The Balance Sheet (1 of 2)

Know Your Numbers, Know Your Options Author

06/18/2020 Added

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By Austin Duerfeldt

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[00:00:00.019](upbeat music)
[00:00:08.920]Hello, this is Austin Duerfeldt here again,
[00:00:11.310]and welcome to the balance sheet section
[00:00:13.490]of the know your options, know your numbers.
[00:00:16.900]The balance sheet is sometimes referred to
[00:00:19.420]as a statement of financial position.
[00:00:22.160]Imagine walking around your property with a camera,
[00:00:25.150]taking pictures, you take a picture of some tractors,
[00:00:28.900]buildings, land growing crops.
[00:00:32.220]Then you drive and take a picture of some of the businesses
[00:00:35.450]that you do business with such as banks, repair shops,
[00:00:38.170]and grain elevators.
[00:00:40.690]When you get home, you take all the pictures that you took,
[00:00:44.130]place them in a single poster board.
[00:00:46.670]And that is essentially what a balance sheet is.
[00:00:49.820]A balance sheet is a summary of all the images
[00:00:53.130]taken during your photo shoot.
[00:00:55.400]It reports the assets, the liabilities and owner's equity.
[00:01:01.720]Think of it as a one page cheat sheet
[00:01:04.130]that shows all that you own what you owe others
[00:01:08.750]and the difference between.
[00:01:11.620]These three categories give managers
[00:01:13.650]and outside lenders the necessary information
[00:01:15.810]to assess the business risk.
[00:01:18.310]In particular, it tells us liquidity and solvency.
[00:01:22.930]With solvency, we are looking at the amount of time
[00:01:25.870]it will take to convert an asset such as corn, cattle,
[00:01:30.070]or combines into cash.
[00:01:33.780]Being more liquid is viewed as being less risky.
[00:01:37.920]With solvency, we look at the ability to pay off debt
[00:01:41.520]as they mature,
[00:01:43.190]just like with liquidity being more solvent
[00:01:46.880]is viewed as being less risky.
[00:01:49.540]To put this
[00:01:51.010]more easily.
[00:01:52.200]If you can show your ability to pay loans and debts,
[00:01:55.400]the businesses looks better to lenders.
[00:01:58.050]Simple enough, right?
[00:02:01.040]When you look at solvency and liquidity together,
[00:02:04.330]you get what's called a business's financial flexibility.
[00:02:08.630]Consider two trees in a fence line.
[00:02:11.720]One tree has deeper root system and is disease free.
[00:02:15.900]The other tree has roots that are shallow
[00:02:19.840]and in a ball with fungus
[00:02:22.070]and woodpecker holes all over the trunk of the tree.
[00:02:25.690]When the wind storm hits,
[00:02:27.160]which tree will most likely be standing
[00:02:29.330]at the end of the storm?
[00:02:32.000]Managers and lenders, both look for financial flexibility
[00:02:37.260]to gauge the odds of longterm survival.
[00:02:41.950]Before we get into the nitty gritty
[00:02:43.580]of the balance sheet and all the glory,
[00:02:46.520]we need to talk about some shortcomings.
[00:02:50.360]First and foremost, understand that the balance sheet
[00:02:52.880]shows us assets and liabilities had a historical cost.
[00:02:57.480]All this makes the balance sheet reliable.
[00:03:00.290]It does leave some things to be desired.
[00:03:03.540]Example is the purchase of land.
[00:03:06.780]If I purchased 80 acres of ground for $5,000 an acre,
[00:03:11.220]that would be a $400,000 asset on my balance sheet.
[00:03:15.430]10 years later, there has been a run-up in land values.
[00:03:19.350]And the ground is now appraising at $9,000 an acre
[00:03:23.130]or
[00:03:24.137]$720,000.
[00:03:27.200]All that is a $320,000 gain.
[00:03:30.050]That gain is not recognized
[00:03:32.070]until the asset is sold typically.
[00:03:35.290]Another point is that there is some judgmental
[00:03:38.630]and estimations going on on the balance sheet.
[00:03:42.830]When we put stored grain on the balance sheet,
[00:03:45.700]we are estimating the bushels that will be sold.
[00:03:49.540]That estimate attempts to cover shrinkage,
[00:03:52.260]spoilage, and other factors.
[00:03:54.820]But until the final sale calculation is an educated guess.
[00:04:00.520]The final point is that the balance sheet will miss items
[00:04:03.760]on the financial value that can't be recorded objectively.
[00:04:08.340]A great example of this is an employee.
[00:04:11.890]Some businesses have very knowledgeable experts on staff.
[00:04:15.880]Well, these experts do generate value for the business.
[00:04:19.150]There is no reliable and objective way
[00:04:21.760]to measure that expertise.
[00:04:26.040]The balance sheet has three main elements.
[00:04:28.550]Assets on the left and liabilities
[00:04:31.180]and owner's equity on the right.
[00:04:33.670]On the left hand side of the balance sheet are the assets
[00:04:36.190]which are broken down into two main parts.
[00:04:39.710]The first part are current assets.
[00:04:42.850]Current assets are those that are expected
[00:04:45.460]to be converted into cash.
[00:04:47.300]Sold or consumed within one year.
[00:04:50.370]When listing current assets,
[00:04:52.300]they are ordered in order of liquidity
[00:04:56.020]or how fast it can be converted into cash.
[00:05:00.680]When we're valuing current assets.
[00:05:04.980]The basis of valuation changes depending
[00:05:07.300]on what type of item we are looking at.
[00:05:10.770]For example, with cash and cash equivalents,
[00:05:14.860]we generally look at fair value.
[00:05:18.440]When we start looking at things like inventories,
[00:05:22.150]we'll run into what's called lower of cost or market.
[00:05:25.580]We'll talk about that a little bit later.
[00:05:30.660]The second part of the asset section
[00:05:32.980]is the noncurrent assets.
[00:05:35.130]Noncurrent assets consists of things such as long term
[00:05:37.900]investments and securities, property plan and equipment,
[00:05:42.200]which can be land,
[00:05:44.470]it can be tractors,
[00:05:47.020]it can be bulls.
[00:05:51.660]It also consists of things such as other assets,
[00:05:54.770]which are referred to mainly as deferred income taxes,
[00:05:58.880]property held for sale.
[00:06:00.990]These other assets should be for unusual items,
[00:06:05.280]something that doesn't occur every year.
[00:06:10.220]The minimum standard is to split equipment
[00:06:13.420]and machinery, breeding livestock,
[00:06:16.400]buildings and improvement and land
[00:06:19.440]into their own separate little categories
[00:06:21.940]within noncurrent assets.
[00:06:27.350]On the right hand side of the balance sheet,
[00:06:29.020]we start out with looking at liabilities.
[00:06:31.600]And again liabilities,
[00:06:33.280]similar to the way that assets worked out is broken down
[00:06:36.810]in two sections.
[00:06:38.650]The current liabilities,
[00:06:40.450]which are the liability amounts that are due within one year
[00:06:44.050]and only in the longterm liability,
[00:06:45.990]amounts do further out than one year.
[00:06:49.470]Now one little caveat that you'll wanna
[00:06:51.410]make sure that you remember is
[00:06:54.300]a longterm liability such as a 30 year note
[00:06:57.140]on a piece of farm ground that you have purchased.
[00:07:01.360]The upcoming current year's worth of payments due
[00:07:04.820]on that land is actually a current liability.
[00:07:07.990]So some notes we'll actually have a portion
[00:07:10.490]of what's due as a current liability.
[00:07:13.200]And then the remainder
[00:07:14.140]is a longterm liability until it's paid off.
[00:07:18.410]The final section on the balance sheet
[00:07:20.400]is the owner's equity.
[00:07:22.570]And basically what we're looking at is the difference
[00:07:25.420]between the asset amount versus the liability amount.
[00:07:30.820]Think of it as the same way as home equity.
[00:07:33.680]When you're thinking of home equity,
[00:07:35.840]you're looking at the difference between
[00:07:37.540]how much of the house that you currently own
[00:07:39.590]versus how much of a house that the bank owns.
[00:07:43.600]Owner's equity on a balance sheet is doing the same thing.
[00:07:47.320]We've listed out all of our assets,
[00:07:49.480]tractors, land, pickup trucks,
[00:07:53.360]and we've got a total dollar amount
[00:07:55.900]of that dollar amount.
[00:07:56.930]Then we also have liabilities
[00:07:58.610]notes that we've signed with the banks
[00:08:02.020]or other lenders in order to purchase those assets.
[00:08:05.520]And until we purchased so or completely pay those off,
[00:08:10.050]those entities have a claim to those assetss.
[00:08:13.710]So, the difference between the amount of asset value
[00:08:19.040]versus how much we owe to those lenders
[00:08:23.650]gives us how much our owner's equity is in the business.
[00:08:29.500]In addition to reporting the three main elements,
[00:08:32.400]there are also some supplemental information
[00:08:34.690]that should be included.
[00:08:36.870]Examples of these are contingencies,
[00:08:40.530]or situations that have uncertainty,
[00:08:43.940]an example of this might be say
[00:08:45.610]that you had just recently inherited a piece of ground
[00:08:50.440]that now is being disputed in court.
[00:08:53.530]That situation of ownership of that land
[00:08:57.740]should be something that we should put down
[00:08:59.730]in the supplemental information.
[00:09:02.930]Another piece of supplemental information
[00:09:05.390]that we need to include
[00:09:07.550]are accounting policies used.
[00:09:10.180]As we go through, we start doing our record keeping.
[00:09:13.710]We're gonna have to make decisions
[00:09:15.210]on what depreciation method we use for equipment.
[00:09:18.530]We're gonna have to make inventory
[00:09:20.120]evaluation method decisions.
[00:09:23.720]When an end user such as a bank loan manager
[00:09:28.000]looks at our balance sheet,
[00:09:29.050]they need to understand how it is
[00:09:30.750]we came up with those amounts within our assets
[00:09:35.730]and what liability information we have
[00:09:38.000]and by having that supplemental information
[00:09:40.140]there on accounting policies.
[00:09:41.920]It allows them to follow along
[00:09:43.340]and understand what's going on.
[00:09:47.150]A third thing for the supplemental section
[00:09:49.900]are contractual situations
[00:09:52.500]or restrictions or covenants to assets and liabilities.
[00:09:57.940]The last thing that we need to pop in,
[00:10:00.220]are the fair values.
[00:10:03.350]So we know the basic layout of a balance sheet.
[00:10:05.990]Which includes the three main categories
[00:10:08.110]of assets, liabilities, and owner's equity.
[00:10:11.740]There is however, an overarching big picture
[00:10:14.710]that needs to be accounted for.
[00:10:17.460]Is your balance sheet covering personal business
[00:10:20.290]or a combination.
[00:10:22.080]Again, if you can remember back
[00:10:23.670]to when you met with me the last time
[00:10:25.750]when we were talking about the introduction
[00:10:27.460]into record keeping.
[00:10:29.970]Is my house, is my spouse's supplemental income
[00:10:33.570]from an off farm business showing up on the balance sheet
[00:10:37.450]that I'm handing into the banker?
[00:10:41.140]We need to make sure that we understand
[00:10:43.000]what it is that we're putting on the balance sheet
[00:10:45.880]and be able to explain it to those that are either
[00:10:49.020]trying to make decisions or be looking at lending us money.
[00:10:53.620]An example, financial ratios and other analysis
[00:10:56.980]will be skewed if personal and business items
[00:11:00.860]are commingled not separated.
[00:11:03.490]There is also another level that we can talk about.
[00:11:07.270]If you start in on enterprise analysis
[00:11:09.910]and break the farm into let's say hog books,
[00:11:13.460]raw crop book keeping, cattle book keeping,
[00:11:16.540]you will technically have three sets of financials.
[00:11:19.990]This is fantastic for analyzing enterprise performance,
[00:11:24.460]but for loans you may be asked for a whole farm.
[00:11:28.210]This requires a consolidation financial statement,
[00:11:32.200]or simply basically we're taking all the parts
[00:11:35.620]and then summing them up on one consolidated sheet.
[00:11:40.604](upbeat music)

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The Balance Sheet (1 of 2)

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