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PowerPoint Presentation Materials
For
Financial Accounting:
A New Perspective
by
Paul Solomon
5-1
CHAPTER 5
Using the Balance Sheet to Make
Decisions
PERFORMANCE OBJECTIVES:
Ratios
PO3: Calculate, interpret, & discuss
ratios for
Liquidity
 Activity or turnover
 Financial leverage
 Profitability
 Valuation

5-3
PERFORMANCE OBJECTIVES:
Valuation
PO 16: Describe valuation by

Distinguishing among
Historical cost
 Replacement cost
 Fair market value
 Present value of future cash flows


Identifying GAAP methods for major
asset, liability accounts
5-4
PERFORMANCE OBJECTIVES:
Other
PO 17: Identify limitations of financial
statements
5-5
USER FOCUS
Annual report on liquidity,
leverage
5-6
INSIGHTS
Executory contracts
When are all valuation methods
equivalent?
Limitations of balance sheet
5-7
TOPICS
Using classified balance sheet to make
better decisions
Using balance sheet ratios to make
better decisions
Using information not found in balance
sheet to make decisions
How assets are measured
5-8
CLASSIFIED BALANCE
SHEET
Classifies assets, liabilities into current
and noncurrent categories
Current categories
Accounts expected to be
 Turned into cash
 Sold
 Exchanged
 Discharged
Within one year

5-9
CMU
Balance Sheet
12/31
Assets
Current assets
Liabilities
$56,300 Current
$9,000
Investments
Property, plant,
Equipment
2,000 Noncurrent
4,000
Total assets
5-10
16,700 Owner’s Equity 61,900
$75,000
Total liabilities
& Equity
$75,000
WHY DISTINGUISH BETWEEN
CURRENT, NONCURRENT?
To allocate resources to meet
needs
Timing influences decisions
5-11
HOW TO DISTINGUISH BETWEEN
CURRENT, NONCURRENT
Operating cycle
Related to current assets, liabilities

Average length of time it takes to move
through 3 phases
Purchasing
 Selling
 Collecting

5-12
CURRENT ASSETS
Current assets are
Cash
 Noncash assets that will be

Converted into cash
 Sold
 Consumed

Within 1 year or operating cycle,
whichever is longer
5-13
LIQUIDITY
Measure of availability of cash

How quickly noncash assets can be
turned into cash
Sign of financial health
5-14
CURRENT LIABILITIES
Current liabilities are
Obligations that will be eliminated
within one year or operating cycle of
business
 Paid by

Current assets
 Creating other current liabilities

5-15
USING BALANCE SHEET
RATIOS
Ratios
Show percentage relationship
between 2 numbers
 Summarize information
 Easily understood, interpreted,
compared

Example: Return on equity

5-16
Measures performance
HOW TO USE LIQUIDITY
RATIOS
Help determine solvency

Ability to meet obligations that
come due in current period
Working capital
Current assets – Current liabilities
 Limitation: measures absolute
ability to meet debts

5-17
LIQUIDITY RATIOS
Current ratio
Acid test (Quick) ratio
Bank ratios
5-18
CURRENT RATIO
Measures relative ability to meet maturing
current debts (solvency)
Current Asset
Current Liabilities
High ratio desirable
5-19
ACID TEST RATIO
Measures relative ability to meet maturing
current debts (solvency)
Current assets – (Inventories + prepaid Assets)
Current Liabilities
High ratio desirable
5-20
BANK RATIOS
Approving Susan’s Loan
Banker’s measure of loan risk
To protect lender
Loan to value
 Loan to liquidation value

5-21
LOAN TO VALUE
Maximum Loan Liability
Market value of collateral
Lower is better
5-22
LOAN TO LIQUIDATION
VALUE
Maximum Loan Liability
Liquidation Value of Asset
Lower is better
5-23
LEVERAGE RATIOS
Evaluate financial risk
Debt to Assets Ratio
 Debt to Equity Ratio

5-24
DEBT TO ASSETS RATIO
Indicates long-run solvency of business
Describes relative amount of financial risk
Total Liabilities
Total Assets
5-25
DEBT TO EQUITY RATIO
Indicates long-run solvency of business
Describes relative amount of financial risk
Total Liabilities
Total Owners’ Equity
5-26
USER FOCUS:
Discussions of Liquidity, Leverage
Contained in Annual Report

Management’s Discussion &
Analysis (MD&A)
Provides liquidity, leverage ratios
 Provides discussion/interpretation of
ratios

Example: Merck
5-27
USING INFORMATION TO
MAKE DECISIONS: MD&A
Outside balance sheet
Management’s Discussion and
Analysis of Operations (MD&A)
Relates to balance
 Liquidity and Capital Resources

5-28
USING INFORMATION TO
MAKE DECISIONS: Notes 1
Information that documents, supports,
elaborates on specific items
Summary of significant accounting
policies

Essential accounting principles of
business
Other notes

5-29
Detail for balance sheet accounts
USING INFORMATION TO
MAKE DECISIONS: Notes 2
Commitments
Executory contract
 Example: noncancelable lease
arrangements

Contingency
May never materialize
 Potential future obligation

5-30
INSIGHT 5-1:
Executory Contract
Promise to perform duties in future
Commitment
No current liability
Definition: liability

5-31
Probably future sacrifices of economic
benefits arising from present obligations
HOW ARE ASSETS
MEASURED?
Entry prices


Historical cost
Current cost
Exit prices


5-32
Fair market value (FMV)
Present value of future cash flows
INSIGHT 5-2:
When are Valuation Methods
Equivalent?
At point of exchange when recorded

Historical costs = current cost = fair market
value (FMV) = present value of future cash
flows
Valuation methods differ when reported
5-33
ASSET VALUATION
Personal balance sheet

Estimated current value or fair market
value (FMV)
Business balance sheet

5-34
Follows GAAP
ASSET VALUATION:
Current Assets
Asset
Category
Current
5-35
Account
Measurement
Cash
Monetary
Marketable Sec. FMV or cost
A/R
FMV less
allowance
Inventory
LCM
ASSET VALUATION:
Investments
Asset
Category
Investments
5-36
Account
Measurement
Equity
Bonds
Long term
Notes
Receivables
FMV
Present value
of future cash
flows
ASSET VALUATION:
Property, Plant, Equipment
Asset
Category
Property,
Plant,
Equipment
5-37
Account
Measurement
Buildings,
Cost less
Equipment, etc. Accumulated
Depreciation
ASSET VALUATION:
Intangible Assets
Asset
Category
Intangibles
5-38
Account
Measurement
Patents,
Goodwill, etc
Cost less
Amortization
KEY QUALITATIVE
CHARACTERISTICS
Characteristics of accounting
information

Relevance


Makes a difference in a decision
Reliability
Degree of confidence in information
 Verifiability


5-39
Traceable
INSIGHT 5-3:
Limitations of Balance Sheet
Not all obligations reported in
liabilities
Asset valuation not always current
market value
Qualitative information incomplete
Money measurement assumes
stable dollar; no inflation
Human resources not reported,
valued
5-40