

specified future dates and often placesome restrictions on the activities of thefirm until the debt is fully repaid.

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Bonds Payable

Bonds payable are a major source offunds for larger companies.

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Bonds Payable

When it issues bonds, a companyobligates itself to make periodic

interest payments and to pay back theentire principal at the maturity date.

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Bonds Payable

A company usually issues bondswhen the amount it is borrowing is

too large to borrow from one source.

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Mortgage Payable

A mortgage payable also involvespayment of principal and interest, but

it also represents a pledge of certainassets that will revert to the lender ifthe debt is not paid.

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Unreported Liabilities

A company sometimes has liabilitieswhich do not appear on the face of the

balance sheet. They may only be disclosed in the notes

to the financial statements.

An example is a lawsuit.

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Owners Equity

Owners equity represents theowners claims on the assets of the

business. Arithmetically, it is the difference

between assets and liabilities.

Owners Equity = Assets Liabilities

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Owners Equity

A corporations shareholders equityconsists of two items:

Paid-in capital represents the directinvestments by the owners of the firm.

Retained earnings represent the earningsof the firm that have been reinvested inthe business.

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Owners Equity

An important point to remember isthat retained earnings do not

represent cash available for thepayment of dividends.

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Owners Equity

The retained earnings account is thecumulative story of all the income the

firm has earned, all the losses it hasincurred, and all the dividends it haspaid out to shareholders.

Balance Sheets Differ for

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Balance Sheets Differ forFirms in Different Industries

The composition of assets dependsupon the industry in which a firm

operates.


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A company in the steel andautomobile industries will own many

property, plant and equipment assets.


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A company in the retail industry willshow a high dollar amount of

inventory but may show only onebuilding on one piece of land.

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Balance Sheet Analysis

Using ratios, numbers on the balancesheet can be compared in order to

gauge the financial strength orweakness of a company.

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Ratios are useful only when they arecompared with something else, such

as that company's ratio in formeryears or industry average ratios.

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Ratios are based on past data, whichmay be problematic, and they are also

only as good as the data that comprisethem.

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Vertical Analysis

Vertical analysis, or verticalpercentage analysis, is based on the

percentage relationship of each line inthe balance sheet to the total.

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Liquidity Ratios

Liquidity ratios represent the abilityof a company to convert its assets to

cash.

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Liquidity Ratios

The current ratio is computed bydividing total current assets by total

current liabilities.

Current ratio =Current assets

Current liabilities

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Liquidity Ratios

The current ratio is computed bydividing total current assets by total

current liabilities. What is a good current ratio for a

company depends on the industry inwhich the company operates.

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Liquidity Ratios

The quick ratio, or acid-test ratio, iscomputed by dividing quick assets

by current liabilities. Quick assets are cash, cash equivalents,

and net receivables.

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Liquidity Ratios


by current liabilities. Inventory and prepaid expenses are

excluded.

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Liquidity Ratios


by current liabilities. The quick ratio always will be less than

the current ratioinventory and prepaidexpenses are excluded.

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Liquidity Ratios


by current liabilities.

Quick ratio=Cash and cash equivalents + Receivables

Current liabilities

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Liquidity Ratios

What a good quick ratio is dependson the industry in which a company

operates.

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Asset Management Ratios

Asset management ratios focus on thecomposition of the firm's assets as

well as changes in the composition ofassets over time.

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Debt Management Ratios

Debt management ratios are thecomposition ratios drawn from a

vertical analysis of the right side of thebalance sheet.

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Debt Management Ratios

Debt management ratios include thedebt-to-assets ratio, which is

computed by dividing total debt bytotal assets. This ratio indicates the firm's changing

reliance on borrowed resources.

The lower the ratio, the lower the firm'srisk.

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Limitations of Balance

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Limitations of BalanceSheet Analysis

Information useful for analyzing andclarifying financial statements is

contained in other parts of acompany's financial reports, such asthe notes to the financial statements.

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The Balance Sheet

Documents

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