Chapter 4

The Balance Sheet

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Chapter Outline

The Purpose of the Balance Sheet

Balance Sheet Formats
Balance Sheet Content
Components of the Balance Sheet
Balance Sheet Analysis

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Learning Outcomes
State the purpose of regularly preparing a balance
sheet for a hospitality business.
Explain the way managers and accountants actually
prepare a balance sheet.
Analyze a balance sheet to better understand the
financial condition of your own business.

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The Purpose of the Balance Sheet

The type of information contained on a businesss
balance sheet is of critical importance to several
different groups including:
Owners
Investors
Lenders
Creditors
Managers

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Owners
The balance sheet, prepared at the end of each defined
accounting period, lets the owners of the business know
about the amount of that business which they actually
own.
A lien is the legal right to hold anothers property to satisfy
a debt.
A banks lien is similar to a businesss liabilities.
These liabilities must be subtracted from the value of the
business before its owners can determine the amount of
their own equity (free and clear ownership).
The balance sheet is designed to show the amount of a
business owners free and clear ownership.
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Investors
Investors seek to maximize the return on investment
(ROI) they receive.
When a businesss balance sheet from one accounting
period is compared to its balance sheet covering
another time period, investors can measure their return
on investment.
Investors must have the information contained in a
balance sheet if they are to accurately compute their
annual returns on investment (ROI).

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Lenders
Lenders are most concerned about a businesss ability
to repay its debts.
Lenders read the balance sheet of a business in an
effort to better understand the financial strength (and
thus the repayment ability) of that business.

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Creditors
Business creditors, much like lenders, are concerned
about repayment.
It would not be unreasonable for vendors to ask to see
their customers respective balance sheets before a
decision was made regarding the wisdom of extending
credit to them.
The balance sheet is the financial document that most
accurately indicates the long-term ability of a business
to repay a vendor who has extended credit to that
business.

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Managers
Managers most often are more interested in the
information found on the income statement than that
found on the balance sheet.
However, they too must be able to read and analyze
their own balance sheets to determine items such as
the current financial balances of cash, accounts
receivable, inventories, and accounts payable, and
other accounts that have a direct impact on operations.

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Limitations of the Balance Sheet

Knowledgeable readers of a balance sheet recognize
that accountants utilize a variety of evaluation
approaches, each of which may make the most sense
for specific asset types based upon circumstances and
available information.
It is also important to note that balance sheets have
been criticized because of the company assets they do
not value.
Consider the fact that, of all the assets listed on the
balance sheet, none take into account the relative
value, or worth, of a restaurant or hotels staff, including
its managers.
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Balance Sheet Formats

A balance sheet represents an accountants systematic
method of documenting the value of a businesss
assets, liabilities, and owners equity on a specific date.
There are two basic methods accountants use to
display the information on a balance sheet.
When using the account format, those preparing the
balance sheet list the assets of a company on the left
side of the report and the liabilities and owners equity
accounts on the right side.

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Balance Sheet Formats

When using the report format those preparing the
balance sheet list the assets of a company first and
then the liabilities and owners equity accounts
(vertically)
The totals are presented in such a manner as to prove
to the reader that assets equals liabilities plus owners
equity.
In both type formats, the date on which the balance
sheet was prepared is clearly identified.

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Balance Sheet Content

The Accounting formula is stated as
Assets = Liabilities + Owners Equity
The content of a balance sheet tells its readers as much
as possible about each of these three accounting
formula components.

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Why a Balance Sheet Balances

Dr. Dopsons Stuff Theory
Dr. Dopsons Stuff Theory is simple. For all the stuff
(assets) you have in your life, you got it from either:
Borrowing money that you have to repay such as
through credit cards or loans (liabilities) or
Acquiring the stuff through others such as your
parents, siblings, or friends (investors equity) or
paying for the stuff yourself through money you
earned (retained earnings equity)

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Why a Balance Sheet Balances

Dr. Dopsons Stuff Theory
You are reporting your stuff and how you GOT (past
tense) your stuff.
In this sense, the list of your stuff balances with how
you got it.
This is why a balance sheet balances!
This same concept applies to businesses when
preparing their balance sheets.
All assets (stuff) must equal liabilities plus owners
equity (how they got their stuff).

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Components of the Balance Sheet

The balance sheet is subdivided into components under
the broad headings of
Assets,
Liabilities,
Owners Equity.
These subclassifications have been created by
accountants to make information more easily accessible
to readers of the balance sheet and to allow for more
rapid identification of specific types of information for
decision making.
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Current Assets
Current Assets are those which may reasonably be
expected to be sold or turned into cash within one year.
Liquidity is defined as the ease in which current assets
can be converted to cash in a short period of time (less
than 12 months).
Current assets, typically listed on the balance sheet in
order of their liquidity, include:
Cash
Marketable securities
Accounts receivable (net receivables)
Inventories
Prepaid expenses
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Current Assets
For purposes of preparing a balance sheet, the term
cash refers to the cash held in cash banks, money held
in checking or savings accounts, electronic fund
transfers from payment card companies, and
certificates of deposit (CDs).
Marketable securities include those investments such
as stocks and bonds that can readily be bought sold
and thus are easily converted to cash.
These are stocks and bonds the business purchases
from other companies. These are not to be confused
with a companys stocks that are listed on its balance
sheet as owners equity.
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Current Assets
Accounts receivable represent the amount of money
owed to a business by others (such as customers).
Net receivables (the term net means that something
has been subtracted out) are those monies owed to the
business after subtracting any amounts that may not be
collectable (doubtful accounts).
In the hospitality industry, inventories will include the
value of food, beverages and supplies used by a
restaurant, as well as sheets, towels and the in-room
replacement items (hangers, blow dryers, coffee
makers and the like) used by a hotel.
Prepaid expenses are best understood as items that will
be used within a years time, but which must be
completely paid for at the time of purchase.
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Current Assets
Cash is listed first because it is already cash.
Marketable securities are less liquid than cash, but can
be readily sold for cash.
Net receivables can be collected from others
(customers), but not as easily as converting marketable
securities to cash.
Inventories must be made ready for sale to customers
and the money must be collected.
There is no guarantee that payment for all inventories
will be collected in full, and thus some may end up
being reported as receivables.
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Current Assets
Prepaid expenses are the least liquid current asset
because once paid, refunds for this money are very
difficult (if not impossible) to receive.
Those prepaid expenses that will be of value or benefit
to the business for more than one year (for example a
three year pre-paid insurance policy) should be listed on
the balance sheet as Other Assets.

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Non Current (Fixed) Assets

Non Current (Fixed) Assets consist of those assets
which management intends to keep for a period longer
than one year, and typically include investments,
property and equipment (land, building, furnishings and
equipment, less accumulated depreciation), and other
assets.
Included in this group are investments made by the
business which management intends to retain for a
period of time longer than one year, unlike marketable
securities, which can be readily sold and converted to
cash within one year.
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Non Current (Fixed) Assets

Property and Equipment, which includes land, building,
furnishings and equipment, usually make up a significant
portion of the total value of a hospitality business and
are another form of non-current asset. These are listed
on the balance sheet at their original cost less their
accumulated depreciation.
Other assets are a non-current asset group that includes
items that are mostly intangible, including the value of
goodwill (the difference between the purchase price of
an item and its fair market value).
Goodwill is an asset that is amortized (systematically
reduced in value) over the period of time in which it will
be of benefit to the business.
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Liabilities
Current liabilities are defined as those obligations of the
business that will be repaid within a year.
The most important sub-classifications of current
liabilities include notes payable, income taxes payable,
and accounts payable.
In the hospitality industry, current liabilities typically
consist of payables resulting from the purchase of food,
beverages, products, services and labor.

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Liabilities
Current period payments utilized for the reduction of
long-term debt are also considered a current liability.
Guests pre-paid deposits (such as those required by a
hotel that reserves a ballroom for a wedding to be held
several months in the future) are also listed as a current
liability (because these monies are held by the business
but have not been earned at the time the hotel accepts
the deposit).

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Liabilities
Dividends that have been declared but not yet paid and
income taxes that are due but not yet paid will also be
included in this liability classification.
Long-term liabilities are those obligations of the
business that will not be completely paid within the
current year.
Typical examples include long-term debt, mortgages,
lease obligations, and deferred incomes taxes resulting
from the depreciation methodology used by the
business.

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Owners Equity
While the liabilities section of the balance sheet
identifies non-owner (external) claims against the
businesss assets, the owners equity portion identifies
the asset claims of the businesss owners.
When a company is organized as a sole proprietorship,
the balance sheet reflects that single ownership.
When a partnership operates the business, each
partners share is listed on the balance sheet.
For corporations, common stock is the balance sheet
entry that represents the number of shares of stock
issued (owned) multiplied by the par value (the value of
the stock recorded in the companys books).
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Owners Equity
Common stock is valued at its historical cost regardless
of its current selling price.
Initially, most companies designate a stated or par value
for the stock they issue and as each share is sold, an
amount equal to the par value is reported in the
common stock section of the balance sheet.
Differences between the selling price and par value are
reported in the paid in capital portion of the balance
sheet.
Some companies also issue preferred stock that pays
its stockholders (owners) a fixed dividend.
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Owners Equity
When more than one type of stock is issued by a
company, the value of each type should be listed
separately on the balance sheet.
Retained earnings are the final entry on the owners
equity portion of the balance sheet.
Retained earnings refer simply to the accumulated
account of profits over the life of the business that have
not been distributed as dividends.
If net losses have occurred, the entry amount in this
section may be a negative number.

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Balance Sheet Analysis

After the balance sheet has been prepared, managerial
accountants use a variety of methods to analyze the
information it contains.
Three of the most common types of analysis are:
Vertical (common-size) analysis
Horizontal (comparative) analysis
Ratio analysis

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Vertical Analysis of Balance Sheets

Income statements can be analyzed using vertical and
horizontal techniques. In very similar ways, the balance
sheet can be reviewed using these same techniques.
When using vertical analysis on a balance sheet, the
businesss Total Assets take on a value of 100%.
Total Liabilities and Owners Equity also take a value of
100%.

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Vertical Analysis of Balance Sheets

When utilizing vertical analysis, individual asset
categories are expressed as a percentage (fraction) of
Total Assets. Individual liability and owners equity
classifications are expressed as a percentage of Total
Liabilities and Owners Equity.
Each percentage computed is a percent of a common
number, which is why this type analysis is sometimes
referred to as common-size analysis.
Vertical analysis of the balance sheet may be used to
compare a units percentages with industry averages,
other units in a corporation, or percentages from prior
periods.
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Horizontal Analysis of Balance

Sheets
A second popular method of evaluating balance sheet
information is the horizontal analysis method.
As was true with the income statement, a horizontal
analysis of a balance sheet requires at least two
different sets of data.
Because of this comparison approach the horizontal
analysis technique is also called a comparative
analysis.

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Horizontal Analysis of Balance Sheets

Managers who use horizontal analysis to evaluate the
balance sheet may be concerned with comparisons
such as their:
Current period results vs. prior period results
Current period results vs. budgeted (planned) results
Current period results vs. the results of similar
business units
Current period results vs. industry averages

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Determining Variance
The dollar change or variance shows changes from
previously experienced levels, and will give you an
indication of whether your numbers are improving,
declining, or staying the same.
All dollar variances and percentage variances on the
balance sheet can be calculated in the same way.
The dollar differences between identical categories
listed on two different balance sheets is easy to
compute and is always the numerator in any percentage
change (variation) calculation.

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Inflation Accounting
The second reason for computing percentage change in
the preparation of balance sheets (as well as other
financial documents) is because the value of money
changes over time.
As economists (as well as managerial accountants)
know well, if you don't adjust for inflation (the tendency
for prices and costs to increase) just about everything is
more expensive today than it was 30 years ago.

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Inflation Accounting
Because of the potential effects of inflation and deflation
(the tendency for prices and costs to decrease),
managerial accountants must know how to properly
consider them when comparing financial data from two
different time periods.
The purchasing power (amount of goods and service
that can be bought) of money is likely diminished over
time due to the effects of inflation.
Accounting for inflation (sometimes called current dollar
accounting) can be very complex.

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Review of Learning Outcomes

State the purpose of regularly preparing a balance
sheet for a hospitality business.
Explain the way managers and accountants actually
prepare a balance sheet.
Analyze a balance sheet to better understand the
financial condition of your own business.

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