Module 2--The Balance Sheet

Question 1

What is the BALANCE SHEET composed of?

Answer 1

■ The balance sheet is a financial statement that shows three groups of accounts at a specific point in time.
* 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.

Question 2

What are ASSETS?

Answer 2

■ Assets are what the organization owns (possessions)

Question 3

What are the TWO TYPES of ASSETS?

Answer 3

• 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

Question 4

What are some examples of CURRENT ASSETS?

Answer 4

■ Cash – cash and bank balances

■ Marketable securities
* Investments valued at the lower of original cost or current market
* 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

Question 5

Why is INVENTORY COSTLY?

Answer 5

■ 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.

Question 6

How is INVENTORY VALUED?

Answer 6

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.

Question 7

EXAMPLE of VALUING INVENTORY

Answer 7

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

Question 8

What is the WEIGHTED AVERAGE?

Answer 8

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

Question 9

What is FIFO?

Question 10

What is LIFO?

Answer 10

LIFO 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.

Question 11

What are the TWO GROUPINGS on NON CURRENT ASSETS?

Answer 11

■ 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

Question 12

What are TANGIBLE NONCURRENT ASSETS?

Answer 12

Tangible Noncurrent 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

Question 13

What are INTANGIBLE NONCURRENT ASSETS?

Answer 13

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

Question 14

What are LIABILITIES?

Answer 14

A liability is an obligation to pay an amount at a future date for current or past benefits received.

Question 15

What are the TWO TYPES of LIABILITIES?

Answer 15

• Current liabilities – to determine liquidity
• Noncurrent liabilities (fixed or long-term)

Question 16

What are CURRENT LIABILITIES?

Answer 16

Current liabilities are payable within one year of the balance sheet date.
■ Accounts payable – monies owed to the supplier 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)

Question 17

What are NONCURRENT LIABILITIES?

Answer 17

■ 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

Question 18

What are CONTINGENT LIABILITIES?

Answer 18

■ 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.

Question 19

What are SHAREHOLDER Equity?

Answer 19

■ Preferred 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.

■ Treasury 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.

Question 20

WHAT are TREASURY SHARES?

Answer 20

■ 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

Question 21

WHAT is a SUMMARY CONCEPT?

Answer 21

A company with more liabilities than assets would have a negative equity or net worth, but the
balance sheet still would be in balance.

Question 22

WHAT are LIQUIDITY MEASURES?

Answer 22

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

Question 23

What is WORKING CAPITAL?

Answer 23

■ 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!

Question 24

What is the CURRENT RATIO?

Answer 24

■ 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.

Question 25

What is a QUICK RATIO?

Answer 25

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.

Question 26

Liquidity Measures Solutions

Answer 26

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

Question 27

What is a DEBT Ratio?

Answer 27

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

Question 28

What is the DEBT-to-EQUITY Ratio?

Answer 28

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.

Question 29

What is the Long-term Debt Ratio?

Answer 29

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.)

Question 30

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

Question 31

1. What is an example of a noncurrent asset?
   A. Cash
   B. Machinery
   C. Inventory
   D. Marketable securities

Answer 31

B. Machinery

Question 32

2. 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

Answer 32

B. FIFO

Question 33

3. Which asset is neither depreciated nor amortized?
   A. Land
   B. Buildings
   C. Office equipment
   D. Patents

Answer 33

A. Land

Question 34

4. 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

Answer 34

C. One year

Question 35

5. 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

Answer 35

B. Treasury shares

Question 36

6. 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

Answer 36

D. Total assets

Question 37

7. 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

Answer 37

D. Current assets minus current liabilities