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Copyright 2004 The McGraw-Hill Companies, Inc. Permission required for reproduction or display. 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