Slides Show SummaryAGEC 432

Spring 2007

Basic Structure of the Balance Sheet

Assets: Liabilities and Net Worth:

Current assets Current liabilities

plus Intermediate assets plus Intermediate liabilities

plus Long term assets plus long term liabilities

plus Net worth (residual value)(residual value)

equals Total assets equals Total liabilities and net worth

Assets: Liabilities and Net Worth:

Current assets Current liabilities

plus Intermediate assets plus Intermediate liabilities

plus Long term assets plus long term liabilities

plus Net worth (residual value)(residual value)

equals Total assets equals Total liabilities and net worth

Basic Structure of Income Statement

Value of farm productionMinus Farm expensesEquals Income from operationsPlus Gain (loss) on sale of intermediate and long term assetsEquals Net farm incomePlus Non-farm incomeEquals Income (loss) before taxes and extraordinary itemsMinus Provision for income taxesEquals Income before extraordinary itemsPlus Extraordinary itemsEquals Net income

Value of farm productionMinus Farm expensesEquals Income from operationsPlus Gain (loss) on sale of intermediate and long term assetsEquals Net farm incomePlus Non-farm incomeEquals Income (loss) before taxes and extraordinary itemsMinus Provision for income taxesEquals Income before extraordinary itemsPlus Extraordinary itemsEquals Net income

Basic Structure of Cash Flow Statement

Cash availableMinus Cash requiredEquals Cash available less cash requiredPlus Savings withdrawalsEquals Cash positionPlus Net borrowingMinus Other uses of cashMinus Additions to savingsEquals Ending cash balance

Cash availableMinus Cash requiredEquals Cash available less cash requiredPlus Savings withdrawalsEquals Cash positionPlus Net borrowingMinus Other uses of cashMinus Additions to savingsEquals Ending cash balance

Monthly Cash Position

January February March

Cash availableLess Cash requiredPlus Savings withdrawalEquals Cash position

A monthly cash flow statement indicates months of cash flow and surpluses or deficits before borrowing on a LOC…

The value of the LOC to request is at least equal to the highest monthly cash flow deficit.

A monthly cash flow statement indicates months of cash flow and surpluses or deficits before borrowing on a LOC…

The value of the LOC to request is at least equal to the highest monthly cash flow deficit.

? ? ?

Repayment Capacity from Operations

Debt Repayment Capacity Report   

Farm sources of term debt repayment capacity:    Net income     Adjustments to net income:     Plus Depreciation   Less Gain (loss) on sale of assets   Less Non-farm income   Less Family living withdrawals   Less Gifts to others   Subtotal     Term debt repayment capacity from operations  

$0 $0

$0$0$0$0$0$0 $0

$0

+

Repayment margin = repayment capacity – scheduled paymentsCoverage ratio > 1.0 if repayment margin is positive

Repayment margin = repayment capacity – scheduled paymentsCoverage ratio > 1.0 if repayment margin is positive

Slides from Show #2

2006 Cash Flow StatementSources of cash:Beginning cash balanceCash receipts from product salesOther sources of cash Total sources of cash

Uses of cash:Cash operating expensesInterest paymentsPrincipal paymentsCapital expendituresWithdrawals of cashOther selected uses of cashEnding cash balance Total uses of cash

Basic structure:Total sources = total uses

2006 Income StatementCash receipts from product salesOther income Total income

Cash operating expensesInterest paymentsOther cash expensesDepreciation Total expenses

Net income from operationsAllowance for taxes Net income

Basic structure:EBIT = total income – total expenses + interest payments

Interrelationships Between Financial Statements

Balance Sheet 12/31/06Ending cash balanceOther current assets Total current assets

Machinery and equipmentBuildings and improvementsLand Total assets

Accounts payable Current loan paymentAllowance for taxesOther current liabilities Total current liabilities

Remaining balance on loans Total liabilities

Equity

Basic Structure:Equity = total assets – totalLiabilitiesEquity = Retained net Income + asset revaluations

Other statements and schedules:Statement of Change in Owner EquityDepreciable asset schedules

In Class Problem

See Problem #1 under Quizzes and Exams link on WebsiteSee Problem #1 under Quizzes and Exams link on Website

Slides from Show #3

None… Demonstrated impacts of price and yield shocks to financial statements and financial indicators.

None… Demonstrated impacts of price and yield shocks to financial statements and financial indicators.

Slides from Show #4

Lessons from Beaver Study

• Indicators of Indicators of growth/survival:growth/survival:– Increasing liquidity– Increasing solvency– Increasing debt

repayment capacity– Increasing profitability

• Indicators of Indicators of potential failure:potential failure:– Declining liquidity– Declining solvency– Decreasing debt

repayment capacity– Decreasing profitability

Trends in Indicators

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Year Before Failure

Net Cash Income-to-Total Debt

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

0.40

0.50

0.60

1 2 3 4 5

Year Before Failure

Working Capital-to-Total Assets

0.000.050.100.150.200.250.300.350.400.45

1 2 3 4 5

Year Before Failure

Total Debt-to-Total Assets

0.000.100.200.300.400.500.600.700.800.90

1 2 3 4 5

Year Before Failure

FailedFailed

FailedFailed

FailedFailed

FailedFailed

Source: W. H. Beaver, “Financial Ratios and Predictors of Failure”, Journal of Accounting Research

Historical Analysis

• A look backwards like the Beaver study.

• Comparison of current performance with past performance.

• Recommend doing this at the enterprise level as well as for the farm as a whole.

• Reasons underlying unwanted trends such as the declines in last declines in last two years?two years?

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

1 2 3 4 5

Prior Years

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Comparative Analysis

• Comparing current performance with similar operations like the Beaver study.

• Benchmark analysis at enterprise level when possible.

Similar firms

Your firm

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Comparative Analysis

• Comparing current performance with similar operations like the Beaver study.

• Benchmark analysis at enterprise level when possible.

• Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Comparative Analysis

• Comparing current performance with similar operations like the Beaver study.

• Benchmark analysis at enterprise level when possible.

• Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Comparative Analysis

• Comparing current performance with similar operations like the Beaver study.

• Benchmark analysis at enterprise level when possible.

• Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Comparative Analysis

• Comparing current performance with similar operations like the Beaver study.

• Benchmark analysis at enterprise level when possible.

• Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Rate of Return on Assets

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

1 2 3 4 5

Prior Years

Comparative Analysis

• Comparing current performance with similar operations like the Beaver study.

• Benchmark analysis at enterprise level when possible.

• Address reasons why your firm is performing more poorly than other comparable operations before it is too latebefore it is too late.

Slides from Show #5

Comparison of Cost Systems

Features

Job Order Cost System

Process Cost System

Work in process accounts

One work in process account

Multiple work in process accounts

Documents used Job cost sheets Production cost reports

Determination of total manf. costs

Each job Each period

Unit-cost computations

Cost of each job/ units produced for the job

Total manf. costs/ units produced during the period

Comparison of Cost Systems

Features

Job Order Cost System

Process Cost System

Work in process accounts

One work in process account

Multiple work in process accounts

Documents used Job cost sheets Production cost reports

Determination of total manf. costs

Each job Each period

Unit-cost computations

Cost of each job/ units produced for the job

Total manf. costs/ units produced during the period

AB Overhead RateAB Overhead rate = Overhead per activity AB Overhead rate = Overhead per activity ÷ Cost driver per activity÷ Cost driver per activityInitial status:Initial status:Activity Cost Pool Overhead Driver AB overhead activity rateSetting up machines $300,000 1,500 setups $200/setupMachining $500,000 50,000 hours $10/hourInspecting $100,000 2,000 inspection $50/inspection Total $900,000

Step 1: Assigning overhead driver activity to products:Step 1: Assigning overhead driver activity to products:Activity Cost Pool Cost driver Driver Product 1 Product 2

activitySetting up machines # setups 1,500 500 1,000500 1,000Machining Hours 50,000 30,000 20,00030,000 20,000Inspecting # inspections 2,000 500 1,500500 1,500

AB Overhead Rate

Step 1: Assigning overhead driver activity to products:Step 1: Assigning overhead driver activity to products:Activity Cost Pool Cost driver Driver Product 1 Product 2

activitySetting up machines # setups 1,500 500 1,000Machining Hours 50,000 30,000 20,000Inspecting # inspections 2,000 500 1,500

Step 2: Partitioning of overhead:Step 2: Partitioning of overhead: Overhead Product 1 Product 2___Setting up machines $300,000 (33%) $100,000 (67%) $200,000Machining $500,000 (60%) $300,000 (40%) $200,000Inspecting $100,000 (33%) $25,000 (67%) $75,000

33% = 500/1,500 and 67% = 1,000/1,50033% = 500/1,500 and 67% = 1,000/1,500

AB Overhead RateStep 2: Partitioning of overhead:Step 2: Partitioning of overhead: Overhead Product 1 Product 2Setting up machines $300,000 $100,000 $200,000Machining $500,000 $300,000 $200,000Inspecting $100,000 $25,000 $75,000 Total $900,000 $425,000 $475,000Step 3: Overhead costs per unit:Step 3: Overhead costs per unit:Units produced 25,000 5,000 Overhead cost per unit $17 $95

Traditional overhead cost per unit* $30 $30

* $900,000 divided by 30,000 units

Avoids overstating profitability of some enterprises and

understating profitability of others

Avoids overstating profitability of some enterprises and

understating profitability of others

AB Overhead Rate Product 1 Product 2

COP unit costs with ABC costing:COP unit costs with ABC costing:Direct materials $40 $30Direct labor $12 $12ABC overhead $17 $95 Total unit costs $69 $137

COP unit costs with traditional costing:COP unit costs with traditional costing:Direct materials $40 $30Direct labor $12 $12Traditional overhead * $30 $30 Total unit costs $82 $72

* $900,000 divided by 30,000 units

Traditional overhead costing suggests that Product 2 is cheaper to produce than

Product 1, which is not true!which is not true!

Traditional overhead costing suggests that Product 2 is cheaper to produce than

Product 1, which is not true!which is not true!

Slides from Show #6

Sales BudgetSales Budget

Production BudgetProduction Budget

Direct MaterialsBudget

Direct MaterialsBudget

Direct LaborBudget

Direct LaborBudget

OverheadBudget

OverheadBudget

Selling and AdministrativeExpense Budget

Selling and AdministrativeExpense Budget

Budgeted IncomeStatement

Budgeted IncomeStatement

Capital Expenditureand Cash Budgets

Capital Expenditureand Cash Budgets

Budgeted Cash Flow Statement

Budgeted Cash Flow Statement

BudgetedBalance Sheet

BudgetedBalance Sheet

Slides from Show #7

None … showed sensitivity of break even prices and yields to changes in unit costs of production

None … showed sensitivity of break even prices and yields to changes in unit costs of production

Slides from Show #8

PAST FUTUREPRESENT

Historical analysis

Comparative analysis

Historical price and yield trends

Pro forma analysis

Forming expectations about future prices, costs and productivity

Ad hoc extrapolations

Projections based upon available outlook data

Projections based upon econometric analysis

Ad Hoc Modeling Approaches

?

Naïve model – using last year’s prices, costs and yields

Simple linear trend extrapolation of historical prices, costs and yields

Using assumptions made by others

Econometric Model Approach

?Capturing future

supply/demand impacts on prices and unit costs

Linkages to commodity policy

Linkages to domestic economy

Linkages to the global economy

2000 2001 2002 2003 2004 2005 2006

Timeline Required for Capital Budgeting…

Assume it is the year 2000 and John Deere wants to project farm machinery and equipment sales over the next six years to determine if plant expansion is necessary.

Capital budgeting models of investment decisions require projections of the annual farmfarm revenue and cost values over the entire 2001 to 2006 time period.

ConclusionsEconometric models are preferred over

naïve models and linear time trend models.

Much more accurate.Provide much more information (e.g.,

elasticitieselasticities).Allow for sensitivity analysissensitivity analysis with

independent (exogenous) variables when evaluating potential variabilitypotential variability about expected trends.

23 Key Terms to Know

Some Key TermsSome Key Terms

1. Three types of liquidity (HO #1)2. Solvency (HO #1)3. Debt repayment capacity (HO #1)4. Explicit and implicit cost of capital (HO #5)5. Optimal capital structure (HO #1,5)6. Historical and comparative analysis (HO #1)7. Long run planning curve (HO #2)8. Financial risk (HO #2,5)9. Payback period (HO #3)10.Internal rate of return (HO #3)

More Key TermsMore Key Terms

11.Economic life (HO #3)

12.Terminal value (HO #3)

13.Pro forma analysis (HO #4)

14.Structural econometric simulation (HO #4)

15.Coefficient of variation (HO #5)

16.Required rate of return (HO #5)

17.Business risk premium (HO #5)

18.Financial risk premium (HO #5)

More Key TermsMore Key Terms

19.Leverage (HO #1 and #5)

20.Portfolio effect (HO #5)

21.Negatively correlated cash flows (HO #5)

22.Weighted average cost of capital (HO #5)

23.Capital budget constraint (HO #5)