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