The Balance Sheet

Defining the Balance Sheet

A balance sheet reports a company’s financial position on a specific date.

Learning Objectives

State the purpose of the balance sheet and recognize what accounts appear on the balance sheet

Key Takeaways

Key Points

  • The balance sheet summarizes a business’s assets, liabilities, and shareholders ‘ equity.
  • A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time.
  • The balance sheet is sometimes called the statement of financial position.
  • The balance sheet shows the accounting equation in balance. A company’s assets must equal their liabilities plus shareholders’ equity.

Key Terms

  • liability: An obligation, debt, or responsibility owed to someone.
  • asset: Items of ownership convertible into cash; total resources of a person or business, as cash, notes and accounts receivable; securities and accounts receivable, securities, inventories, goodwill, fixtures, machinery, or real estate (as opposed to liabilities).
  • balance sheet: A balance sheet is often described as a “snapshot of a company’s financial condition. ” A standard company balance sheet has three parts: assets, liabilities, and ownership equity.

Balance Sheet

The balance sheet, sometimes called the statement of financial position, lists the company’s assets, liabilities,and stockholders ‘ equity (including dollar amounts) as of a specific moment in time. That specific moment is the close of business on the date of the balance sheet. A balance sheet is like a photograph; it captures the financial position of a company at a particular point in time. The other two statements are for a period of time. As you study about the assets, liabilities, and stockholders’ equity contained in a balance sheet, you will understand why this financial statement provides information about the solvency of the business.

The Balance Sheet: If an error is found on a previous year’s financial statement, a correction must be made and the financials reissued.

The balance sheet is a formal document that follows a standard accounting format showing the same categories of assets and liabilities regardless of the size or nature of the business. Accounting is considered the language of business because its concepts are time-tested and standardized. Even if you do not utilize the services of a certified public accountant, you or your bookkeeper can adopt certain generally accepted accounting principles ( GAAP ) to develop financial statements. The strength of GAAP is the reliability of company data from one accounting period to another and the ability to compare the financial statements of different companies.

Balance Sheet Formats

Standard accounting conventions present the balance sheet in one of two formats: the account form (horizontal presentation) and the report form (vertical presentation). Most companies favor the vertical report form, which doesn’t conform to the typical explanation in investment literature of the balance sheet as having “two sides” that balance out.

Whether the format is up-down or side-by-side, all balance sheets conform to a presentation that positions the various account entries into five sections:

Assets = Liabilities + Equity

1. Current assets (short-term): items that are convertible into cash within one year

2. Non-current assets (long-term): items of a more permanent nature

3. Current liabilities (short-term): obligations due within one year

4. Non-current liabilities (long-term): obligations due beyond one year

5. Shareholders’ equity (permanent): shareholders’ investment and retained earnings

Account Presentation

In the asset sections mentioned above, the accounts are listed in the descending order of their liquidity (how quickly and easily they can be converted to cash). Similarly, liabilities are listed in the order of their priority for payment. In financial reporting, the terms “current” and “non-current” are synonymous with the terms “short-term” and “long-term,” respectively, so they are used interchangeably.

Each of the three segments on the balance sheet will have many accounts within it that document the value of each. Accounts such as cash, inventory, and property are on the asset side of the balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry.

Components of the Balance Sheet

The balance sheet relationship is expressed as; Assets = Liabilities + Equity.

Learning Objectives

Differentiate between the three balance sheet accounts of asset, liability and shareholder’s equity

Key Takeaways

Key Points

  • Assets have value because a business can use or exchange them to produce the services or products of the business.
  • Liabilities are the debts owed by a business, often incurred to fund its operation.
  • A company’s equity represents retained earnings and funds contributed by its shareholders.

Key Terms

  • liabilities: Probable future sacrifices of economic benefits arising from present obligations to transfer assets or providing services as a result of past transactions or events.
  • Assets: A resource with economic value that an individual, corporation, or country owns or controls with the expectation that it will provide future benefit.
  • equity: Ownership interest in a company, as determined by subtracting liabilities from assets.

Components of the Balance Sheet

The balance sheet contains statements of assets, liabilities, and shareholders’ equity.

Assets represent things of value that a company owns and has in its possession, or something that will be received and can be measured objectively. They are also called the resources of the business, some examples of assets include receivables, equipment, property and inventory. Assets have value because a business can use or exchange them to produce the services or products of the business.

Liabilities are the debts owed by a business to others–creditors, suppliers, tax authorities, employees, etc. They are obligations that must be paid under certain conditions and time frames. A business incurs many of its liabilities by purchasing items on credit to fund the business operations.

A company’s equity represents retained earnings and funds contributed by its owners or shareholders (capital), who accept the uncertainty that comes with ownership risk in exchange for what they hope will be a good return on their investment.

Fundamental Relationship

The relationship of these items is expressed in the fundamental balance sheet equation:

Assets = Liabilities + Equity

The meaning of this equation is important. Generally, sales growth, whether rapid or slow, dictates a larger asset base – higher levels of inventory, receivables, and fixed assets (plant, property, and equipment). As a company’s assets grow, its liabilities and/or equity also tends to grow in order for its financial position to stay in balance. How assets are supported, or financed, by a corresponding growth in payables, debt liabilities, and equity reveals a lot about a company’s financial health.

Uses of the Balance Sheet

The balance sheet of a business provides a snapshot of its financial status at a particular point in time.

Learning Objectives

Give examples of how the balance sheet is used by internal and external users

Key Takeaways

Key Points

  • The Balance Sheet is used for financial reporting and analysis as part of the suite of financial statements.
  • Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information.
  • Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general purpose financial statements that companies publish.

Key Terms

  • liquidity: A company’s ability to meet its payment obligations, in terms of possessing sufficient liquid assets.

Uses Of the Balance Sheet

The Balance Sheet is used for financial reporting and analysis as part of the suite of financial statements.

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Using the Balance Sheet: The balance sheet is one of the financial reports included in a company’s annual report.

Management’s analysis of financial statements primarily relates to parts of the company. Using this approach, management can plan, evaluate, and control operations within the company. Management obtains any information it wants about the company’s operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to lay off and when to expand operations.

Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general purpose financial statements that companies publish. These statements include the balance sheet, an income statement, a statement of stockholders ‘ equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.

Users of financial statements need to pay particular attention to the explanatory notes, or the financial review, provided by management in annual reports. This integral part of the annual report provides insight into the scope of the business, the results of operations, liquidity and capital resources, new accounting standards, and geographic area data.

Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements.

Balance Sheet Substantiation

The balance sheet is an especially useful tool when it comes to the substantiation of various accounts. Balance sheet substantiation is the accounting process conducted by businesses on a regular basis to confirm that the balances held in the primary accounting system of record are reconciled (in balance with) with the balance and transaction records held in the same or supporting sub-systems. It includes multiple processes including reconciliation (at a transactional or at a balance level) of the account, a process of review of the reconciliation and any pertinent supporting documentation, and a formal certification (sign-off) of the account in a predetermined form driven by corporate policy

Balance sheet substantiation is an important process that is typically carried out on a monthly, quarterly and year-end basis. The results help to drive the regulatory balance sheet reporting obligations of the organization. Historically, substantiation has been a wholly manual process, driven by spreadsheets, email and manual monitoring and reporting. In recent years software solutions have been developed to bring a level of process automation, standardization and enhanced control to the substantiation or account certification process. These solutions are suitable for organizations with a high volume of accounts and/or personnel involved in the substantiation process and can be used to drive efficiencies, improve transparency and help to reduce risk.

Preparation of the Balance Sheet

Balance sheets are prepared with either one or two columns, with assets first, followed by liabilities and net worth.

Learning Objectives

Identify the elements of a properly formatted balance sheet

Key Takeaways

Key Points

  • Balance sheets are usually prepared at the close of an accounting period, such as month-end, quarter-end, or year-end.
  • Current assets most commonly used by small businesses are cash, accounts receivable, inventory and prepaid expenses.
  • There are two types of liabilities: current liabilities and long-term liabilities. Liabilities are arranged on the balance sheet in order of how soon they must be repaid.

Key Terms

  • inventory: Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.
  • Fixed assets: Assets that produce revenues. They are distinguished from current assets by their longevity. They are not for resale.
  • depreciation: Depreciation subtracts a specified amount from the original purchase price to account for the wear and tear on the asset.

How to Prepare a Balance Sheet

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Balance Sheet Preparation: How to prepare a balance sheet.

All balance sheets follow the same format: when two columns are used, assets are on the left, liabilities are on the right, and net worth is beneath liabilities. When one column is used, assets are listed first, followed by liabilities and net worth. Balance sheets are usually prepared at the close of an accounting period.

Current Assets

To start, focus on the current assets most commonly used by small businesses: cash, accounts receivable, inventory and prepaid expenses. Cash includes cash on hand, in the bank, and in petty cash. Accounts receivable is what you are owed by customers. To make this number more realistic, an amount should be deducted from accounts receivable as an allowance for bad debts.

Inventory may be the largest current asset. On a balance sheet, the value of inventory is the cost required to replace it if the inventory were destroyed, lost, or damaged. Inventory includes goods ready for sale, as well as raw material and partially completed products that will be for sale when they are completed.

Prepaid expenses are listed as a current asset because they represent an item or service that has been paid for but has not been used or consumed. An example of a prepaid expense is the last month of rent on a lease that may have been prepaid as a security deposit. The prepaid expense will be carried as an asset until it is used. Prepaid insurance premiums are another example of prepaid expenses. Sometimes, prepaid expenses are also referred to as unexpired expenses. On a balance sheet, current assets are totaled and this total is shown as the line item called “total current assets. ”

Fixed Assets

Fixed assets are the assets that produce revenues. They are distinguished from current assets by their longevity. They are not for resale. Many small businesses may not own a large amount of fixed assets, because most small businesses are started with a minimum of capital. Of course, fixed assets will vary considerably and depend on the business type (such as service or manufacturing), size, and market.

Fixed assets include furniture and fixtures, motor vehicles, buildings, land, building improvements (or leasehold improvements), production machinery, equipment and any other items with an expected business life that can be measured in years. All fixed assets (except land) are shown on the balance sheet at original (or historic) cost, minus any depreciation. Subtracting depreciation is a conservative accounting practice to reduce the possibility of over valuation. Depreciation subtracts a specified amount from the original purchase price for the wear and tear on the asset.

It is important to remember that original cost may be more than the asset’s invoice price. It can include shipping, installation, and any associated expenses necessary for readying the asset for service. Assets are arranged in order of how quickly they can be turned into cash. Like the other fixed assets on the balance sheet, machineryand equipment will be valued at the original cost minus depreciation. “Other assets” is a category of fixed assets. Other assets are generally intangible assets such as patents, royalty arrangements, and copyrights.

Liabilities

Liabilities are claims of creditors against the assets of the business. These are debts owed by the business.There are two types of liabilities: current liabilities and long-term liabilities. Liabilities are arranged on the balance sheet in order of how soon they must be repaid. For example, accounts payable will appear first as they are generally paid within 30 days. Notes payable are generally due within 90 days and are the second liability to appear on the balance sheet.

Current liabilities include the following:

  • Accounts payable
  • Notes payable to banks (or others)
  • Accrued expenses (such as wages and salaries)
  • Taxes payable
  • The current amount due within a one year portion of long-term debt
  • Any other obligations to creditors due within one year of the date of the balance sheet

The current liabilities of most small businesses include accounts payable, notes payable to banks, and accrued payroll taxes. Accounts payable is the amount you may owe any suppliers or other creditors for services or goods that you have received but not yet paid for. Notes payable refers to any money due on a loan during the next 12 months. Accrued payroll taxes would be any compensation to employees who have worked, but have not been paid at the time the balance sheet is created.

Liabilities are arranged on the balance sheet in order of how soon they must be repaid.

Long-term liabilities are any debts that must be repaid by your business more than one year from the date of the balance sheet. This may include start up financing from relatives, banks, finance companies, or others.

Temporal Classification

Cash, receivables, and liabilities on the Balance Sheet are re-measured into U.S. dollars using the current exchange rate.

Learning Objectives

Identify when it would be necessary to use the temporal method on the balance sheet

Key Takeaways

Key Points

  • Inventory, property, equipment, patents, and contributed capital accounts are re-measured at historical rates resulting in differences in total assets and liabilities plus equity which must be reconciled resulting in a re-measurement gain or loss.
  • If a company’s functional currency is the U.S. dollar, then any balances denominated in the local or foreign currency, must be re-measured.
  • The re-measurement gain or loss appears on the income statement.

Key Terms

  • translation: Uses exchange rates based on the time assets. Liabilities acquired or incurred are required.
  • Temporal Method: Cash, receivables, and liabilities are re-measured into U.S. dollars using the current exchange rate.

A Classified Balance Sheet

“Classified” means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. Most accounting balance sheets classify a company’s assets and liabilities into distinct groups such as current assets property, plant, equipment, current liabilities, etc. These classifications make the balance sheet more useful

The Temporal Method

Cash, receivables, and liabilities are re-measured into U.S. dollars using the current exchange rate. Inventory, property, equipment, patents, and contributed capital accounts are re-measured at historical rates resulting in differences in total assets and liabilities plus equity which must be reconciled resulting in a re-measurement gain or loss.

If a company’s functional currency is the U.S. dollars, then any balances denominated in the local or foreign currency, must be re-measured. Re-measurement requires the application of the temporal method. The re-measurement gain or loss appears on the income statement.

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Temporal Classification: Re-measurement to U.S. dollars.

Translation

A method of foreign currency translation that uses exchange rates based on the time assetsand liabilities are acquired or incurred, is required. The exchange rate used also depends on the method of valuation that is used. Assets and liabilities valued at current costs use the current exchange rate and those that use historical exchange rates are valued at historical costs.

By using the temporal method, any income-generating assets like inventory, property, plant, and equipment are regularly updated to reflect their market values. The gains and losses that result from translation are placed directly into the current consolidated income. This causes the consolidated earnings to be volatile.

Assets

Assets on a balance sheet are classified into current assets and non-current assets. Assets are on the left side of a balance sheet.

Learning Objectives

Sketch the asset section of a balance sheet

Key Takeaways

Key Points

  • The main categories of assets are usually listed first, and normally, in order of liquidity. On a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.
  • Current assets are those assets which can either be converted to cash or used to pay current liabilities within 12 months. Current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities paid within a year.
  • A non-current asset cannot easily be converted into cash. Non-current assets include property, plant and equipment (PPE), investment property, intangible assets, long-term financial assets, investments accounted for using the equity method, and biological assets.

Key Terms

  • liquidity: Availability of cash over short term: ability to service short-term debt.

The Balance Sheet

A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and normally, in order of liquidity. On the left side of a balance sheet, assets will typically be classified into current assets and non-current (long-term) assets.

 Balance Sheet: Sample Domestic Balance Sheet (DBS) to be referenced by Domestic Well-Being Accounting (DWBA)

Current Assets

A current asset on the balance sheet is an asset which can either be converted to cash or used to pay current liabilities within 12 months. Typical current assets include cash and cash equivalents, short-term investments, accounts receivable, inventories and the portion of prepaid liabilities which will be paid within a year.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company’s balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or treasury bills, marketable securities and commercial papers. Cash equivalents are distinguished from other investments through their short-term existence; they mature within 3 months whereas short-term investments are 12 months or less, and long-term investments are any investments that mature in excess of 12 months.

Accounts receivable represents money owed by entities to the firm on the sale of products or services on credit. In most business entities, accounts receivable is typically executed by generating an invoice and either mailing or electronically delivering it to the customer, who, in turn, must pay it within an established timeframe, called credit terms or payment terms.

Most manufacturing organizations usually divide their inventory into:

  • raw materials – materials and components scheduled for use in making a product,
  • work in process (WIP) – materials and components that have began their transformation to finished goods,
  • finished goods – goods ready for sale to customers, and
  • goods for resale – returned goods that are salable.

A deferred expense or prepayment, prepaid expense (plural often prepaids), is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period. For example, if a service contract is paid quarterly in advance, at the end of the first month of the period two months remain as a deferred expense. In the deferred expense, the early payment is accompanied by a related, recognized expense in the subsequent accounting period, and the same amount is deducted from the prepayment.

Non-current Assets

A non-current asset is a term used in accounting for assets and property which cannot easily be converted into cash. This can be compared with current assets such as cash or bank accounts, which are described as liquid assets. Non-current assets include property, plant and equipment (PPE), investment property (such as real estate held for investment purposes), intangible assets, long-term financial assets, investments accounted for by using the equity method, and biological assets, which are living plants or animals.

Property, plant, and equipment normally include items such as land and buildings, motor vehicles, furniture, office equipment, computers, fixtures and fittings, and plant and machinery. These often receive favorable tax treatment (depreciation allowance) over short-term assets.

Intangible assets are defined as identifiable, non-monetary assets that cannot be seen, touched or physically measured. They are created through time and effort, and are identifiable as a separate asset. There are two primary forms of intangibles – legal intangibles (such as trade secrets (e. g., customer lists), copyrights, patents, and trademarks) and competitive intangibles (such as knowledge activities (know-how, knowledge), collaboration activities, leverage activities, and structural activities). The intangible asset ” goodwill ” reflects the difference between the firm’s net assets and its market value; the amount is first recorded at time of acquisition. The additional value of the firm in excess of its net assets usually reflects the company’s reputation, talent pool, and other attributes that separate it from the competition. Goodwill must be tested for impairment on an annual basis and adjusted if the firm’s market value has changed.

Investments accounted for by using the equity method are 20-50% stake investments in other companies. The investor keeps such equities as an asset on the balance sheet. The investor’s proportional share of the associate company’s net income increases the investment (and a net loss decreases the investment), and proportional payment of dividends decreases it. In the investor’s income statement, the proportional share of the investee’s net income or net loss is reported as a single-line item.

Liabilities and Equity

The balance sheet contains details on company liabilities and owner’s equity.

Learning Objectives

Apply the accounting equation to create a balance sheet

Key Takeaways

Key Points

  • In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future.
  • Equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid.
  • The types of accounts and their description that comprise the owner’s equity depend on the nature of the entity and may include: Common stock, preferred stock, capital surplus, retained earnings, treasury stock, stock options and reserve.

Key Terms

  • Preferred Stock: Stock with a dividend, usually fixed, that is paid out of profits before any dividend can be paid on common stock. It also has priority to common stock in liquidation.

In financial accounting, a liability is defined as an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. A liability is defined by the following characteristics:

  • Any type of borrowing from persons or banks for improving a business or personal income that is payable during short or long time;
  • A duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services, or other transaction yielding an economic benefit, at a specified or determinable date, on occurrence of a specified event, or on demand;
  • A duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement; and,
  • A transaction or event obligating the entity that has already occurred.

The accounting equation relates assets, liabilities, and owner’s equity: “” The accounting equation is the mathematical structure of the balance sheet.

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Accounting equation: Assets = Liabilities + Owner’s Equity

In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists. In an accounting context, shareholders ‘ equity (or stockholders ‘ equity, shareholders’ funds, shareholders’ capital, or similar terms) represents the remaining interest in assets of a company, spread among individual shareholders of common or preferred stock.

At the start of a business, owners put some funding into the business to finance operations. This creates a liability on the business in the shape of capital, as the business is a separate entity from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and assets: this is the accounting equation. After liabilities have been accounted for, the positive remainder is deemed the owner’s interest in the business.

In financial accounting, owner’s equity consists of the net assets of an entity. Net assets is the difference between the total assets of the entity and all its liabilities. Equity appears on the balance sheet, one of the four primary financial statements.

The assets of an entity includes both tangible and intangible items, such as brand names and reputation or goodwill. The types of accounts and their description that comprise the owner’s equity depend on the nature of the entity and may include: Common stock, preferred stock, capital surplus, retained earnings, treasury stock, stock options and reserve.

The total changes to equity is calculated as follows:

Equity (end of year balance) = Equity (beginning of year balance) +/- changes to common or preferred stock and capital surplus +/- net income/loss (net profit/loss earned during the period) − dividends. Dividends are typically cash distributions of earnings to stockholders on hand and they are recorded as a reduction to the retained earnings account reported in the equity section.

Liquidity

Liquidity, a business’s ability to pay obligations, can be assessed using various ratios: current ratio, quick ratio, etc.

Learning Objectives

Calculate a company’s liquidity using a variety of methods.

Key Takeaways

Key Points

  • Liquidity refers to a business’s ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. For assets, liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value.
  • A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, typically in order of liquidity.
  • For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity, namely the current ratio, the quick ratio, the operating cash flow ratio, and the liquidity ratio (acid test).

Key Terms

  • cash equivalents: A deferred expense or prepayment, prepaid expense, plural often prepaids, is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period.
  • liquidity ratio: measurement of the availability of cash to pay debt

In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor to pay his debts when they fall due. A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, and typically in order of liquidity. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. Next are cash equivalents, short-term investments, inventories, and prepaid expenses.

Liquidity also refers both to a business’s ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. For assets themselves, liquidity is an asset’s ability to be sold without causing a significant movement in the price and with minimum loss of value.

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Liquidity: Monthly liquidity of an organic vegetable business

For a corporation with a published balance sheet, there are various ratios used to calculate a measure of liquidity. These include the following:

  • The current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a non-banking corporation. However, some current assets are more difficult to sell at full value in a hurry.
  • The quick ratio, which is calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities–this gives a measure of the ability to meet current liabilities from assets that can be readily sold.
  • The operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.
  • The liquidity ratio (acid test) is a ratio used to determine the liquidity of a business entity. Liquidity ratio expresses a company’s ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means fully covered. The formula is the following: LR = liquid assets / short-term liabilities.

Working Capital

Working capital is a financial metric which represents operating liquidity available to a business, organization and other entity.

Learning Objectives

Discuss why working capital is an important metric for businesses.

Key Takeaways

Key Points

  • Net working capital is calculated as current assets minus current liabilities.
  • Current assets and current liabilities include three accounts which are of special importance: accounts receivable, accounts payable and inventories.
  • The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Key Terms

  • operating liquidity: The ability of a company or individual to quickly convert assets to cash for the purpose of paying operating expenses.
  • deficit: the amount by which spending exceeds revenue

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including a governmental entity. Along with fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities – for example has paid off some short-term creditors.

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact: accounts receivable (current asset), inventories (current assets), and accounts payable (current liability). The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Inventory management is to identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence, increases cash flow.

Debtors ‘ management involves identifying the appropriate credit policies, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence, return on capital.

Short-term financing requires identifying the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft).

Cash management involves identifying the cash balance which allows for the business to meet day-to-day expenses, but reduces cash holding costs.

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Statement of cash flows: The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Debt to Equity

The debt-to-equity ratio (D/E) indicates the relative proportion of shareholder’s equity and debt used to finance a company’s assets.

Learning Objectives

Identify the different methods of calculating the debt to equity ratio.

Key Takeaways

Key Points

  • The debt -to- equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders ‘ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage.
  • Preferred stocks can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision.
  • The formula of debt/ equity ratio: D/E = Debt ( liabilities ) / equity = Debt / (Assets – Debt) = (Assets – Equity) / Equity.

Key Terms

  • leverage: The use of borrowed funds with a contractually determined return to increase the ability of a business to invest and earn an expected higher return (usually at high risk).

Debt to Equity

The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two components are often taken from the firm’s balance sheet or statement of financial position. However, the ratio may also be calculated using market values for both if the company’s debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially. “”

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Leverage Ratios of Investment Banks: Each of the five largest investment banks took on greater risk leading up to the subprime crisis. This is summarized by their leverage ratio, which is the ratio of total debt to total equity. A higher ratio indicates more risk.

Preferred stocks can be considered part of debt or equity. Attributing preferred shares to one or the other is partially a subjective decision, but will also take into account the specific features of the preferred shares. When used to calculate a company’s financial leverage, the debt usually includes only the long term debt (LTD). Quoted ratios can even exclude the current portion of the LTD.

Financial analysts and stock market quotes will generally not include other types of liabilities, such as accounts payable, although some will make adjustments to include or exclude certain items from the formal financial statements. Adjustments are sometimes also made, for example, to exclude intangible assets, and this will affect the formal equity; debt to equity (dequity) will therefore also be affected.

The formula of debt/equity ratio: D/E = Debt (liabilities) / equity. Sometimes only interest-bearing long-term debt is used instead of total liabilities in the calculation.

A similar ratio is the ratio of debt-to- capital (D/C), where capital is the sum of debt and equity:D/C = total liabilities / total capital = debt / (debt + equity)

The relationship between D/E and D/C is: D/C = D/(D+E) = D/E / (1 + D/E)

The debt-to-total assets (D/A) is defined asD/A = total liabilities / total assets = debt / (debt + equity + non-financial liabilities)

On a balance sheet, the formal definition is that debt (liabilities) plus equity equals assets, or any equivalent reformulation. Both the formulas below are therefore identical: A = D + EE = A – D or D = A – E

Debt to equity can also be reformulated in terms of assets or debt: D/E = D /(A – D) = (A – E) / E

Market Value vs. Book Value

Book value is the price paid for a particular asset, while market value is the price at which you could presently sell the same asset.

Learning Objectives

Distinguish between market value and book value.

Key Takeaways

Key Points

  • Market value is the price at which an asset would trade in a competitive auction setting.
  • Book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset.
  • In many cases, the carrying value of an asset and its market value will differ greatly. However, they are interrelated.

Key Terms

  • amortization: The distribution of the cost of an intangible asset, such as an intellectual property right, over the projected useful life of the asset.

Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value, or fair market value. International Valuation Standards defines market value as “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion. ”

In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization, or impairment costs made against the asset. An asset’s initial book value is its its acquisition cost or the sum of allowable costs expended to put it into use. Assets such as buildings, land, and equipment are valued based on their acquisition cost, which includes the actual cash price of the asset plus certain costs tied to the purchase of the asset, such as broker fees. The book value is different from market value, as it can be higher or lower depending on the asset in question and the accounting practices that affect book value, such as depreciation, amortization and impairment. In many cases, the carrying value of an asset and its market value will differ greatly. If the asset is valued on the balance at market value, then its book value is equal to the market value.

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Depreciation methods which are essential in calculating book value: 4 Depreciation methods (1. Straight-Line method, (2. Double-Declining Balance method, (3. Sum-of-the-Years’ Digits method, (4.Productive output method)

Ways of measuring the value of assets on the balance sheet include: historical cost, market value or lower of cost or market. Historical cost is typically the purchase price of the asset or the sum of certain costs expended to put the asset into use. Market value is the asset’s worth if it were to be exchanged in the open market in an arm’s length transaction; it can also be derived based on the asset’s present value of the expected cash flows it will generate. Certain assets are disclosed at lower of cost or market in order to conform to accounting’s conservatism principle, which stresses that assets should never be overstated.

Limitations of the Balance Sheet

The three limitations to balance sheets are assets being recorded at historical cost, use of estimates, and the omission of valuable non-monetary assets.

Learning Objectives

Critique the balance sheet

Key Takeaways

Key Points

  • Balance sheets do not show true value of assets. Historical cost is criticized for its inaccuracy since it may not reflect current market valuation.
  • Some of the current assets are valued on an estimated basis, so the balance sheet is not in a position to reflect the true financial position of the business.
  • The balance sheet can not reflect those assets which cannot be expressed in monetary terms, such as skill, intelligence, honesty, and loyalty of workers.

Key Terms

  • carrying value: In accounting, book value or carrying value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or Impairment costs made against the asset.
  • Fixed assets: Fixed assets, also known as non-current assets or property, plant, and equipment (PP&E), is a term used in accounting for assets and property that cannot easily be converted into cash. This can be compared with current assets, such as cash or bank accounts, which are described as liquid assets. In most cases, only tangible assets are referred to as fixed.

Limitations of the Balance Sheet

In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, business partnership, corporation, or other business organization, such as an LLC or an LLP. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a “snapshot of a company’s financial condition. ” Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business’ calendar year. There are three primary limitations to balance sheets, including the fact that they are recorded at historical cost, the use of estimates, and the omission of valuable things, such as intelligence.

Fixed assets are shown in the balance sheet at historical cost less depreciation up to date. Depreciation affects the carrying value of an asset on the balance sheet. The historical cost will equal the carrying value only if there has been no change recorded in the value of the asset since acquisition. Therefore, the balance sheet does not show true value of assets. Historical cost is criticized for its inaccuracy since it may not reflect current market valuation.

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Four depreciation methods: Different methods of depreciation affect the carrying value of an asset on balance sheets.

Some of the current assets are valued on estimated basis, so the balance sheet is not in a position to reflect the true financial position of the business. Intangible assets like goodwill are shown in the balance sheet at imaginary figures, which may bear no relationship to the market value. The International Accounting Standards Board (IASB) offers some guidance (IAS 38) as to how intangible assets should be accounted for in financial statements. In general, legal intangibles that are developed internally are not recognized, and legal intangibles that are purchased from third parties are recognized. Therefore, there is a disconnect–goodwill from acquisitions can be booked, since it is derived from a market or purchase valuation. However, similar internal spending cannot be booked, although it will be recognized by investors who compare a company’s market value with its book value.

Finally, the balance sheet can not reflect those assets which cannot be expressed in monetary terms, such as skill, intelligence, honesty, and loyalty of workers.