Depriciation Analysis

Why depreciation is a Non Cash Expense?, Why Reserve Maintained for Depreciation ? , Why Depreciation expense needs to be added back to Net Income in Cash Flow.

Definition of Depreciation:

Financial Reporting Standard 15 (covering the accounting for tangible fixed assets) defines depreciation as follows:

"The wearing out, using up, or other reduction in the useful economic life of a tangible fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for goods and services produced by the asset.'

A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn.

In determining the expenses for a period, it is therefore important to include an amount to represent the consumption of fixed assets during that period (that is, depreciation).

In essence, depreciation involves allocating the cost of the fixed asset (less any residual value) over its useful life. To calculate the depreciation charge for an accounting period, the following factors are relevant:

- the cost of the fixed asset;

- the (estimated) useful life of the asset;

- the (estimated) residual value of the asset.

What is the relevant cost of a fixed asset?

The cost of a fixed asset includes all amounts incurred to acquire the asset and any amounts that can be directly attributable to bringing the asset into working condition.

Directly attributable costs may include:

- Delivery costs

- Costs associated with acquiring the asset such as stamp duty and import duties

- Costs of preparing the site for installation of the asset

- Professional fees, such as legal fees and architects' fees

Note that general overhead costs or administration costs would not be included as part of the total costs of a fixed asset (e.g. the costs of the factory building in which the asset is kept, or the cost of the maintenance team who keep the asset in good working condition)

The cost of subsequent expenditure on a fixed asset will be added to the cost of the asset provided that this expenditure enhances the benefits of the fixed asset or restores any benefits consumed.

This means that major improvements or a major overhaul may be capitalised and included as part of the cost of the asset in the accounts.

However, the costs of repairs or overhauls that are carried out simply to maintain existing performance will be treated as expenses of the accounting period in which the work is done, and charged in full as an expense in that period.

What is the Useful Life of a fixed asset?

An asset may be seen as having a physical life and an economic life.

Most fixed assets suffer physical deterioration through usage and the passage of time. Although care and maintenance may succeed in extending the physical life of an asset, typically it will, eventually, reach a condition where the benefits have been exhausted.

However, a business may not wish to keep an asset until the end of its physical life. There may be a point when it becomes uneconomic to continue to use the asset even though there is still some physical life left.

The economic life of the asset will be determined by such factors as technological progress and changes in demand. For purposes of calculating depreciation, it is the estimated economic life rather than the potential physical life of the fixed asset that is used.

What about the Residual Value of a fixed asset?

At the end of the useful life of a fixed asset the business will dispose of it and any amounts received from the disposal will represent its residual value. This, again, may be difficult to estimate in practice. However, an estimate has to be made. If it is unlikely to be a significant amount, a residual value of zero will be assumed.

The cost of a fixed asset less its estimated residual value represents the total amount to be depreciated over its estimated useful life.

Depreciation of fixed assets :Introduction

In our introduction to accounting for fixed assets, we described how businesses need to account for the consumption of fixed assets over time in a way that reflects their reducing value. The term given to this consumption is depreciation. This revision note explains the various methods available to calculate depreciation and highlights how subjective this calculation can be. Other revision notes provide worked example of each depreciation method.

Depreciation Methods :

The total amount to be depreciated over the life of a fixed asset is determined by the following calculation:

Cost of the fixed asset less residual value

The period over which to depreciate a fixed asset is known as the "useful economic life" of the asset.

So how much of this depreciable amount is charged against profits in each accounting period?

A depreciation method is required to allocate, in a systematic way, the total amount to be depreciated between each accounting period of the asset's useful economic life.

There are various methods of depreciation available. However, most businesses appear to adopt one of the two methods described below.

Method 1 - Straight-line depreciation:

The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.

As a result, the depreciation charge for the asset can be calculated using the following formula:

Dpn = (C- R)/ N

where:

Dpn = Annual straight-line depreciation charge

C = Cost of the asset

R = Residual value of the asset

N = Useful economic life of the asset (years)

Whilst it is simple and popular, Is the straight line depreciation method the most appropriate way of calculating depreciation?

The answer lies in understanding that depreciation is a process of allocation, not valuation.

The pattern of annual depreciation charges for a fixed asset should attempt to match the pattern of benefits derived from that asset. Therefore, where the benefits from an asset are likely to be reasonably constant over its life the straight-line method of depreciation would be appropriate as it results in a constant annual depreciation charge.

In practice it may be difficult to assess the pattern of benefits relating to an asset. In such cases the straight-line method may often be chosen simply because it is easy to understand and calculate.

Method 2 - Reducing balance method:

The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's life but the annual depreciation charge reduces progressively as the asset ages.

To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of the asset. Thus, depreciation is calculated as a percentage of the reducing balance.

For certain fixed assets, the benefits derived may be high in the early years, but may decline as the asset ages. For such assets, the reducing-balance method of depreciation would be appropriate insofar as it matches the depreciation expense with the pattern of benefits.

Once a particular method of depreciation has been chosen for a fixed asset, the method should be applied consistently over its life. It is only permissible to switch from one method to another if the new method provides a fairer presentation of the financial results and financial position.

Total depreciation charged

It should be noted that, whichever method of depreciation is selected, the total depreciation to be charged over the useful life of a fixed asset will be the same.

It is simply the allocation of the total depreciation charge between accounting periods that is affected by the choice of method.

Need for Provision of Depreciation:
The need for provision for depreciation arises for the following reasons:

(1) Ascertainment of true profit or loss-Depreciation is a loss. So unless it is considered like all other expenses and losses, true profit/loss cannot be ascertained. In other words, depreciation must be considered in order to find out true profit/loss of a business.

(2) Ascertainment of true cost of production-Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost of production would be shown less than the true cost. Sale price is normally fixed on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at a low level resulting in loss to the business;

(3) True Valuation of Assets-Value of assets gradually decreases on account of depreciation. If depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through Balance Sheet.

(4) Replacement of Assets-After some time an asset will be completely exhausted on account of use. A new asset then be purchased requiring large sum of money. If the whole amount of profit is withdrawn from business each year without considering the loss on account of depreciation, necessary sum may not be available for. buying the new assets. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan by selling some other assets. This is contrary &0sound commercial policy.

(5) Keeping Capital' Intact-Capital invested in buying an asset, gradually diminishes on account of depreciation. If loss on account of depreciation is not considered in determining profit/ loss at the year end, profit will be shown more. If the excess profit is withdrawn, the working capital will gradually reduce, the business will become weak and its profit earning capacity will also fall.

 (6) Legal Restriction-According to Sec. 205 of the Companies Act, 1956 dividend cannot be declared without charging depreciation on fixed assets. Thus in "Case of joint stock companies charging of depreciation is compulsory.

Sources :  ezinearticles.com , tutor2u.net,accountingcoach.com

Why Depreciation Expense needs to be added back to Net Income in Cash Flow ?

Depreciation Expense:

Depreciation moves the cost of an asset to Depreciation Expense during the asset's useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you can see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the Cash account on the balance sheet.

Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.

Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There is no cash involved.

In the operating activities section of the cash flow statement, add back expenses that did not require the use of cash. Examples are depreciation, depletion, and amortization expense.

Let's illustrate how a depreciation expense is handled by continuing with the Good Deal Co.

June Transactions and Financial Statements:

The only transaction recorded by Good Deal during June was the depreciation on the office equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for $1,100 and it was put into service on the same day. Let's assume that a depreciation expense of $20 per month is recorded by Good Deal. As a result, Good Deal's financial statements at June 30 will be as follows:

Good Deal Co. Income Statement For the Month Ended June 30, 2012 Revenues $  0  Expenses Depreciation Expense   20  Net Income $(20)

Good Deal Co. Income Statement For the Six Months Ended June 30, 2012 Revenues $800 Expenses Cost of Goods Sold 500 Depreciation Expense     20 Total Expense   520 Net Income $280

Good Deal Co. Balance Sheet June 30, 2012 Assets Liabilities & Owner's Equity Cash $   850  Liabilities Accounts Receivable 0  Accounts Payable $       0 Inventory 200  Owner's Equity Supplies 150  Matt Jones, Capital (excl. net inc.) 2,000 Office Equipment 1,100  Matt Jones, Curr Yr. Net Income      280 Less: Accum. Depreciation      (20) Total Matt Jones, Capital   2,280 Total Assets $2,280  Total Liabilities & Owner's Equity $2,280

A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown below:

Good Deal Co. Balance Sheets June 30 and May 31, 2012 Assets 6-30-12  5-31-12 Change  Cash $   850  $   850 $   0  Accounts Receivable 0  0 0  Inventory 200  200 0  Supplies 150  150 0  Office Equipment   1,100  1,100 0  Less: Accumulated Depreciation      (20)          0   (20) Total Assets $2,280  $2,300 $(20) Liabilities & Owner's Equity Liabilities Accounts Payable $       0  $       0 $   0  Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000  2,000 0  Matt Jones, Curr Yr. Net Income      280       300   (20) Total Matt Jones, Capital   2,280    2,300   (20) Total Liabilities & Owner's Equity $2,280  $2,300 $(20) (If you are wondering why June 30 is shown before May 31, it is because accountants usually place the most current amounts closest to the account names. This is a courtesy to the reader in that these are assumed to be the more important amounts and will be easier to read if placed closest to the words.)

Good Deal Co. Statement of Cash Flows For the Month Ended June 30, 2012 Operating Activities Net Income $ (20) Add: Depreciation Expense     20  Cash Provided (Used) in Operating Activities 0  Investing Activities 0  Financing Activities       0  Net Increase in Cash     0  Cash at the beginning of the month   850  Cash at the end of the month $850

The cash flow statement for the month of June illustrates why depreciation expense needs to be added back to net income. Good Deal did not spend any cash in June, however, the entry in the Depreciation Expense account resulted in a net loss on the income statement. To convert the bottom line of the income statement (a loss of $20) to the amount of cash provided or used in operating activities ($0) we need to add back or remove the depreciation expense amount.

Good Deal Co. Balance Sheets June 30, 2012 and December 31, 2011 Assets 6-30-12  12-31-11 Change  Cash $   850  $   0 $    850  Accounts Receivable 0  0 0  Inventory 200  0 200  Supplies 150  0 150  Office Equipment   1,100  0 1,100  Less: Accumulated Depreciation      (20)      0      (20) Total Assets $2,280  $   0 $2,280  Liabilities & Owner's Equity Liabilities Accounts Payable $       0  $   0 $       0  Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000  0 2,000  Matt Jones, Curr Yr. Net Income      280       0      280  Total Matt Jones, Capital   2,280       0   2,280  Total Liabilities & Owner's Equity $2,280  $   0 $2,280

Good Deal Co. Statement of Cash Flows For the Six Months Ended June 30, 2012 Operating Activities Net Income $   280  Add back: Depreciation Expense 20  Increase in Inventory (200) Increase in Supplies     (150) Cash Provided (Used) in Operating Activities (50) Investing Activities Increase in Office Equipment (1,100) Financing Activities Investment by Owner   2,000  Net Increase in Cash    850  Cash at the beginning of the year         0  Cash at June 30, 2012 $   850

Let's review the cash flow statement for the six months ended June 30:

• The operating activities section starts with the net income of $280 for the six-month period. Depreciation expense is added back to net income because it was a noncash transaction (net income was reduced, but there was no cash spent on depreciation). The increase in the Inventory account is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts, the net change in cash that is explained by operating activities is a negative $50.
• The increase in long-term assets caused a cash outflow of $1,100 which is reported in the investing activities section.
• There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section reports the owner's $2,000 investment into the Good Deal Co.
• Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $850. This agrees with the change in the Cash account as shown on the balance sheets from December 31, 2011 and June 30, 2012.

Sources :  ezinearticles.com , tutor2u.net,accountingcoach.com

Balance Sheet Analysis

Balance Sheet:

A Balance sheet, is known as a "statement of financial position", reveals a company's assets, liabilities and owners' equity (net worth).

This means that assets, or the means used to operate the company, are balanced by a company's financial obligations along with the equity investment brought into the company and its retained earnings.

Assets are what a company uses to operate its business, while its liabilities and equity are two sources that support these assets. Owners' equity, referred to as shareholders' equity in a publicly traded company, is the amount of money initially invested into the company plus any retained earnings, and it represents a source of funding for the business.

It is important to note, that a balance sheet is a snapshot of the company's financial position at a single point in time.

Balance Sheet Accounts: The Chart of Accounts is normally arranged or grouped by the Major Types of Accounts. The Balance Sheet Accounts (Assets, Liabilities, & Equity) are presented first, followed by the Income Statement Accounts (Revenues & Expenses).

Here we're going to discuss the Balance Sheet Portion of the Chart Of Accounts and how it's organized.

While most balance sheet accounts that need to be set up are common to all businesses, some depend on the type of business. Inventory accounts are needed for those businesses that produce and sell goods or "inventoriable" services as well as those that just buy and resell the goods.

The Assets, Liabilities, and Equity are presented in separate sections of a Balance Sheet in order that important relationships and subtotals and totals can be presented.

Note: This USA Order may vary depending on your country.

General Components of a Balance Sheet:

Assets :
Formal Definition:The properties used in the operation or investment activities of a business.

Informal Definition:All the good stuff a business has (anything with value). The goodies.

Additional Explanation: The good stuff includes tangible and intangible stuff. Tangible stuff you can physical see and touch such as vehicles, equipment and buildings. Intangible stuff is like pieces of paper (sales invoices) representing loans to your customers where they promise to pay you later for your services or product.

Assets are generally assigned to sub-categories or sub-groups. Similar types of assets are grouped together. The groups are based on the asset's purpose or use and liquidity (availability of the asset for paying debts).

The order that the Assets are presented are based on the following guidelines:

1. List the Items that are cash.
2. List the Items that are held primarily for converting into cash and list them in the order of their expected conversion into cash (beginning with the fastest and moving toward the slowest).
3. List the Items used in operations that could be converted into cash listed in the order of their expected conversion into cash (beginning with the fastest and moving toward the slowest).
4. List the Items whose cost provide future benefits or can not be converted into cash.

• Current Assets:
  Current Assets include Cash and Assets that will be converted into cash or consumed in a relatively short period of time, usually within a year or the business's operating cycle. Prepaid Expenses and Supplies (already paid for or a liability incurred) are included because they will normally be used or consumed within the operating cycle.
  • Cash and Cash Equivalents 
    Anything accepted by a bank for deposit is considered as Cash or Cash Equivalents. Cash in the form of coins and currency, undeposited checks, money orders, deposits in banks are examples. The cash must be available for immediate use and not restricted in any manner.
    • Cash On Hand
      • Cash Register Drawer(s) Funds
      • Undeposited Cash
    • Petty Cash
    • Bank Checking Accounts
      • General
      • Payroll
    • Savings Accounts
    • Money Market Accounts
  • Short-Term Investments 
    
    Short-Term Investments include readily marketable securities that can easily be sold and converted back into cash. These type of investments normally result from a business in the lucky position of having excess cash available. The invested should be temporary in nature and not made to exercise control over another business or satisfy any other requirements and/or agreements. Reported at current market value by using an allowance for unrealized market gains and losses.
    
    
    • Certificates of Deposit
    • Stocks
    • Bonds
    • Other Short Term Investments
    • Valuation Allowance for Market Value Fluctuations
  • Receivables 
    
    Included in this category are Accounts Receivable (open account customer balances resulting from sales) and customer Notes (principal and interest resulting from sales) that are formalized agreements and evidenced in writing. Short term temporary loans and advances are also included. An allowance for estimated uncollectible amounts is also provided.
    
    
    • Accounts Receivable
      This account will normally have a sub ledger that contains a record for each customer or client.
    • Allowance For Bad Debts (Contra Account)
      Used to record customer accounts that may not be collected.
    • Trade Notes Receivable - Current principal portion
    • Interest Receivable
    • Other Receivables
      • Short Term Owner Loans and Advances
      • Short Term Employee Loans & Advances
      • Short Term Travel and Expense Advances
  • Inventory 
    
    The accounts set up in the inventory section depend on the type of business. Is the business a service, retailer, wholesaler or manufacturer ? For retailers and wholesalers an inventory sub ledger is usually maintained to keep track of each individual product. Manufacturing types of businesses usually and Service types of businesses occasionally maintain sub legers for projects, jobs, and processes.
    
    
    • Manufacturer
      • Raw Materials
      • Manufacturing Supplies
      • Work In Process
        • Direct Labor
        • Direct Material
        • Manufacturing Costs
          • Direct Labor
          • Direct Material
          • Manufacturing Overhead - Actual
            • Indirect Labor
            • Supervision Salaries
            • Fringe Benefits
            • Manufacturing Supplies
            • Small Parts
            • Perishable Tools
            • Utilities
            • Depreciation
            • Rent
            • Leases
            • Repairs & Maintenance
            • Insurance
            • Property Taxes
          • Overhead Costs Applied
        • Finished Goods
      • Retailer or Wholesaler
        • Merchandise Inventory
        • Store Supplies
      • Service
        • Work In Process - Projects / Jobs
        • Completed / Unbilled Projects / Jobs
      • Common To All
        • Office Supplies
    • Prepaid Expenses
      
      Prepaid Expenses are assets created by the early payment of cash or assuming a liability. They expire and are charged to expenses based on the passage of time, usage, or other factors. All Prepaid Expenses could be recorded in a single account or separate accounts could be used for each different type.
      
      
      • Prepaid Insurance
      • Prepaid Rent
      • Prepaid Advertising
      • Prepaid Interest
      • Other Prepaid Expenses
    • Other Current Assets
      This category includes other current assets that do not neatly fit into any of the other categories. The amounts must be deemed collectible in a relatively short period of time (operating cycle).
      
      • Notes Receivable - Current principal portion of Long-term Notes
      • Other Current Assets
  • Long-Term Investments
    Investments that are intended to be held and not converted into cash for an extended period of time (longer than the operating cycle). Reported at current market value by using an allowance for unrealized market gains and losses.
    
    • Stocks
    • Bonds
    • Other Long Term Investments
    • Valuation Allowance for Market Value Fluctuations
  • Property, Plant, and Equipment
    Assets of a durable nature that are used to provide current and future economic benefits to the business.These accounts will normally have a sub ledger that contains a record for each parcel of land, building, or piece of machinery and equipment along with depreciation calculations and amounts.
    
    
    • Land
    • Buildings
    • Accumulated Depreciation - Buildings (Contra Account)
    • Building Improvements
    • Accumulated Depreciation - Building Improvements (Contra Account)
    • Machinery and Equipment
    • Accumulated Depreciation - Machinery and Equipment (Contra Account)
    • Office Equipment
    • Accumulated Depreciation - Office Equipment (Contra Account)
    • Computer Equipment
    • Accumulated Depreciation - Computer Equipment (Contra Account)
    • Vehicles
    • Accumulated Depreciation - Vehicles (Contra Account)
    • Furniture and Fixtures
    • Accumulated Depreciation - Furniture and Fixtures (Contra Account)
    • Leasehold Improvements
    • Accumulated Amortization - Leasehold Improvements (Contra Account)
    • Computer Software
    • Accumulated Amortization - Computer Software (Contra Account)
    • Other Property, Plant, or Equipment
    • Accumulated Depreciation - Other Property, Plant, or Equipment
  • Other Noncurrent Assets
    All assets that are noncurrent and that do not fit neatly into any of the other categories.
    
    • Long Term Owner Loans & Advances
    • Long Term Employee Loans & Advances
    • Notes Receivable - Long-term principal portion of Long-term Notes
    • Security Deposits
    • Intangible Assets
      • Patents
      • Organization Costs
      • Goodwill
      • Accumulated Amortization (Contra Account)

• Liabilities :
  Formal Definition:Claims by creditors to the property (assets) of a business until they are paid.Informal Definition:Other's claims to the business's stuff. Amounts the business owes to others.
  Additional Explanation: Usually one of a business's biggest liabilities (hopefully they are not past due) is to suppliers where they have bought goods and services and charged them.
  Liabilities are listed in the order of their expected payment date (maturity). In other words, how soon they must be repaid. Liability accounts are separated into current (short-term) liabilities and long-term liabilities. Short-Term Liabilities generally are debts that must be repaid within 1 year from the date of the balance sheet. Long-Term Liabilities are debts that must be paid more than 1 year from the date of the balance sheet.
  
  • Current Liabilities
    Current liabilities are the portion of obligations (amounts owed) due to be paid within the current operating cycle (normally a year) and that normally require the use of existing current assets to satisfy the debt.
    
    • Short Term Notes (Demand Notes)
    • Accounts Payable Trade
      A sub ledger is normally maintained in order to keep up with and track amounts owed to individual suppliers.
    • Accounts Payable Other
    • Payroll Liabilities
      • Accrued Salaries and Wages Payable
      • Employee Payroll Withholdings (Deductions)
        • Employee U.S. Federal Income Tax Withheld
        • Employee State Income Tax Withheld
        • Employee Local Income Tax Withheld
        • Employee FICA Withheld
        • Employee Medicare Withheld
        • Employee Garnishments Withheld
        • Employee Benefits
          • Employee Insurance Deduction Withheld
          • 401 K Deduction Withheld
          • IRA Deduction Withheld
        • Other Payroll Withholdings
      • Employer Provided Benefits
        • Mandatory
          • Employer FICA Contribution Payable
          • Employer Medicare Contribution Payable
          • Employer Federal Unemployment Payable
          • Employer State Unemployment Payable
          • Employer Workmen's Compensation Insurance Payable
        • Optional
          • Employer Provided Health Insurance Payable
          • Employer Provided Life Insurance Payable
          • Employer Provided 401 K Contributions Payable
          • Employer Provided IRA Contributions Payable
    • Sales Tax Payable
    • Unearned Revenues
    • Customer Advances and Deposits Payable
    • Interest Payable
    • Bank Loans (Notes Payable) - Current principal portion of Long-Term Notes
    • Notes Payable (other than bank notes) - Current principal portion of Long-Term Notes
    • Accrued and Estimated Liabilities
      • Accrued / Estimated Taxes Payable
        • Accrued Real Estate and Property Taxes Payable
        • Accrued Income and Franchise Taxes Payable
          • Accrued Federal Taxes Payable
          • Accrued State Taxes Payable
          • Accrued Local Taxes Payable
      • Other Accruals Payable
    • Other Current Liabilities
  • Long-Term Liabilities
    Long term liability accounts are the portions of debts with due dates greater than a year or the operating cycle. These are obligations that are not expected to be paid within the current operating cycle.
    
    • Bank Loans (Notes Payable) - Long Term principal portion
    • Notes Payable (other than bank notes) - Long Term principal portion
    • Other Long-Term Liabilities

Equity (Capital):
Formal Definition: The owner's rights or claims to the property (assets) of the business.

Informal Definition: What the business owes the owner(s). The good stuff left for the owner(s) assuming all liabilities (amounts owed) have been paid.

The accounts set up in this section will depend on the legal structure of your business. These accounts report the Owner's Capital Invested and the Accumulated Profits or Losses for the business since it began. Owner sub ledgers may also be maintained to keep up with and track shares and interests and amounts owed individual owners.

• Sole Proprietorship
  • Owner's Capital
  • Owner's Drawing
• Partnership or Limited Liability Company
  • Partner's or Member's Capital
  • Partner's or Member's Drawing
• Corporation
• Capital Stock
  • Common Stock
    • Common Stock Par or Stated Value
    • Premium Paid on Common Stock
  • Preferred Stock
    • Preferred Stock Par or Stated Value
    • Premium Paid on Preferred Stock
• Retained Earnings

Sample Balance Sheet:

Example Company Balance Sheet December 31, 2011 ASSETS LIABILITIES Current Assets Current Liabilities Cash $   2,100  Notes Payable $   5,000  Petty Cash 100  Accounts Payable 35,900  Temporary Investments 10,000  Wages Payable 8,500  Accounts Receivable - net 40,500  Interest Payable 2,900  Inventory 31,000  Taxes Payable 6,100  Supplies 3,800  Warranty Liability 1,100  Prepaid Insurance      1,500  Unearned Revenues      1,500  Total Current Assets    89,000  Total Current Liabilities    61,000  - Investments    36,000  Long-term Liabilities Notes Payable 20,000  Property, Plant & Equipment Bonds Payable   400,000  Land 5,500  Total Long-term Liabilities   420,000  Land Improvements  6,500  Buildings 180,000  Equipment 201,000  Total Liabilities   481,000  Less: Accum Depreciation    (56,000) Prop, Plant & Equip - net   337,000  - Intangible Assets STOCKHOLDERS' EQUITY Goodwill 105,000  Common Stock 110,000  Trade Names   200,000  Retained Earnings 229,000  Total Intangible Assets   305,000  Less: Treasury Stock    (50,000) Total Stockholders' Equity   289,000  Other Assets      3,000  - Total Assets $770,000  Total Liab. & Stockholders' Equity $770,000   The notes to the sample balance sheet have been omitted.

Analysis of a Balance Sheet:

Since balance sheets present the health of a company as of one point in time, valuable information will be lost if managers do not take the opportunity to compare the progress and trend of a business by regularly evaluating and comparing balance sheets of past time periods. Information is power. The information that can be gleaned from the preparation and analysis of a balance sheet is one financial management tool that may mean the difference between success and failure.

For analyzing and better understanding of your company's liquidity and leverage position you can calculate liquidity and leverage ratios using data from your balance sheet, 

These financial ratios turn the raw financial data from the balance sheet into information that will help you manage your business and make knowledgeable decisions.

A ratio shows the relationship between two numbers. It is defined as the relative size of two quantities expressed as the quotient of one divided by the other. Financial ratio analysis is important because it is one method loan officers use  to evaluate the credit worthiness of potential borrowers. Ratio analysis is a tool to uncover trends in a business as well as allow the comparison between one business and another. 

In the following section, four financial ratios that can be computed from a balance sheet are examined: 

• Current Ratio 

• Quick Ratio 

• Working Capital 

• Debt/Worth Ratio

Current Ratio :

The current ratio (or liquidity ratio) is a measure of financial strength. The number of times 

current assets exceed current liabilities is a valuable expression of a business’ solvency. 

Here is the formula to compute the current ratio: 

Current Ratio =     Total Current Assets/Total Current Liabilities

The current ratio answers the question, “Does my business have enough current assets to meet the payment schedule of current liabilities with a margin of safety?” A rule-of-thumb puts a strong current ratio at 2. 

Of course, the adequacy of a current ratio will depend on the nature of the small business 

and the character of the current assets and current liabilities. While there is usually little doubt about debts that are due, there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. 

A current ratio can be improved by either increasing current assets or decreasing current liabilities. 

This can take the form of the following: 

• Paying down debt. 

• Acquiring a loan (payable in more than one year’s time). 

• Selling a fixed asset. 

• Putting profits back into the business. 

A high current ratio may mean that cash is not being utilized in an optimal way. That is, the cash might better be invested in equipment. 

Quick Ratio: 

The quick ratio is also called the “acid test” ratio. It is a measure of a company’s liquidity. The quick ratio looks only at a company’s most liquid assets and divides them by current liabilities. 

Here is the formula for the quick ratio: 

Quick Ratio =     (Current Assets - inventory)/ Current Liabilities 

The assets considered to be “quick” assets are cash, stocks and bonds, and accounts receivable (all of the current assets on the balance sheet, except inventory). The quick ratio is an acid test of whether or not a business can meet its obligations if adverse conditions occur. Generally, quick ratios between 0.5 and 1 are considered satisfactory as long as the collection of receivables is not expected to slow. 

Working Capital Working capital should always be a positive number. It is used by lenders to evaluate a company’s ability to weather hard times. Often, loan agreements specify a level of working capital that the borrower must maintain. 

Working Capital = Total Current Assets - Total Current Liabilities 

The current ratio, quick ratio and working capital are all measures of a company’s liquidity. In general, the higher these ratios are, the better for the business and the higher degree of liquidity. 

Debt/Worth Ratio /Leverage Ratio:

The debt/worth ratio (or leverage ratio) is an indicator of a business’ solvency. It is a measure of 

how dependent a company is on debt financing (or borrowings) as compared to owner’s equity. It 

shows how much of a business is owned and how much is owed. 

The debt/worth ratio is computed as follows: 

Debt/Worth Ratio =     Total Liabilities/ Net Worth 

Sources: dwmbeancounter.com , zionsbank.com .