Module 2--The Balance Sheet Flashcards
What is the BALANCE SHEET composed of?
■ The balance sheet is a financial statement that shows THREE groups of accounts at a specific point in time (a snapshot).
* Assets – what an organization owns
* Liabilities – what an organization owes and must be paid sometime in the future
* Equity – owners’ investment through issuance of shares and accumulated retained earnings
■ Total assets on the balance sheet must equal total liabilities and equity.
**Balance sheet is a snapshot at a moment in time
What are ASSETS?
■ Assets are what the organization owns (possessions)
What are the TWO TYPES of ASSETS?
- CURRENT ASSETS – A company’s assets including cash and those items expected to be turned into cash within one year of the date of the balance sheet (includes accounts receivable, inventory and prepaid expenses). These are needed to determine liquidity.
- NON CURRENT ASSETS – Assets of the company that are used in production and have a useful life of more than one year. They are occasionally referred to as long-term or fixed assets
What are some examples of CURRENT ASSETS?
■ Cash – cash and bank balances
■ Marketable securities
* Investments valued at the lower of original cost or current market (bonds and stocks)
* Have a maturity of more than 90 days but will be used by the company when cash is needed
■ Accounts receivable
* Monies owed to the company
* Less allowance for doubtful accounts
– Percent of accounts receivable assumed not to be collected
■ Notes receivable
* Unconditional promise to pay a definite sum of money on demand at a future date
* To be paid within one year
■ Prepaid expenses – expenses relating to a period of time after the date of the balance sheet, which have already been paid
■ Inventory
* Products (including direct labor)
– Raw materials
– Work in progress
– Finished goods
* Indirect materials
– Supplies used in the manufacturing process that do not become part of the product itself
Why is INVENTORY COSTLY?
■ Issue
The challenge for a company dealing with products is to minimize inventory but to have enough products available for customers.
■ Costs
* Spoilage
* Obsolescence
* Money is tied up
* Insurance costs
* Risk of theft
* Warehousing costs
■ Solution is just in time (JIT)
Concept of JIT – To reduce the high costs of inventory, a company may wait until an order is received before the product is made.
How is INVENTORY VALUED?
Companies may use different methods to value inventory.
■ Weighted average
* Average cost of goods available for sale during the period
* Total cost divided by the units for sale during the period
■ FIFO
* First items produced for inventory are first sold.
* Remaining inventory is the most recently produced items.
■ LIFO
* Last items produced for inventory are first sold.
* Items that remain were the first ones produced.
■ Companies may use different inventory valuation methods under GAAP.
■ A company MUST USE the same inventory valuation method for shareholder and tax purposes.
* Taxes may drive the decision for companies.
**GAAP allows for multiple methodologies.
EXAMPLE of VALUING INVENTORY
Example – Valuing Inventory
Inventory accounting does not relate to the actual units that have been sold.
Companies need to do a physical inventory check at least once a year.
■ Goods available for sale (GAS) = Beginning inventory plus additions to inventory
■ Ending inventory (EI) = GAS minus units sold
■ Cost of goods sold (COGS) = GAS minus EI
Mathematical Examples of the different practices of handling inventory
■ WEIGHTED AVERAGE
■ FIFO
■ LIFO
WA FIFO LIFO SR 10 10 10
COST of GOOD Sold 4.4 4.1 4.7
—————————————————————-
GROSS MARGIN 5.6 5.9 5.3
**LOWER MARGIN = lower taxes
What is the WEIGHTED AVERAGE?
Weighted Average
■ Use GAS to calculate the weighted average cost.
* Total dollars (in millions) divided by total units (in millions)
$7.7 ÷ 7 = $1.1 million per unit
■ Ending inventory (EI) – 3 units
3 million units at $1.1 per unit = $3.3 million EI
■ Cost of goods sold (COGS)
$7.7 million GAS – $3.3 million EI = $4.4 million COGS
What is FIFO?
FIRST IN FIRST OUT
What is LIFO?
LIFO (Last in First Out)is an approach to valuing inventory in which it is assumed that the products most recently obtained are the ones that are sold first. It is used in many cases to reduce taxes in the current period.
What are the TWO GROUPINGS on NON CURRENT ASSETS?
■ Tangible
* Definition – part of the business used in production or delivery of service that does not become part of the product itself, has a useful life greater than one year, and has physical presence (e.g., property, plant, equipment)
* Accounting treatment
– In most cases tangible noncurrent assets are depreciated.
– The balance sheet shows the original cost of the noncurrent assets and the accumulated depreciation (excepting land, which is not depreciated).
– Depreciation for shareholder books is different than depreciation for IRS books.
■ Intangible
* Definition – assets with a value to the company that have no physical presence (e.g., goodwill, patents, franchises)
* Accounting treatment
– Impairment
– Amortization
What are TANGIBLE NONCURRENT ASSETS?
TANGIBLE NON-CURRENT ASSETS
The balance sheet shows the original cost of the noncurrent assets and the accumulated depreciation. Noncurrent assets are never appreciated.
■ Land is not depreciated, but remains at original cost.
■ Buildings
■ Furniture
■ Machinery
■ Leasehold improvements
■ Long-term investments mature more than one year after the date of the balance sheet.
■ Overfunded pension plan
**Assets you turn around into cash that take longer than one year AND they do not go into your products but are used to produce your product.
What are INTANGIBLE NONCURRENT ASSETS?
INTANGIBLE NONCURRENT ASSETS
Intangible noncurrent assets are either amortized or impaired. Therefore, intangible noncurrent assets are valued at original cost less amortization or impairment. Goodwill, patents and franchises are types of intangible assets.
■ ‘GOODWILL” occurs when one company buys another company for an amount in excess of the appraised fair market value of the assets of the other firm.
* Cost of acquisition in excess of market value of net assets
* U.S. rules of goodwill
– Tax books (IRC) – amortized over 15 years on a straight-line basis
– Shareholder books (GAAP) – Goodwill is reviewed for IMPAIRMENT. Impairment expenses are likely to occur irregularly and in varied amounts.
Example: Your company buys XYZ company for $20 million. Its net assets appraise at $15 million. You will have $5 million on your balance sheet as goodwill.
■ PATENTS
* Purchased
– Booked at purchase price or at fair market value on date of acquisition
– Cost of purchased patents are amortized over their remaining useful lives.
■ Internally developed
* Many companies have very valuable patents that they developed internally, and these are not shown on the balance sheet at all.
* These are research and development expenses when the costs are incurred and they are not listed as an asset.
■ FRANCHISES
* Fees paid up front are an asset.
* Amortized over the useful life
Example - $400k paid to McDonald’s for
■ COPYRIGHTS
What are LIABILITIES?
A liability is an obligation to pay an amount at a future date for current or past benefits received. Something you owe to third parties
What are the TWO TYPES of LIABILITIES?
- CURRENT LIABILITIES? – to determine liquidity
- NONCURRENT LIABILITIES (fixed or long-term)
What are CURRENT LIABILITIES?
Current liabilities are payable within one year of the balance sheet date.
■ Accounts payable – monies owed to the supplier/vendors for goods or services provided to the company
■ Notes payable – obligations represented by promissory notes
■ Accrued payables or liabilities – accrued wages and benefits (e.g., profit-sharing, welfare plans, pensions, vacation, incentives)
■ Severance pay – monies owed to terminated employees
■ Taxes payable – tax obligation to be paid within one year of balance sheet date
■ Current maturities of long-term obligations – (e.g., car loans, mortgages)
What are NONCURRENT LIABILITIES?
■ Part of permanent capital not payable within one year
■ Notes payable – obligations represented by promissory notes
■ Mortgages payable – long-term debt secured by real property
■ Bonds – monies borrowed by the company from the public domain
■ Deferred taxes – tax obligation to be paid at a future date
■ Financial or capital lease obligations – method of financing
operating equipment
■ Severance pay (more than one year) – monies to be paid to terminated employees
■ Post-employment benefits (ASC 715) – retiree welfare benefits
* Accelerated expense recognition and contributed to less prevalence of the benefit in the US
What are CONTINGENT (OR CONTINUING) LIABILITIES?
■ Potential liability
A large lawsuit filed against a company will remain a material contingency until the lawsuit is decided. Contingencies are disclosed in the footnotes of the financial statement.
■ Real liability
Example:
Several years ago, Pennzoil filed suit against Texaco for $10 billion over the acquisition of Getty Oil.
When first filed, the suit was a contingency in Texaco’s financial statements. When Pennzoil won the suit, it became a real liability for Texaco. The settlement amount of $3 billion remained a real liability for Texaco until it was paid.
Which is more RISKIER for a organization–EQUITY or LIABILITY?
EQUITY is MORE RISKIER than debt for two main reasons:
■ The order of payments–bonds must be paid before paying shareholders
■ Because the risk in higher–the return paid to shareholders must be higher. Higher risk = higher return.
**When is a company looks at it, DEBT bc a company has to make those payments first
What are SHAREHOLDER Equity?
■ PREFERRED SHARES shares have a claim to assets upon liquidation after creditors but before common shareholders.
* Preferred shares usually have a fixed-dollar dividend specified that must be paid before dividends can be paid to common shareholders.
* Some preferred shares are convertible, meaning that they can be converted to common shares under specified conditions.
* Some preferred shares do not have voting rights.
■ COMMON SHARES are the form in which an owner’s interest is represented – distributed in units known as shares with voting rights and possibly dividends. Appreciation and dividends are not fixed or guaranteed.
* Par value of common stock is the stated or nominal value. It has very little meaning. Some companies’ stock has zero par value based on the state of incorporation.
* The amount shareholders paid for shares in excess of par value is recorded as additional paid-in capital.
■ TRESURY SHARES are the company’s purchase of its own shares and show as a reduction in shareholders equity.
■ Retained earnings are the company’s cumulative after tax earnings that have not been paid out in dividends and have been kept for use in the business.
What are the ORDER of PAYMENTS?
- DEBT
- PREFERRED SHARES
- COMMON SHARES
WHAT are TREASURY SHARES?
■ Definition – the company’s purchase of its own shares. They are a reduction in what otherwise would be the shareholders’ equity. Treasury shares are not included in the calculation of earnings per share.
■ Purpose of treasury shares
* Market price is low – “Good deal”
* Fewer shares outstanding
* Increase demand and price of shares
* Return cash to shareholders
■ Uses of treasury shares
* Acquisition financing
* Fund employee benefits programs [options, stock purchase, 401(k), etc.]
* Hostile take-over defense
* Stock dividends
WHAT is a SUMMARY CONCEPT?
A company with more liabilities than assets would have a negative equity or net worth, but the balance sheet still would be in balance.
WHAT are LIQUIDITY MEASURES?
Liquidity measures the organization’s ability to pay its financial obligations and the solvency of the organization.
■ Assess the company’s ability to meet current obligations
■ Related to the balance sheet
■ Measurements
* Working capital – current assets minus current liabilities
* Current ratio – ratio of current assets to current liabilities
* Quick ratio – ratio of short-term liquid assets to current liabilities
What is WORKING CAPITAL?
■ Indicator of ability to survive in the near future – does not provide relationship to scope of the organization.
■ Banks and other lenders often require a company to maintain a minimum working capital balance.
If an organization is shut down due to a strike, it still has to pay its bills, rent, non-strikers salaries, utilities, insurance and other costs. Consider an airline that leases its aircraft and is not flying because of a strike!
cURRENT ASSETS - YOUR CURRENT LIABILITIES.
What is the CURRENT RATIO?
■ Determines appropriate working capital
■ As a general rule, the ratio should be at least 2-to-1, but many well-managed, financially sound companies now operate with lower ratios.
■ Quality of assets relates to inventories and receivables.
cURRENT ASSETS / CURRENT LIABILITIES
What is a QUICK RATIO?
Quick ratio, also known as the “ACID TEST,” looks at assets that can be quickly converted to cash.
■ As a general rule, the ratio should be at least 1-to-1, but many successful companies currently operate with lower ratios.
■ Excludes inventories and prepaid expenses – Inventories are excluded because they usually are two steps away from becoming cash. The product must be sold, then the receivable must be
collected.
Liquidity Measures Solutions
Liquidity Measures Solutions
■ Working capital
$400,000,000 – $170,000,000 = $230,000,000
■ Current ratio
$400,000,000
____________ = 2.35
$170,000,000
■ Quick ratio
$20,000,000 + $40,000,000 + $156,000,000
_____________________________________ = 1.27
$170,000,000
What is a DEBT Ratio?
Debt ratios help determine how a company is financed – through debt or equity.
■ Measures company’s ability to survive adverse business conditions
■ Methodology used to assess creditworthiness
■ Related to the balance sheet
■ Measurements
* Debt-to-equity ratio – ratio of total liabilities to shareholders’ equity
* Long-term debt ratio – ratio of long-term debt to long-term debt and shareholders’ equity
What is the DEBT-to-EQUITY Ratio?
A certain amount of debt is normal; but excessive debt may be a hazard.
■ Determines the relative amount of debt to equity
■ Recognize that different companies may do these ratio calculations somewhat differently.
Always find out how the ratio is calculated before reaching any conclusions.
■ Debt expectations differ by industry
* Manufacturing companies normally are expected to have more equity than noncurrent liabilities.
* Utilities and financial companies often operate safely with much higher ratios, even with debt exceeding equity.
What is the Long-term Debt Ratio?
Long-Term Debt Ratio
■ Used to assess company’s risk and creditworthiness
* This ratio is very important when companies seek additional financing through debt.
* The denominator of the equation (long-term debt/noncurrent liabilities + shareholders’ equity) equals total permanent capital.
* The higher the proportion of noncurrent liabilities, the more leverage exists. High leverage has more risk than low leverage.
■ As a general rule in manufacturing companies, most lenders believe this ratio should be no higher than about 40%. (In finance companies and utilities the percent usually is much larger.)
**Measures Capital for the longterm
Debt Ratio Solutions
■ Debt-to-equity ratio
$316,000,000
____________ = .90
$351,000,000
■ Long-term debt ratio
$146,000,000
_____________________________________ = .29
$146,000,000 + $351,000,000
- What is an example of a noncurrent asset?
A. Cash
B. Machinery
C. Inventory
D. Marketable securities
B. Machinery
- In times of rising costs, which of the following would produce the most profit?
A. Weighted average
B. FIFO
C. LIFO
D. Just in time
B. FIFO
- Which asset is neither depreciated nor amortized?
A. Land
B. Buildings
C. Office equipment
D. Patents
A. Land
- Within what time period are taxes due as payable if they are listed as current liabilities?
A. One month
B. Six months
C. One year
D. Two years
C. One year
- Which of the following describes a company’s purchase of its own shares?
A. Common shares
B. Treasury shares
C. Retained shares
D. Preferred shares
B. Treasury shares
- Total liabilities plus shareholders’ equity is equal to which of the following?
A. Total income
B. Total costs
C. Profit or loss
D. Total assets
D. Total assets
- What is the formula for calculating working capital?
A. Current assets divided by current liabilities
B. Cash plus marketable securities plus receivables divided by current liabilities
C. Total liabilities plus shareholders’ equity divided by total assets
D. Current assets minus current liabilities
D. Current assets minus current liabilities
- Which asset is neither depreciated nor amortized?
A. Buildings
B. Patents
C. Office equipment
D. Land
D. Land
- What is the formula for calculating working capital?
A. Current assets minus current liabilities
B. Cash plus marketable securities plus receivables divided by current liabilities
C. Total liabilities plus shareholders’ equity divided by total assets
D. Current assets divided by current liabilities
A. Current assets minus current liabilities
- What is an example of a noncurrent asset?
A. Marketable securities
B. Machinery
C. Cash
D. Inventory
B. Machinery
- Total liabilities plus shareholders’ equity is equal to which of the following? (**)
A. Profit or loss
B. Total costs
C. Total income
D. Total assets
D. Total assets
- In times of rising costs, which of the following would produce the most profit?
A. FIFO
B. LIFO
C. Weighted Average
A. FIFO
6 Within what time period are taxes due as payable if they are listed as current liabilities?
A. One Year
B. Six Months
C. Two Years
D. One Month
A. One Year
- Which of the following describes a company’s purchase of its own shares?
A. Retained shares
B. Treasury shares
C. Preferred shares
D. Common shares
B. Treasury shares
