Definition and Purpose
The balance sheet is a financial statement that measures the financial position of the farm business at a given point in time. The underlying principle of the balance sheet is the Universal Accounting Equation:
Assets = Liabilities + Net worth (Owner Equity)
The word “balance” in “balance sheet” is a statement that every penny of assets comes from one of two sources: liabilities or owner equity.
Figure 1: Balance Sheet Equation
The balance sheet is a measure of financial “position.” Ultimately, “position” refers to the level of wealth of the owners, known as “owner equity” or “net worth.” “Position” is also a statement of the level of who “owns” the assets of the business, creditors (liabilities), or owners (owner equity). Good financial position means greater wealth for the owners.
Figure 2: Balance Sheet
The balance sheet is a very important document for lenders as it shows the value of collateral, financial wealth of the business and owners, and working capital position (a risk management strategy).
Balance Sheet Structure
There are a variety of structural issues with the balance sheet and all seem to follow the Rule of Two.
- Two ways to format a balance sheet: two-way versus three-way
- Two types of balance sheets: market basis versus cost basis
- Two kinds of assets: market assets versus capital assets
- Two ways to value assets: market value versus cost value
A confusion is that the word “market” is often used yet its meaning changes depending on the context of its usage.
Two-Way versus Three-Way Balance Sheet
The two-way balance sheet refers to having two categories of assets and liabilities, current and non-current. This is the format that is recommended by the Farm Financial Standards Council (FFSC) and the type commonly used outside of production agriculture. An alternative and acceptable format is the three-way balance sheet, which adds a third, intermediate category to both assets and liabilities. Lenders tend to favor the three-way format as it more closely tracks the length of time farm assets are useful and thus how loans should be structured for those assets.
- Current Assets: Market assets expected to be used/converted to cash within 12 months
- Cash, accounts receivable, inventory, supplies, prepaid expenses, and others
- Intermediate Assets: Capital assets with a useful life from 1 to approximately 10 years
- Machinery, equipment, and breeding livestock
- Fixed, or Long-Term Assets: Capital assets with a useful life of more than 10 years
- Buildings, land, and land improvements
Figure 3: Two Ways to Format
Market Basis versus Cost Basis Balance Sheet
There are two kinds of balance sheets, not to be confused with the two kinds of balance sheet formats. The two kinds of balance sheets are cost basis and market basis.
Cost-Basis Balance Sheet
Market-Basis Balance Sheet
Market Assets versus Capital Assets
There are two kinds of asset on the balance sheet: market assets and capital assets.
Market Assets
Capital Assets
Market Value versus Cost Value
There are two ways to value assets: market value and cost value.
Market Value
Cost Value
Figure 4: Cost versus Market Value
Summary
Which balance sheet should be used? There is a good economic answer to that question and that is: “It depends!” If your question is financial position due to operations only, then cost basis. If your question is overall financial position or collateral value, then market basis. If your question is determining valuation equity or deferred taxes, then both are needed.
Test your knowledge of balance sheet structure
True or false? A capital asset is one that is put to work to create a market asset.
Which balance sheet shows the financial position of a farm business based only on the profitability of past operations?
True or false? Cost value is used for valuing assets on the cost-basis balance sheet and Market Value is used for valuing assets on the market-basis balance sheet.
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References:
- Farm Financial Standards Council. (2021, January). Financial guidelines for agriculture.
- Preparing the Balance Sheet (2021), drafted by Katie Wantoch, UW–Madison Division of Extension; reviewed by Kevin Bernhardt, UW Center for Dairy Profitability/UW-Platteville, and Jenny Vanderlin, UW Center for Dairy Profitability; based on material from Understanding the Farm Balance Sheet, Part I Factsheet (2018), by Sandy Stuttgen, UW–Madison Division of Extension.
This material is based upon work supported by USDA/NIFA under Award Number 2018-70027-28586.