Chapter 8: Balance Sheet, content use and analysis

financial assets examples

notes receivables, government bonds, bonds and share capital of other companies

number or days in selling period

number of days in business year/inventory turnover

Non-current liabilities define

obligations that a business does not expect to pay within the next year

short term notes payable define

obligations that arise because a business signs a note (legal document) that it will pay within one year

four stages of decision making

recognising problem, identifying alternatives, evaluating alternatives, making the decision itself

what ratios for profitability

return on total assets, and return on owner's equity

whys the balance sheet important for predicting financial performance

see if it has sufficient cash to pay for expenses and whether it has enough inventory to meet customers demands for product

quick assets

short-term marketable securities, accounts receivable, short-term notes receivable

length of business operating cycle effect on current ratio

shorter business cycle less likely it is to need a large amount of working capital or a high current ratio to operate efficiently

activity ratios(2)

show length of parts of the operating cycle, inventory turnover accounts receivable inventory

days in sales receivable ratio

shows how many days sales are tied up in accounts receivable

financial flexibility

Ability of a business to adapt to change

unearned revenues

advance collections for future delivery of goods or performance of services

when comparing business return on total assets consider:

age of assets of each business, business using recently purchased assets at higher costs will show a lower return on these assets

when comparing return on total assets with that of another business you should consider

age of assets of each business, with inflation a business using recently purchased assets (at higher costs) will show a lower return on these assets. Older assets also have higher amounts of accumulated depreciation and therefore lower book values

property and equipment define

all physical, long-term assets used in the operations of a business often referred to as fixed or operating assets, eg: land, buildings, equipment etc.

accounts payable define

amounts owed to suppliers

inventory turnover ratio define

shows number of times business turns over or sells inventory during that period

Receivables includes

accounts receivable(amounts owed by customers) and notes receivable(and related interest)

older assets have higher

accumulated depreciation and therefore lower book values

(net) means

accumulated depreciation has been deducted from the cost

to estimate number of days in operating cycle

add number of days in the selling and collection period

when a business uses assets other property and equipment

the assets that remain on its balance sheet at their historical cost

Non-current assets

business intends to hold for more than one year, non-current marketable securities, are financial assets

If the amount of inventory on hand is decreasing as a proportion of sales from year to year

business may have underestimated sales and the need to make additional inventory purchases

lower debt ratio means

business more likely to be able to pay interest it owes as well as other fixed costs, relied less on creditors to finance its assets, higher financial flexibility, able to borrow money at a lower interest rate because lenders may think it has a lower level of risk

difference between a balance sheet and income statement

income statement reports on a business actions over a period of time or flow of business operating activities while the balance sheet presents a business financial position on a specific date.

calculating days in sales receivable

net sales/365 days =avg days sales in accounts receivable. avg accounts receivable/one days sales

current ratio formula

current assets/current liabilities

satisfactory quick ratio

1:1 or when quick assets and current liabilities are equal

old satisfactory current ratio

2 to 1, if current assets were twice its current debt business could pay short term debts in emergencies

Revenue and expense information on the balance sheet shows the results of

CVP analysis and budgeting decisions

Current Assets

Cash and other assets business expects to convert into cash, sell, or use up within one year, current assets presents items in order of their liquidity

Cash includes

Cash on hand , Cheque, and Savings accounts.

Owners equity

Current investment in the assets of the business

Two common indicators of a business liquidity

Current ratio, quick (acid-test) ratio

Liabilities

Economic obligations, classified into current and non-current liabilities

To assess long term financial flexibility

Financial users calculate a business debt ratio

Owners equity for sole proprietorship

For a sole proprietorship balance sheet lists the total owners equity in a single capital account, this account is affected by the owners additional investments or withdrawals and by net income

Balance sheets help to evaluate

Liquidity, financial flexibility, profitability, operating capability

Liquidity

Measure of how quickly a business convert its assets into cash to pay its bills

Current liabilities

Pay within a year using current assets

Why the balance sheet is important

Provides information that helps internal and external users to evaluate business ability to achieve its primary goals of earning a satisfactory profit and remaining solvent, presents a business financial position on a specific date

Business activity statements

Records the amount of input tax credits for GST included in the price you have paid for inputs and the amount of GST payable on taxable sales you have made

How do external users assess how well a business manages liquidity

Studying its working capital

Examples of current liabilities

accounts payable, salaries payable, unearned revenues, and short-term notes (and interest) payable

why measure operating capability

assess how well business is maintaining operating level and predict future changes in operating activity

when a business uses property or equipment

asset still exists in the business until the business has finished using it, business reports whats left as book value

when is current value irrelevant

balance sheet doesnt always show current value bc historical cost concept for land eg. but if business has no intention of selling current value irrelevant

whys liquidity an important financial characteristic

because to remain solvent a business must have cash, to run its operations and pay its liabilities as they become due

Corporate social responsibility (CSR)

becoming important as investors paying attention to the ethical, social, and environmental performance in terms of assets and liabilities and thus on returns to investors

book value

book value of an asset is its original cost minus the related accumulated depreciation

What ratios measure operating capability

business activity ratios, to determine length of the parts of business operating cycle, inventory turnover and accounts receivable turnover

when return on owners equity is higher than return on total assets this show

business has beneffited from using debt to help finance its assets

before preparing balance sheet

business must be certain that the monetary totals for each of its assets and liabilities and monetary total for owners equity are correct, also that revenue and expense amounts from previous periods have been transferred to owners capital account

report form balance sheet

common because its easier to show accounts vertically on a standard sheet of paper

creditors equity

creditors claims on the assets of a business

working capital formula

current assets minus current liabilities

working capital

current assets minus current liabilities, excess of current assets is the dollar amount of liquid resources a business has to work with after it pays off all its short term debts

to assess short-term financial flexibility

current ratio and quick ratio

is current ratio or working capital better liquidity measure

current ratio because it allows comparisons of different sized businesses

to assess long-term financial flexibility

debt ratio

why do users evaluate a business profitability

determine how well it has met profit objectives in relation to resources invested

return on owners equity shows

dividing net income by average owners equity shows the business return(in percentage terms) to the owner-resulting from all the business activities during the accounting period

limitation of income statement

don't provide much information about a business cash management bc based on accrual accounting

Mix of items that make up current assets, effect on current ratio

eg if business has a high proportion of prepaid items within current assets it may be in a weak liquidity position because prepaid assets are used up rather than being converted into cash

whys financial flexibility an important financial characteristic

enables a business to increase or reduce its operating activities as needed eg: business with financial flexibility can revise its purchasing plan to take advantage of temporary reductions in wholesale inventory prices

balance sheet lists owners equity as

ending owners equity in a single capital account

profitability ratios

evaluate how well a business has met its profit objectives in relation to the resources invested

why does analysis need to be based on both together

external users need both to evaluate performance and financial position, determine whether business made satisfactory profit and calculate other measures of operating capability

balance sheet define

financial statement that reports the types and monetary amounts of a business assets liabilities and owners equity on a specific date, prepared at the end of the accounting period

whats a good current ratio for a new business

high current ratio, indicates strong ability to pay current debts

operating capability evaluate

how well its maintaining operating level, predict changes in future operating activity.

how satisfied business managers, investors, and creditors are with their return on assets depends on

how well similar types of businesses performed and whether return met or exceeded expectations

intangibles define

identifiable non-monetary asset without physical substance

business classified balance sheet shows

important subtotals in related groupings for the assets, liabilities, and owners equity of the business

relationship between income statement and balance sheet

income statement shows how business used financial resources to earn net income and remain solvent. operating activities, owner investments, owner withdrawals all affect business mix of financial resources and claims to resources

satisfactory current ratio considerations (3)

industry structure, length of business operating structure, mix of current assets

Prepaid items define

insurance, rent, office supplies, and shop supplies will not be converted into cash but will be used in one year

quick ratio exclusions

inventory, because it may not be sold soon and sold on credit. prepaid items, because they're not easily turned into cash

when is quick ratio used

lenders often use when deciding whether to extend credit

retail business operating cycle define

length of time it takes to invest cash in inventory, make credit sales, and the convert the receivables into cash

provisions define

liabilities of an uncertain timing or amount

current liabilities listed in order of

liquidity

current ratio and quick ratio used to assess

liquidity, short term financial flexibility

account form balance sheet

lists components in an accounting equation format, assets on the left and liabilities and owners equity on the right

Non-current liabilities examples

long term notes payable, mortgages payable, bonds payable

higher debt ratio means

lower financial flexibility, business may not be able to borrow money (or may need to pay higher interest rate to borrow money)

Examples of current assets

marketable securities, receivables, inventory and prepaid items

if inventory turnover too high

may not be keeping enough inventory on hand and missing out on additional sales

net income define

measure of business profits available to owners after incurring the financial costs related to creditors

accounts receivable turnover

measures how efficiently business collects credit from customers, shows how many times the average receivable is collected each period

quick ratio

more convincing indicator of a business short term debt paying ability

higher inventory turnover =

more efficient purchasing and sales and less cash needed to invest in inventory, purchases inventory more often, less likely to have obsolete inventory

ending balance in the account for owners capital is affected by

owner's additional investments or withdrawals and by net income

owners equity

owners current investment in the assets of a business, assets less liabilities

non-current liabilities section shows

past financing decisions of the business managers

debt ratio define

shows percentage of total assets provided by creditors and is calculated as total liabilities/total assets, helps evaluate whether a business has the resources to replace property and equipment

current ratio

shows relationship between current assets and current liabilities, most commonly used indicator of short run liquidity, if less than 2.0 might not be able to replenish inventory

whats a 'classified' balance sheet

shows subtotals for assets liabilities and owners equity in related groupings

Marketable Securities define

sometimes called temporary investments or short-term investments are items such as government bonds and capital stock of companies in which the business has temporarily invested (and which the business expects to sell within a year)

Residual equity

term sometimes for owners equity because creditors have first claim on an asset

accumulated depreciation

total amount of depreciation expense recorded over the life of an asset to date, portion of the assets cost that has been 'used up' to earn revenues to date

business managers have the responsibility to

use business assets to earn satisfactory profit, earn satisfactory return on investment

why make short-term investments

use for cash not immediately needed for purchasing or paying liabilities instead of keeping cash in bank they purchase marketable securities to earn additional revenue through interest or dividends

when does the quick ratio show potential problems

when business has a poor mix of current assets. a business with a lot of inventory has less liquidity than indicated by its current ratio because the current ratio takes into account inventory

return on total assets ratio shows

whether a business has used its economic resources efficiently

external users analyse a balance sheet to determine

whether the business has the right mix of assets, liabilities, and owners equity to justify making an investment in the business

investors concerns

whether they'll receive a return and how much some investors interested in 'solid' businesses where financial statements indicate stable earnings and so a steady return but some want newer businesses with higher return but more risk