This reading introduces the readers to balance sheets, one of the three major financial statements. We will learn about the structure and presentation of balance sheet, calculation of various elements of balance sheet, and common ratios associated with it.

Understanding Balance Sheets

The balance sheet describes the financial situation of a business at a given time. It provides us critical information about the value of the firm’s assets, liabilities and the owner’s equity. The balance sheet of a company shows the assets on one side and the liabilities and owner’s equity on the other side in such a way that both sides balance in accordance with the accounting equation.



Assets = Liabilities + Owner’s Equity



Assets: Assets are what a business owns or what is owed to it. It includes items such as cash, accounts receivable, merchandise to be sold, supplies, equipment, and land. Assets also include intangible items such as patents, franchises, and copyrights.



Liabilities: Liabilities are what the business owes to others. Some examples are payments to be made to suppliers, salaries to employees, taxes to government agencies, rent to landlords, mortgage, and loans and interest payments to financial institutions.



Owner's equity: Owner's equity is the money that the owners of the business have put into the business. It also includes the owner's claim on the assets of the business.



To understand a balance sheet better, let us take a look at the elements of balance sheet of a fictitious company, Innovative Products, Inc. The balance sheet is shown on the next page. As you can see, the balance sheet shows all assets on top, and then all liabilities and shareholder’s equity below the assets. This style of presentation is called report form or vertical presentation. Alternatively, balance sheet can also be presented in a horizontal format in which the assets will be shown on the left side, and liabilities and equity will be shown on the right hand side. In a balance sheet, the total assets will always be equal to the sum of liabilities and shareholder’s equity.



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Elements of Balance Sheet

The main purpose of the balance sheet statement is to report a company’s financial position on a particular date.&nbsp;



<h3>Uses</h3>



Balance sheet is an important statement in financial analysis and has many uses:



<ul><li>The balance sheet provides a clear assessment of the resources available with a company to generate future cash flows.</li><li>The balance sheet also provides information about the liquidity position of the firm, that is, its ability to meet its short-term obligations.</li><li>The balance sheet also provides information about the long-term solvency of the company.</li></ul>



<h3>Limitations</h3>



The balance sheet also has a few limitations:



<ul><li>By looking at the balance sheet an analyst cannot determine the market value of the firm, nor can he find its liquidation value. This is because many assets such as land and building are recorded at historical costs rather than market value.</li><li>The balance sheet does not record many important intangible items such as employee skills, knowledge, management experience, and reputation.</li></ul>

Balance Sheet in Financial Analysis

The asset side of the balance sheet is presented below:



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Assets are what the company owns, and this section of the balance sheet tells you what kind of assets the company owns, and the value of those assets.&nbsp;



The assets can be broadly classified into current assets and non-current assets.&nbsp;



<h3>Current Assets</h3>



Current assets include cash, accounts receivable, marketable securities, inventory, and prepaid expenses such as taxes and insurance. These are the assets that can be converted into cash in the near future, usually less than one year.



<ul><li>Cash and Cash-equivalents&nbsp;– The first kind of current assets are the most liquid – cash or cash equivalents. Cash equivalents include negotiable items such as commercial paper, money market funds, and U.S. treasury bills. Next are marketable securities, which are short-term investments that can easily be transitioned to cash.</li><li>Accounts receivable&nbsp;– This refers to money due to the company from sales to customers.</li><li>Inventory&nbsp;– This is an investment that the company has made in the manufacture and production of goods.</li><li>Prepaid expenses&nbsp;– These are expenses the company has paid ahead of time. This could include rent, payment on leases, or other expenses paid ahead of time.</li></ul>



<h3>Non-current Assets</h3>



Noncurrent assets include investments, property, plant and equipment, intangibles, goodwill and other long-term assets.&nbsp;&nbsp;Noncurrent assets are not expected to be converted to cash or consumed within one year or the operating cycle, whichever is longer.&nbsp;&nbsp;&nbsp;



Property, Plant, and Equipment (PP&amp;E)



<ol type="1"><li>Property, plant, and equipment – These include the land, building, machines, equipment, and furniture, which are valued at the purchase price or original market value, whichever is lower.</li><li>Depreciation – Depreciation is an important consideration for assets that fall in the category of property, plants, and equipment. Depreciation means the apportionment of the cost of these assets over their useful lives.  The accumulated depreciation is the amount that has been recorded as depreciation expense since the date the asset was purchased. The balance in the accumulated depreciation account is deducted from the original cost of the fixed assets.</li></ol>



Under IFRS, PP&amp;E can be reported using the cost model or the revaluation model. Under U.S. GAAP, PP&amp;E can be reported using only the cost model.



We will discuss other assets in the following lessons.

Asset Side of the Balance Sheet

These are the assets that are not directly used in the operations of the business. This includes investments in debt and equity securities of other companies, land purchased to profit from price appreciation, noncurrent receivables, and any cash kept aside for a special purpose that is not accounted for as current asset.



The financial investments can be classified as follows:



1. Held-to-Maturity (HTM) securities (or debt investments)



An HTM security is a debt investment made by an investor company that is intended to be and able to be held until it matures.&nbsp; HTM securities are typically reported under long-term assets on the balance sheet.&nbsp; The investor company carries HTM investments at amortized cost.



2. Available for Sale (AFS) securities&nbsp;



AFS securities include equity securities that an investor company does not intend to trade in the short term and debt securities that the investor company does not into to trade short term and not classified as HTM.



AFS securities can be reported on the balance sheet as current assets or long-term assets.



AFS securities are reported at fair value.



Income Statement:&nbsp;Dividend income, interest income, realized gains and realized losses from AFS securities are reported on the investor company’s income statement.



Unrealized Gains and Losses from AFS Securities:



<figure class="wp-block-table"><table><tbody><tr><td>GAAP</td><td>IFRS</td></tr><tr><td>Appreciation in market value of AFS securities are not reported on the income statement and do not impact net income. AFS market value changes are reflected on the balance sheet; the difference between net income and the equity value on the balance sheet is reconciled by the firm’s other comprehensive income (OCI) activities. Once the AFS securities are sold, the accumulated OCI adjustments to the balance sheet are reversed and a gain or loss is finally recognized on the company’s income statement.</td><td>Applies a designation called “net income recognized directly in equity” which is similar to OCI in GAAP.</td></tr></tbody></table></figure>



3. Held for Trading (HFT) securities



Debt or equity securities that an investor company intends to trade, commonly within the next quarter.



Balance Sheet:&nbsp;HFT securities are typically current assets and reported at fair value.



Income Statement:&nbsp;Under both IFRS and GAAP, dividend income, interest income, realized gains and losses, and unrealized gains and losses are reported on the income statement.



Example:Thinking about the nature of HFT securities, many companies are not likely to frequently report HFT assets on the balance sheet.&nbsp; A company likely to regularly report HFT securities on its balance sheet would be a financial services firm, as a standard business activity for an entity like an investment bank could involve trading securities.



4. Designated Fair Value Instruments&nbsp;



As of 2009, both IFRS and GAAP allowed companies to designate financial assets as fair value instruments.&nbsp; Once this classification is made, it cannot be changed and the reporting is similar to that of HFT securities, as unrealized gains and losses are reported directly on the income statement and not as part of other comprehensive income or net income recognized directly in equity.

Non-current Assets - Investments and Funds

<h3>Intangible Assets</h3>



These include copyrights, patents, franchises, etc., that the business uses in its operations to generate future cash flow, but does not have any physical form.



Any other assets which do not fall in any of the above categories are classified as other assets. An example is long-term pre-paid expenses.



The assets section of the balance sheet provides you with a big picture overview of the financial health of the company. By understanding the balance sheet, you'll understand how much money the company has.&nbsp;



<h3>Goodwill</h3>



While goodwill is an intangible asset, it is listed as a separate item on the company’s balance sheet.Note that some assets such as goodwill have infinite life. Such assets are not amortized. Instead goodwill is impaired under US GAAP. The companies are required to determine the fair value of the reporting units, using present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities.) If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so the fair value is equal to carrying value. The impairment loss is reported as a separate line item on the income statement as an expense, and new adjusted value of goodwill is reported in the balance sheet. This is done atleast annually.&nbsp;

Intangible Assets and Goodwill

The liability side of the balance sheet is presented below:



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The liability side of the balance sheet tells you how much money the company owes. The liabilities can be broadly classified as current liabilities and non-current liabilities. Non-current liabilities include long-term liabilities and deferred tax liabilities.&nbsp;



<h3>Current Liabilities</h3>



<ul><li>Accounts payable&nbsp;– These are the bills for which the company owes money to vendors or suppliers. This includes operating expenses and inventory. The company has bought these services on credit. The money is generally due within 30 to 60 days.</li><li>Bank notes&nbsp;– These are money the company has borrowed from a commercial lender, such as a bank. The money must be repaid to the bank within one year.</li><li>Other current liabilities&nbsp;– These are short-term liabilities, usually accruals. Companies always owe employee salaries, interest, and taxes. Unpaid expenses are estimated and listed as accruals.</li><li>Current portion of long-term debt&nbsp;– The current portion of long-term debt are the current liabilities that were originally long-term debts when the company originally borrowed the money. However, time has passed, and the amounts listed in the section are due in less than a year.</li><li>Total current liabilities&nbsp;– This is the sum of accounts payable, bank notes, other current liabilities, and the current portion of long-term debt. The total current liabilities are due within one year of the date of the balance sheet.</li></ul>



<h3>Long-term Debt&nbsp;</h3>



This refers to money the company borrowed that is a long-term loan. The loan matures anywhere from just over a year to thirty years. There are a variety of ways to fund this debt – debentures, mortgage bonds and convertible bonds. It can also include tax liabilities. Financial liabilities such as loans, notes payable, etc. are shown on balance sheet at amortized cost. Some long-term liabilities are also shown at fair value. These include held-for-trading liabilities, derivatives, and liabilities hedged with derivatives.



These are the types of liabilities that are listed on the balance sheet. Understanding these liabilities helps you see what kind of debt the company is carrying.&nbsp;

Liabilities Side of Balance Sheet

Shareholders’ Equity is the residual interest in the assets of an entity that remains after deducting liabilities.&nbsp;



Shareholders’ equity includes:



<ul><li>Common stock:&nbsp;This is the amount contributed by common shareholders.</li><li>Preferred stock:&nbsp;Preferred stock is a hybrid form of financing, sharing some features with debt and some with common equity. It pays the preferred stockholder a fixed, agreed-upon dividend at regular intervals.</li><li>Treasury stock:&nbsp;These are the shares that a company has issued and later reacquired. Purchasing treasury stock decreases assets and stockholders’ equity</li><li>Retained earnings:&nbsp;This refers to the income that has been retained in the business (that is, not paid out in dividends to stockholders) over life of business.&nbsp;&nbsp;</li><li>Non-controlling interest (Minority interest):&nbsp;A minority investment or a minority interest refers to the non-controlling share in a company held by an investor or another company. For example, a private equity firm may have a non-controlling share in a company. The minority investment is usually less than 50% of the total outstanding shares of the company.&nbsp;</li><li>Accumulative other comprehensive income:&nbsp;This reflects the changes in a company’s equity during the accounting period other than net income and contributions by or distributions to the company’s owners.</li></ul>

Stockholders' Equity

The balance sheet provides a broad picture of the company’s financial position along with the details about its assets and liabilities. However, if an analyst wants to take a close look at the shareholder’s activities, he will use the&nbsp;statement of changes in shareholder’s equity.



The statement of changes in shareholder’s equity provides a summary changes in balance sheet equity accounts from one accounting period to the next. This statement is an important link between the balance sheet and the income statement



Presented below is a sample statement of changes in shareholder’s equity.



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Statement of Changes in Shareholder’s Equity

In a common size balance sheet, each element of the balance sheet is presented as a percentage of total assets. A common-size statement helps in comparison of different companies as it eliminate the effects of size of the business. Common size income statement can be used to time-series analysis of the same company over time or to perform cross-sectional analysis across firms.



To prepare a common size balance sheet, we divide each entry in the balance sheet by the firm’s total assets.



Presented below is the common size balance sheet of a company for two years 2012 and 2013.



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Common Size Balance Sheet

This quiz is a part of the CFA Level 1 reading 'Understanding Balance Sheets'. 

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Understanding Balance Sheets

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