The purpose of this portion is to bring us up to speed as to where we should be in dealing in today’s financial world. As quickly as we go over this, there will be things that have changed and then we will be behind again. The intent is to give enough definitions and answer enough questions that it will help better fill out the loan packages that are required by the lenders today.
A BALANCE SHEET is a snapshot of a business’s financial condition at a specific moment in time, usually at the close of an accounting period. It does give a fairly clear picture of the business at that moment, but does not in itself reveal how the business arrived there or where it is going next. That is one reason why the balance sheet is not the whole story – you must also look at the information from each of the other financial statements (and historical information as well) to get the most benefit form all the data. A balance sheet comprises assets, liabilities, and owners’ or stockholders’ equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners’ equity. An ASSET is anything the business owns that has monetary value. LIABILITIES are the claims of creditors against the assets of the business – or what you owe for what you own.
A balance sheet helps a small business owner QUICKLY get a handle on the financial strength and capabilities of the business or operation. Is the business in a position to expand? Can the business easily handle the normal financial ebbs and flows of revenues and expenses? Or should the business take immediate steps to bolster cash reserves?
Balance sheets can identify and analyze trends, particularly in the area of receivables and payables. Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt uncollectable? Has the business been slowing down payables to forestall an inevitable cash shortage?
Balance sheets, along with income statements, are the most basic elements in providing financial reporting to potential lenders such as banks, investors, and vendors who are considering how much credit to grant the firm.
The balance sheet consists of three categories of items: assets, liabilities and stockholders’ or owner’s equity.
- 1) discuss the structure and major components of a balance sheet
- 2) discuss the preparation and the use of a balance sheet to analyze a farm or ranch business
- 3) discuss the categories of assets and liabilities and examples of each category
There are two basic formats for the balance sheet to be presented in. One, which we do NOT generally use, is the report format. Another arrangement in common use lists the assets on the left side of a financial statement and the liabilities and owner’s equity on the right side. Because of its similarity to the account, a basic accounting device is referred to as the account form of the balance sheet. It is customary to begin the asset section with cash. Receivables, supplies, prepaid insurance and other assets that will be converted into cash or used up in the near future follow this item. The assets of a relatively permanent nature, such as land, buildings, and equipment, follow in that order. In the liabilities and owner’s equity section of the balance sheet, it is customary to present the liabilities first followed by owner’s equity. The general reason for this is that the creditors would need to be satisfied first before the owner’s portion would be given back to the owner in a given situation.
By definition, it is any thing (tangible or intangible) that has monetary value. An asset is a desirable thing. It is any thing you own, i. e. property, that can be used to pay debts.
Assets are the economic resources used to carry out an entity’s economic activities of consumption, production, and exchange. The primary attribute of all assets is service potential; that is, the capacity to provide services or benefits to the company that uses them. To be considered an asset, an economic resource must have three characteristics:
- 1) the resources must singly, or in a combination with other resources, have the capacity to contribute directly or indirectly to the entity’s future net cash in-flows. This service potential may exist because the asset is expected to be exchanged for something else of value to the entity, to be used in producing something of value, or to be used to settle its liabilities.
- 2) the entity must be able to obtain the future benefits and control other’s access to it. Control means that the entity generally can deny or regulate the ability of other’s to use the asset.
- 3) the transaction or event giving rise to the entity’s right to or control over the benefit must have already occurred. That is, an entity has no asset for a particular future benefit if the transaction or event giving it access to or control over the benefit has yet to occur. As a corollary, once an asset is acquired by an entity it continues to be an asset until it is exchanged, or used up, or until some other event destroys the future benefit, or removes the entity’s ability to obtain and control it.
CURRENT ASSETS AND NON-CURRENT ASSETS
CURRENT ASSETS are cash and other assets that my reasonably be expected to be realized in cash or sold or used up usually within one year or less, through the normal operations of the business. In addition to cash, the current assets usually owned by a service business are notes receivable and accounts receivable, supplies and other pre-paid expenses. CASH, by definition, is any medium of exchange that a bank will accept at face value. It includes bank deposits, currency, checks, bank drafts, and money orders. NOTES RECEIVABLES are claims against debtors evidenced by a written promise to pay a sum of money at a definite time to the order of a specified person or to the bearer. ACCOUNTS RECEIVABLES are also claims against debtors, but are less formal than notes. They arise from sales or services or merchandise on account. PRE-PAID EXPENSES include supplies on hand and advance payments of expenses such as insurance and property taxes. As we talk further about pre-paid expenses this is probably the one most common area on a Balance Sheet that is overlooked. We generally do not think about what we have already done for our operation to be part of our assets, but it is. We have moved cash out of our cash account to pay for another commodity that we will still consider an asset.
NON-CURRENT or PLANT ASSETS are tangible assets used in the business that are of a permanent or a relatively fixed nature. These are almost always kept more than 1 year. Plant assets include equipment, machinery, buildings, and land. With the exception of land, such assets gradually wear out or otherwise loose their usefulness with the passage of time. They are said to DEPRECIATE. This briefly means that if an item is said to depreciate, it will generally be worth less than you paid for it over time. Land, on the other hand, generally APPRECIATES, or increases in value with the passage of time. This presents a whole other side of the coin that we are not going to get into at this point of time. Your accountant will be the person with whom these subjects should be discussed.
So, ASSETS are categorized as:
- 1) current assets – or short term assets generally attainable in 12 months or less
- 2) non-current assets – or any type of longer than 12 month asset that you are not planning to convert to cash
LIABILITIES on the other side of the balance sheet are debts owed to outsiders (creditors) and are frequently described on the balance sheet by titles that include the word “payable.” Those occurring most frequently are called current liabilities and those that are due over a year are termed long-term liabilities or non-current. Owner’s equity is also referred to as net worth, bottom line, or “operating in the black”. It is the residual interest in the assets of an entity that remains after deducting its liabilities. Thus the adage of the old accounting equation, again: ASSETS = LIABILITIES + OWNER’S EQUITY OR ASSETS – LIABILITIES = OWNER’S EQUITY
The latter is not the preferred equation because creditors always take precidence.
Liabilities are probable future sacrifices of economic benefits arising from present obligations of a present obligation of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.
An obligation of an entity must have three characteristics to be considered a liability:
- 1) it must entail a responsibility to another entity or entities that will settle by a sacrifice involving the transfer of assets, provision of services or other use of assets as a specified or determined date, or occurrence of a specified event, or on demand. The specific identity of the “creditor” need not be known with certainty for a liability to exist as long as a future transfer or use of assets to settle the liability is probable.
- 2) the responsibility must obligate the entity in such a way that it has little or no discretion to avoid the future sacrifice. Although most liabilities involve legal rights and duties, some are the results of equitable (ethical or moral) obligations, or constructive (inferred from the facts).
- 3) the transaction or other event obligation the entity must already have occurred. Once a liability has been incurred by an entity, it continues to be a liability until the entity settles it, or another event discharges it or removes it from the entity’s responsibilities.
Liabilities arise primarily from deferring payment for goals or services received and from borrowing funds. Other liabilities results from collecting economic resources in advance of providing goods or services to customers. Liabilities also arise from selling products subject to warranties, from regulations imposed by governmental units, and from non-reciprocal transfers to owners or other entities.
CURRENT LIABILITIES AND NON-CURRENT LIABILITIES
CURRENT LIABILITIES will be due within a short time, usually one year or less, and that are to be paid out of current assets. The most common liabilities in this group are notes payable and accounts payable, which are exactly, like their receivable counterparts except the debtor-creditor relationship is reversed. Other current liability accounts commonly found in the ledger are salaries payable, interest payable, and taxes payable.
NON CURRENT LIABILITIES or long-term or non-current liabilities will not be due for a comparatively long time (usually more than one year). They are also sometimes referred to as fixed liabilities. As the portion that comes due within the one-year range are to be paid, such liabilities become current. If the obligation was to be renewed rather than paid at maturity, however, it would continue to be classed as a long-term. When payment of a long-term debt is to be spread over a number of years, the installments or portion paid out of this year’s crop proceeds due within one year from a balance sheet date are classes as a current liability. When a note is accompanied by security in the form of a mortgage, the obligation may be referred to as mortgage note payable or mortgage payable.
Thus we see that Liabilities are also categorized into the same 2 categories as assets and for the same basic reasoning.
- 1) current liabilities – or short term liabilities are generally those annual/monthly payments that come out of this year’s crop proceeds
- 2) non-current liabilities – are generally those that will not pay off this year but will continue on in the future