GDBA 532

Class 3: The Balance Sheet – Assets

Yijing Jiang
[email protected], Office MB14-315
Office hours: by appointment
 Balance Sheet
Balance Sheet is a financial snapshot of a company at a
specific moment in time.

A photo of all company’s financial stuff at the end of a day. It

gives you a picture of what a company owns, what it owes to
others, and what is left over to the shareholders.

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 Balance Sheet
Balance Sheet is useful to various stakeholders:
1. Investors: investors use the balance sheet to assess a
company’s financial health and stability.
2. Creditors: creditors, such as banks and suppliers, analyze
the balance sheet to evaluate a company’s ability to repay
debts.
3. Managers: managers use the balance sheet to monitor
and manage the operations, and to make informed
decisions
4. Regulators: ensure compliance.

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 Balance Sheet
(A snapshot of a company’s financial position at a point of time)

Assets: Liabilities:
What the company owns What the company owes to
or controls. external parties.

Shareholders’ Equity:
The residual interest in the
company’s asset after
deducting liabilities.
(What’s left for owners).

Assets = Liabilities + Shareholders’ Equity

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 ASSETS: Everything the company owns
Current assets: realizable within one year
Long-term assets: those that will be used for multiple years, possibly indefinitely,
in the course of business operation

LIABILITIES: Everything the company owes

Current liabilities: payable within one year
Long-term liabilities: payable beyond one year

OWNERS’ EQUITY: What is left for owners

Shares: represent ownership in a company
Retained Earnings: represent the accumulated profits a company has earned
and retained for reinvestment into the business

Why differentiating current/long-term assets and liabilities?

For liquidity assessment & risk management:
• Current liabilities represent the company’s short-term obligations.
• Current assets shows whether a company has sufficient resources to
meet its short-term obligations.
Ana and Ben decided to open a bookstore.

Transaction 1): Ana and Ben each invested $10,000 to the bookstore’s
bank account.

Balance Sheet
Assets Liabilities
Current Assets:
Cash
$20,000

Shareholders’ Equity:
Shares $20,000

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 Cash
The most readily available current asset.

The balance sheet does not distinguish the form in which

money is held. Below are all cash:
• Physical currency – banknotes and coins
• Money in chequing/savings account

Criteria: represents funds that the company can access and

utilize; being readily available.

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 Shares
Shareholders contribute their capital to a company and get
the following rights in return:
• having a residual interest in the company;
• vote on important issues;
• receiving dividends, when approved.

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 Transaction 2): They purchased $1,000 books for the bookstore
and paid in cash.

Balance Sheet
Assets Liabilities
Current Assets:
Cash $19,000
Inventory $1,000

Shareholders’ Equity:
Shares $20,000

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Inventory
Assets that have been bought for resale or for use in
production.

In a manufacturing company, inventory consists of

three separate classes:
 raw material;
 work-in-process;
 finished goods.

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 Historical Cost
Value of an accounting item is recorded at its
original cost when acquired by the company.

The historic cost may undervalue some assets.

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 Inventory Valuation
Valuation of Inventory (i.e., inventory costing) is the process of
determining the monetary value of the goods that a company
has.

It can be done:

• on the basis of the cost of specific items of inventory;

• on the basis of the average cost of inventory;
• on a “first-in first-out” inventory flow assumption;
• on the basis of a “last-in first-out” inventory flow
assumption (U.S. GAAP only).

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 Inventory
Inventory Valuation in Manufacturing Companies:
Variable Cost vs. Full Cost:

“Variable” costs include:

• raw materials;
• direct labour;
• variable overhead.
Variable costs are always included in valuing inventory. This is called
the “variable cost” model (or “direct cost” model).

A proportionate share of “fixed” overhead must also be included in

valuing inventory based on the normal operating capacity..
The “full cost” model (or “absorption cost” model).

The variable cost model is better for short-term decision-making; the

full cost model is required for financial reporting purposes.

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 Inventory
Exhibit 4.3: Inventory Valuation Using Variable Costing vs.
Full Costing (Direct Costing vs. Absorption Costing)

Pergammon Peripherals Inc. (PPI) makes computer equipment, including

printers. One of the company’s popular models is the B2200.

Variable costs Cost per unit

• Materials $ 60.00
• Labour & variable overhead 50.00
Total variable cost $110.00
Fixed manufacturing cost 40.00
Total full cost $150.00
Markup (33⅓% of full cost)) 50.00
Selling price $200.00

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Inventory
At the beginning of January, PPI had no inventory of B2200
printers.

During the year, the company manufactured 2,500 units of

B2200 printers and sold 2,000 of them. At the end of
December, PPI had 500 B2200 printers in inventory.

Inventory ending balance: $150x500 = 75,000

Cost of goods sold: $150x2000 = $300,000
Total manufacturing cost $375,000

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Inventory

Inventory Valuation: Lower of Cost or Market Price

Once the cost has been determined, a further comparison is

done between the cost and the market price. If the market price
is less than the cost, then the inventory value for the balance
sheet is reduced to that level.

Note that if the market price is higher than cost, the

inventory value is not increased.

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Exhibit 4.4: Inventory — Lower of Cost or Market Price
Burlington Spa Inc. sells hot tubs and related equipment. At the
end of December the company did an inventory count and
determined that it had the following on hand:
1). Ten new hot tubs, which had cost $4,000 each and normally
retailed for $6,000 each. Due to inflation, the replacement cost
for the same units would now be $4,500 each, and Burlington
Inc. intends to increase the selling price to $6,750 in January.
2). Various spare parts and accessories that had cost $10,000.
Of those parts, approximately one quarter (by value) were
obsolete or damaged and unsalable.
3). Various chemicals, which had cost $5,000. Due to intense
competition and the declining price of commodities, these could
currently be replaced for $4,000.
 In the balance sheet for December, inventory would be valued as follows:

Exhibit 4.4 Historica Market price Lower of costor

l cost market price

10 hot tubs @ $4,000 each $40,000 $45,000 $40,000

Spare parts & accessories 7,500

$10,000 (cost) less 25% 7,500
obsolete or damaged
Chemicals (at replacement 5,000 4,000 4,000
market price)
Inventory on balance sheet $51,500
 Inventory Turnover
Inventory turnover = sales for the year ÷ inventory at year-end

Inventory turnover ratio tells us how well the company manages

its inventory. It's a measure that indicates how many times a store's
inventory is sold and replaced over a year.

A low turnover ratio could indicate:

• Overstocking
• Outdated products
• Poor sales performance
• Potential financial strain (holding onto inventory for extended
periods ties up cash).

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Inventory Turnover

Exhibit 4.5: Inventory Turnover Ratio and Days’ Sales in Inventory

Continental Containers has an inventory total of $7,300 as at
December 31, 2020.
Sales for the year 2020 were $73,000.
Inventory turnover ratio:
= sales for the year ÷ inventory at year-end
= $73,000 ÷ $7,300
= 10.0 times per year
The company is turning over its inventory 10 times each year.

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 Ana & Ben’s bookstore business:
Transaction 3): They sold one book at $125. The customer paid
in cash. The cost of the book is $100.

Balance Sheet
Assets Liabilities
Current Assets:
Cash $19,125
Inventory $900

Shareholders’ Equity:
Shares $20,000
Retained Earnings $25

(a). The bookstore receives $125 cash, so cash increases by $125.

(b). Next, $100 of books are sold. Inventory decreases by $100.

Combining (a) and (b), the revenue is $125, the expense is $100 (cost of
goods sold), so the effect on net income is $25. Retained earnings increases
by
21 $25. (Reminder: retained earnings = previous retained earnings + net
income – dividends)
 Transaction 4): They sold another book. The cost of the book is $200.
They sold it at $250. This time, the customer promises to pay in a month.

Balance Sheet
Assets Liabilities
Current Assets:
Cash $19,125
Accounts Receivable $250
Inventory $700

Shareholders’ Equity:
Shares $20,000
Retained Earnings $75

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Accounts Receivable
Sales of goods are frequently made on credit terms.
Customers are expected to pay according to the
“terms of trade”, commonly 30 days.

Accounts receivable represents the money that the

customer owes to the company.

Anticipating a receivable cannot be collected, bad

debt expenses, and hence allowance for doubtful
accounts, are recognized.

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 Transaction 5): A week later, the customer paid the amount in full.

Balance Sheet
Assets Liabilities
Current Assets:
Cash $19,375
Accounts Receivable 0
Inventory $700

Shareholders’ Equity:
Shares $20,000
Retained Earnings $75

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Accounts Receivable
Receivables Turnover Ratio = Sales revenue / Receivables

The receivables turnover ratio measures how quickly a

company gets paid by its customers.

A higher receivables turnover ratio indicates that a

company is efficient in collecting money from customers. It
shows that the company is managing its credit effectively
and getting paid promptly, which is important for
maintaining a healthy cash flow.

A low ratio may indicate risk of bad debt.

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Exhibit 4.2: Receivables Turnover Ratio
Continental Containers has a receivables balance of $10,000 as at
December 31, 2020.
Sales for the year 2015 were $73,000.
Receivables turnover ratio:
= annual sales ÷ end of year receivables
= $73,000 ÷ $10,000
= 7.3 times per year

The company is turning over its receivables 7.3 times each year.
 Long-term Assets

Long-term Assets: Assets the company intends to hold for

periods longer than one year.

Long-term assets are generally recognized as historical

costs minus depreciation or amortization.

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 Transaction 6): Ana and Ben purchased a computer for bookstore’s
business. The price, $1,000, is paid in full in cash.

Balance Sheet
Assets Liabilities
Current Assets:
Cash $18,375
Inventory $700

Long-term Assets:
Equipment $1,000 Shareholders’ Equity:
Shares $20,000
Retained Earnings $75

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 Land and Buildings
Land is not subject to depreciation.
Building is subject to depreciation.
Building:
carrying
value
Year 1: Cost $800,000
Less accumulated depreciation 40,000 $760,000

Year 2: Cost $800,000

Less accumulated depreciation 80,000 $720,000

Year 3: Cost $800,000

Less accumulated depreciation 120,000 $680,000

And so on for each year, until the carrying value is reduced to zero:

Year 20: Cost $800,000

Less accumulated depreciation 800,000 $ nil
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 Property, Plant and Equipment
(PPE)
Exhibit 4.8: Depreciation of Plant and Equipment:

Terri’s Tools has just bought a new delivery truck. The cost was $60,000. The
company expects to keep the truck for two years. At the end of two years, Terri’s
Tools will sell it and replace it with a new one. The expected selling price in two
years is $40,000.

Cost $60,000
Expected selling price 40,000 (residual value)
Total loss in value over two years $20,000

Annual depreciation expense $10,000 ($20,000 ÷ 2)

The general formula for (straight line) depreciation is as follows:

(cost - residual value) ÷ number of years = annual depreciation expense.

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 Intangible Assets
Some assets have similar characteristics to plant and
equipment (in that they are owned and used over a long time
period), but they have no physical form. These are called
intangible assets.
• With a finite life (e.g., patents; trademarks), subject to
amortization;
• Without a finite life (goodwill), subject to an impairment test.

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 Total Assets

When all the assets are added together, the total represents
all the assets the company has control over.

This total is used by analysts to get an objective measure of

the size of the company. The greater the total assets, the
larger the company, and so the greater the profit it should
make.

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 Total Assets

Asset turnover ratio = sales revenue / total assets

It shows the extent to which assets have been used

efficiently (or inefficiently).

A higher asset turnover ratio means that the company

generates more revenue from the things it owns.

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Total Assets
Exhibit 4.9: Asset Turnover Ratio

Philomena’s Fashions had total assets of $500,000 at the

end of 2019 and $550,000 at the end of 2020.

Sales in 2019 were $5,000,000, and $6,600,000 in 2020.

Assets have increased (by 10%), but sales have increased

even more (32%).

Asset turnover ratio:

= sales ÷ total assets
2019: $5,000,000 ÷ $500,000 = 10 times
2020: $6,600,000 ÷ $550,000 = 12 times

The company is turning over its assets more quickly in

2020, indicating that it is more efficient.

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