Study: How is a comparative Balance Sheet prepared and how is it helpful to users?
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Slides 1-2 (1m:08s)
Links to an external site.
Welcome to Introduction to Accounting Preparing for a User's Perspective
How is a comparative Balance Sheet prepared and how is it helpful to users?
A comparative balance sheet is a balance sheet that provides account balances as of more than one date as can be seen in XYZ's December 31, 20X7 and 20X8 comparative balance sheet below:
Comparative, comes from the word "compare", which is to identify and evaluate differences between two or more similar items.
Management prepares comparative balance sheets to help users recognize positive and negative trends based on movements in account balances from one year to the next.
By analyzing a comparative balance sheet, including changes in various ratios, a financial statement user can effectively pull the curtain back to understand more about the company and its financial health.
Please stop the video and take a minute to see if you can spot any positive or negative trends in XYZ's comparative balance sheet.
So, how is XYZ doing? Did you notice any positive or negative trends that creditors, lenders or investors would want to be aware of before making a credit, lending, or investing decision?
Here are just a few trends that you might have noticed:
Slide 3 (0m:33s):
Links to an external site.XYZ's Current assets
Links to an external site. stayed about the same, only decreasing by $1,000, from last year's $50,000 last year to this year's $49,000; however, its current liabilities
Links to an external site. increased $6,000, from last year's $20,000 to this year's $26,000. This trend has made XYZ less liquid because it has less current assets with which to pay off its current liabilities in the next year.
Slide 4 (0m:43s):
Links to an external site. XYZ's current ratio
Links to an external site. validates this drop in liquidity
Links to an external site. because it dropped from 2.5, which is computed as $50,000 in current assets / $20,000 in current liabilities, down to 1.88 which is the $49,000 in current assets / $26,000 in current liabilities. This is a significant decline in liquidity; however, XYZ still has $1.88 of current assets for every $1 of current liability so it is not too bad yet.
Slide 5 (0m:31s):
Links to an external site. Maybe you noticed that XYZ's accounts receivable dropped significantly declining by $8,000. This drop could be due to better collection efforts, stricter lending policies, bad debts, or simply fewer sales. To really answer this question, we would want to review XYZ's income statement
Links to an external site. focusing on sales figures and bad debt expenses and the statement of cash flows to see the amount of cash collected from customers this year compared to last year. But at least it begs the question, "Why did accounts receivable decline?"
Slide 6 (0m:30s):
Links to an external site. Property and equipment, net of depreciation
Links to an external site.increased by $20,000, from $30,000 last year to $50,000 this year, so XYZ is clearly investing more in its equipment. Is the company expanding? Is it preparing for a significant increase in sales? Once again, the comparative balance sheet will help you recognize positive and negative trends, but you will most likely need other information including XYZ's full set of financial statements and annual report to have a shot at explaining the cause of such trends.
Slide 7 (0m:33s):
Links to an external site. Its long-term debt increased by $50,000 from $35,000 last year to $85,000 this year. It seems clear that at least $20,000 of this [debt] was used to purchase additional property, but what was the remaining $30,000 used for? The statement of cash flows would help us answer this question.
Slide 8 (1m:50s):
Links to an external site. Here are a couple other computations that are interesting to users:
Debt Ratio
Links to an external site.: Total liabilities/Total assets
Users compute a company's debt ratio to assess what percentage of the company's assets were funded by debt. A debt ratio of 1 indicates that for every $1 of asset, the company has $1 of liabilities. In other words 100% of the company's assets were funded by debt and the company is VERY highly leveraged
Links to an external site., in fact the company is bordering on technical insolvency. If the debt ratio is greater than 1, it would indicate that for every $1 of asset, the company has more than $1 of liabilities. This is not a good situation and the company would be described as being "technically insolvent". This is an example of leverage going out of control. A debt ratio below one means that for every $1 of assets, the company has less than $1 of liabilities, hence being technically "solvent". Debt ratios less than 1 reveal that the owners have contributed the remaining amount needed to purchase the company's assets.
Here are XYZ's debt ratios for 20X8 and 20X7:
20X8 20X7
Debt ratio .91 .54
(debt ratio computations: 20X8: Total liabilities $131,000 / $144,000 Total assets = .91; 20X7: Total liabilities $70,000 / $130,000 Total assets = .54)
Based on XYZ's debt ratios above, it is clear that XYZ is on a negative trend toward insolvency as its liabilities increase as a percentage of its assets. Lenders and investors seeing this trend should be very cautious.
Slide 9 (2m14:s):
Links to an external site.Debt to Equity Ratio
Links to an external site. : Total liabilities/Total equity
And that should make sense because it is "debt to equity", that's one way to read these. The other one, the debt ratio, its to debt to assets, but we just call it the debt ratio. At any rate, The debt to equity ratio
Links to an external site. is similar to the debt ratio in its focus on a company's leverage, that's long-term solvency, but it tries to show the relative proportion of how assets were funded either by debt or by equity. So, in other words, assets are equal to liabilities and equity, so if we see these relative proportions, it will help us understand how the assets were funded.
If total liabilities are greater than total equity, the debt to equity ratio will be greater than 1 indicating that more than 50% of the company's assets have been funded by debt. If this ratio grows larger every year, the company is becoming more highly leveraged by debt.
If the debt to equity ratio is exactly 1, it indicates that exactly 1/2 of all assets were funded by debt and the other 1/2 were funded by equity.
As the debt to equity ratio continues to drop below 1 [for example] if we draw a number line here and this is one [here in the middle, with lower numbers on the left and higher numbers on the right], if it's on this side [the left side of 1 on the number line, indicating that the] the debt to equity ratio is lower than 1, then that means its assets are more funded by equity. If it's greater than one, its assets are more funded by debt. So as the debt to equity ratio continues to drop below one it indicates the company is reducing its reliance on debt to fund assets and its leverage is going down. It also means that the owner's ownership % of assets is going up.
So here are XYZ's debt to equity ratios for year 20X8 and 20X7:
20X8 20X7
Debt ratio 10.08 1.17
(debt ratio computations: 20X8: Total liabilities $131,000 / $13,000 Total equity = 10.08; 20X7: Total liabilities $70,000 / $60,000 Total assets = 1.17)
So as you can see, it's growing along this number line, that means that we are getting more liabilities in relation to equity to fund the assets. XYZ's debt to equity ratio significantly increased from only 1.17, where liabilities and equity funded XYZ's assets almost equally, all the way up to 10.08 indicating an almost complete reliance on debt to obtain assets, which is a very high level of leverage.
Slides 10-11 (0m:55s):
Links to an external site. The XYZ Company examples on the previous slides showed that we were able to use XYZ's comparative, classified balance sheet to recognize that XYZ is becoming less liquid and less solvent.
You should also realize that we can use XYZ's comparative, classified balance sheet to compare against other companies in the same, or different industries, to see if the trends we found in XYZ are also occurring in companies elsewhere. If all companies are having the same challenges, it is possible that XYZ is doing the best it can given the macro-economic situation it operates in; however, if XYZ is the only company in the industry experiencing declining liquidity and solvency Links to an external site.it is possible that such poor results were caused by poor management decisions, poor customer relations, poor operations, etc. and the focus might need to be on how to improve company management.
Just in case you haven't heard enough on the comparative balance sheet, here is a short 1m:21s video that might be of help.
What Is The Function of a Comparative Balance Sheet
Links to an external site.I hope you enjoyed this topic and Aloha.