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Chapter 4:
Understanding
Balance Sheets

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 Contents

1 Components and Format of Balance

Sheet
2 Measurement Bases of Assets and
Liabilities
3 Equity

4 Uses and Analysis of the Balance

Sheet
5
1. Components and Format of the Balance
Sheet
The balance sheet is also known as the
statement of financial position or
statement of financial condition.
Express an entity’s financial position at a
point of time in terms of:
Assets
Liabilities
Equity
Purposes of Balance sheet

To help users answer:

Does the company have enough assets to
pay debts ?
What is the company’s value ?
Was the company added value the last year
?
 balance sheet elements

Assets (A): resources controlled by the

company as a result of past events and from
which future economic benefits are expected
to flow to the entity.

Liabilities (L): obligations of a company arising

from past events, the settlement of which is
expected to result in an outflow of economic
benefits from the entity.

Equity (E): represents the owners’ residual

interest in the company’s assets after deducting
its liabilities.

Copyright © 2013 CFA

 Accounting Equation

Assets – Liabilities = Equity

Assets = Liabilities + Equity

Reflects the Reflects how those resources were

resources financed
controlled by
the company

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ASSETS

“Resourses controlled by a company for the

purpose of generating profit”
Classification based on the convertibility to
cash
Current (Short-term) assets
Non-current (Long-term) assets
 Asset Classification
Current
Current (Short-
(Short- Noncurrent
Noncurrent
term)
term) Assets
Assets (Long-term)
(Long-term)
Assets
Assets
Resources
Resources or or claims
claims to to Resources
Resources or or claims
claims to
to
resources
resources that
that are
are resources
resources thatthat are
are
expected
expected toto be
be sold,
sold, expected
expected to to be
be sold,
sold,
collected,
collected, or
or used
used collected,
collected, or or used
used that
that
within
within one
one year
year oror the
the extend
extend beyond
beyond oneone
operating
operating cycle
cycle ofof the
the year
year or
or the
the operating
operating
business.
business. cycle
cycle of
of the
the business.
business.
Current assets

Cash & cash equivalents

Other financial assets (short-term
marketable securities)
Receivables
Inventories
Prepaid expenses

DA
C
 Cash and Cash Equivalents
Cash: currency, coins, check received (but not yet
deposited), checking accounts, petty cash, savings
accounts, money market accounts.
Cash equivalent are highly liquid, short-term
investments that are so close to maturity, the risk
is minimal that their value will change significantly
with changes in the interest rates.
E.g., marketable securities, commercial
paper, Treasury bills and short-term government
bonds with a maturity date of three months or less.
Marketable securities and money market holdings are
considered cash equivalents because they are liquid
and not subject to material fluctuations in value with
a maturity date of three months or less.

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 Cash and Cash Equivalents

The amount of cash and cash equivalents

will be reported on the balance sheet as
the first item in the listing of current
assets.
The change in the amount of cash and
cash equivalents during an accounting
period is explained by the statement of
cash flows

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 Marketable Securities

Marketable securities are other short-term

financial assets (except for cash and cash
equivalents)
Including: investments in debt (bonds,
treasury bills, notes) or equity securities
(comment stocks, mutual fund shares
investments in debt with a maturity
date of more than three months.

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 Trade Receivables
Are the amounts owed to a company by its
customers for products and services
already delivered.
Are typically reported at net realizable
value, an approximation of fair value,
based on estimates of collectability.
Issues relate to trade receivables:
Relationship between the changes of trade
receivables and sales reflect the company’s
trading policies or problems of collecting cash
Estimation of the allowance for doubtful
accounts
Concentration of credit risk

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 Inventories

Are physical products that will eventually

be sold to the company’s customer.
Including:
Inputs into a process to manufacture a final
product: raw materials and work in process
Finished goods
Inventories is sold, the cost of that
inventories is reported as an expense
(COGS)
Inventory valuation methods:
IFRS: FIFO, weighted average cost, specific
identification methods
US GAAP: also allow LIFO
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 Other Current Assets

Reflects items that are individually not

material enough to require a separate line
items on the balance sheet, and so are
aggregated into a single amount.
Companies usually disclose the
components in a note to the financial
statements.
E.g., prepaid expenses (advance payment)

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Long-term assets

Investments
Tangible fixed assets (Property, plant &
Equipments)
Intangible assets (i.e. patents, copyrights,
trademarks, goodwill)
Financial leases
Deffered charges

Kinhdo Kinhdo31-5
4
Property, Plant and Equipment (PPE)

PPE are tangible assets that are used in

company operation and expected to be
used (provide economic benefits) over
more than one fiscal period.
E.g., land, building, equipment,
machinery, furniture and nature resources
(mineral and petroleum resources)
Depreciation is the process to allocate the
cost of long-lived assets over its useful
life.

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 Intangible assets

Are indefinable non-monetary assets

without physical substance.
E.g., licenses, patents, trademarks,
copyrights, franchises, goodwill…
Intangible assets are amortized on a
systematic basis over the best estimated
of their useful life.

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 Deferred Charge

A deferred charge is a long-term prepaid expense

that is treated as an asset on a balance
sheet and is carried forward until it is
actually used.
Deferred charges often stem from a
business making a payment for a good or
service that it has not yet received, such
prepaying insurance premiums or rent.

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Copyright © 2012 CFA
 LIABILITIES

“an obligation of an entity arising

from past transactions or events, the
settlement of which is expected to result in an
outflow from the enterprise of resources
embodying economic benefits.
Classification based on time of payment.
Short-term liabilities
Long-term liabilities
 Liabilities

Current liabilities: are liabilities

expected to be settled within one year or
within one operating cycle of the business,
whichever is greater, after the reporting
period
Non-current liabilities: are all others
liabilities.
Working capital = current assets – current
liabilities
Working capital tell analysts about the
ability of an entity to meet liabilities as
they fall due.
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Copyright © 2012 CFA
 Current liabilities

Trade payables, also known as accounts payable: Amounts

that a company owes its vendors for purchases of goods and
services—in other words, the unpaid amounts of the
company’s purchases on credit as of the balance sheet date.
Notes payable: Financial liabilities owed by a company to
creditors, including trade creditors and banks, through a formal
loan agreement.
Accrued expenses (also called “accrued expenses payable,”
“accrued liabilities,” and other “nonfinancial liabilities”) are
expenses that have been recognized on a company’s income
statement but that have not yet been paid as of the balance
sheet date.
Deferred income (also called “deferred revenue” and
“unearned revenue”) arises when a company receives
payment in advance of delivery of the goods and services
associated with the payment.

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 Non-Current liabilities

Long-term financial liabilities: Include loans (i.e.,

borrowings from banks) and notes or bonds payable
(i.e., fixed-income securities issued to investors).
Usually reported at amortized cost on the balance
sheet.
In certain cases, liabilities, such as bonds, issued by
a company are reported at fair value.

Deferred tax liabilities: Amount of income taxes

payable in future periods with respect of taxable
temporary differences.
Result from temporary timing differences between a
company’s income as reported for tax purposes
(taxable income) and income as reported for
financial statement purposes (reported income).

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components of shareholders’ equity

Capital contributed by owners (or common stock

or share capital)
Preferred shares
Treasury shares (or treasury stock)
Retained earnings
Accumulated other comprehensive income (or
other reserves, items recognized directly in
equity)
Noncontrolling interest (or minority interest)

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 EQUITY

“the claims of owners on the net assets of the

company (ownership in total assets after all
liabilities associated are paid off).”
Including:
Common stock / Preferred stock
Paid-in capital (Additional paid-in capital or
contributed capital)
Retained earnings
 Components of equity

Capital contributed by owners (common stock, or issued capital):

the amount contributed to the company by owners.
Preferred shares: classified as equity or financial liabilities based
upon their characteristics rather than legal form.

Perpetual, non-redeemable preferred shares are classified as

equity
Preferred shares with mandatory redemption at a fixed
amount at future date are classified as financial liabilities

cổ phiếu thường khác với cổ phiếu ưu đãi

cổ phiếu ưu đãi bớt rủi ro hơn cổ phiếu thường

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 Components of equity

Treasury shares (or treasury stock or

own shares repurchased): are shares in
the company that have been
repurchased by the company.
A purchase of treasury shares reduces
shareholders’ equity by the amount of
acquisition cost and reduce number of
total shares outstanding.

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 Components of equity
Retained earnings = net income -
devidends : the cumulative amount of earnings
recognized in the company’s income statements
which have not been paid to the owners of
the company as dividend.
Accumulated others comprehensive income
(or other reserves): the cumulative amount of
other comprehensive income or loss
Non-controlling interest ( lợi ích của cổ đông
thiếu số/ cổ đông không kiểm soát) (or
minority interest): the equity interest of
minority shareholders in the subsidiary
companies that have been consolidated by the
parent(controlling) company but that are not
wholly owned by the parent company
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Copyright © 2012 CFA
3. MEASUREMENT BASES OF ASSETS AND LIABILITIES

Fair value. Fair value is the amount at

which an asset could be exchanged, or a
liability settled, between knowledgeable
willing parties in an arm’s-length
transaction.
Historical cost. The historical cost of an
asset or liability is its cost or fair value at
acquisition, including any costs of
acquisition and/or preparation.

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Limitations of BS in financial analysis

The balance sheet is a mixed model with

respect to measurement (some items at
historical cost, some items at current
value). (Special time)
Even current value reflects a value that was
current at the end of the reporting period.
Future cash flows, which affect value, are
driven by items excluded from the balance
sheet (e.g., reputation, management skills).

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 Statement of Change in Equity

Presents information about the increases

or decreases in a company’s equity over a
period

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 Analysis of balance sheets

Analytical Tools
Common-size analysis.
Balance sheet ratios.
Liquidity
A company’s ability to meet its short-term financial
commitments.
Assessment focus: The company’s ability to convert
assets to cash and to pay for operating needs.
Solvency
A company’s ability to meet its financial obligations
over the longer term.
Assessment focus: The company’s financial structure
and its ability to pay long-term financing obligations.

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 common-size balance sheets

Common-size balance sheets show each line item

on the balance sheet as a percentage of total
assets.
Common-size statements facilitate comparison
across time periods (time-series analysis) and
across companies (cross-sectional analysis)
because the standardization of each line item
removes the effect of size.
This format can be distinguished as “vertical
common-size analysis.”

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 common-size balance sheets

($ thousands) A B C
ASSETS
Cash, cash equivalents, marketable
1,900 200 3,300
securities
Accounts receivable 500 1,050 1,500
Inventory 100 950 300
Total current assets 2,500 2,200 5,100
Property, plant, and equipment, net 750 750 4,650
Goodwill 0 300 0
Total assets 3,250 3,250 9,750
LIABILITIES AND EQUITY
Accounts payable 0 2,500 600
Total current liabilities 0 2,500 600
Long-term bonds payable 10 10 9,000
Total liabilities 10 2,510 Copyright
9,600 © 2013 CFA
 common-size balance sheets

(percent of total assets) A B C

ASSETS
Cash, cash equivalents, marketable 58.46 33.85
6.15%
securities % %
15.38 32.31 15.38
Accounts receivable
% % %
29.23
Inventory 3.08% 3.08%
%
76.92 67.69 52.31
Total current assets
% % %
23.08 23.08 47.69
Property, plant, and equipment, net
% % %
Goodwill 0.00% 9.23% 0.00%
100.00 100.00 100.00
Total assets
% % %
LIABILITIES AND SHAREHOLDERS’ Copyright © 2013 CFA
 common-size balance sheets
(percent of total assets) A B C
ASSETS
Cash, cash equivalents, marketable
58% 6% 34%
securities
Accounts receivable 15% 32% 15%
Inventory 3% 29% 3%
Total current assets 77% 68% 52%
Property, plant, and equipment, net 23% 23% 48%
Goodwill 0% 9% 0%
100 100 100
Total assets
% % %
LIABILITIES AND SHAREHOLDERS’
EQUITY
Accounts payable 0% 77% 6%
Total current liabilities 0% 77% 6%
Long-term bonds payable 0% 0% 92%
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 Analysis of balance sheets

Liquidity
A company’s ability to meet its short-term financial
commitments.
Assessment focus: The company’s ability to convert
assets to cash and to pay for operating needs.
Solvency
A company’s ability to meet its financial obligations
over the longer term.
Assessment focus: The company’s financial structure
and its ability to pay long-term financing obligations.
Analytical Tools
Common-size analysis.
Balance sheet ratios.

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 Balance sheet Ratios: liquidity ratios

Liquidity ratios indicate a company’s ability to

meet current liabilities.
hệ số khả năng thanh toán nhanh
Ratio Calculation
Current Current assets /Current liabilities
Quick (acid (Cash + Marketable securities +
test) Receivables) / Current liabilities
Tài sản ngắn hạn nhanh (inventory/ …)
thanh toán chậm
Cash (Cash + Marketable securities) /
Current liabilities

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 Balance sheet Ratios: Solvency Ratios

Solvency ratios indicate financial risk and financial

leverage and a company’s ability to meet its financial
obligations over time.
Ratio Calculation
Long-term debt to equity Total long-term debt ÷ Total equity
Debt to equity Total debt ÷ Total equity
Total debt (also known Total debt ÷ Total assets
as debt to assets)
Debt to capital Total debt ÷ (Total debt + Total
equity)
Financial leverage Total assets ÷ Total equity

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 Solvency
Liquidity
A company’s ability A company’s
to meet short- ability to meet
term obligations. long-term
Are the company’s obligations.
current assets What is the
adequate to its company’s capital
current liabilities? structure?
How much of cash
Is the company
does the company
able to pay
generate from
borrowings’
operations?
interests and
principals when
come due?
 II. LIQUIDITY ANALYSIS

CAN NOT MEET SHORT TERM OBLIGATION!

Lê Thu Hằng
 Liquidity

How well positioned is the firm to meet its near-

term obligations?

Current ratio = Current assets/Current liabilities

Quick ratio = (Cash + Short-term marketable

investments + Account receivables)/Current
liabilities

Cash ratio = (Cash + Short-term marketable

investments)/ Current liabilities
 II. LIQUIDITY ANALYSIS

Current assets
Current ratio =
Current liabilities

Cash + ST investment +
Quick ratio Accounts receivable
=
Current liabilities

Cash + ST investment
Cash ratio =
Current liabilities
 CURRENT RATIO
Current assets
Current ratio =
Current liabilities

Current assets include:

Cash
Short-term marketable investments
Receivables
Inventory
Other
 CURRENT RATIO

Meaning?

Measure a firm’s ability to pay short-term

obligations by its current assets
 CURRENT RATIO
Current assets
Current ratio =
Current liabilities

Current assets include:

Cash
Short-term marketable investments
Receivables
Inventory
Other
 QUICK RATIO
Cash + ST investments +
Quick ratio = Receivables
Current liabilities

Current assets include:

Cash
Short-term marketable investments
Receivables
Inventory
Other
 QUICK RATIO

Meaning?

Measure a company’s ability to pay its

current liabilities with more liquid assets.
(excluding inventory)
QUICK RATIO

High proportion in current

asset
Policy of sale or Bad
debt!
CASH RATIO
 Discussion by category

Category Description
Activity Activity ratios. How efficient are the firm’s
operations and the firm’s management of
assets?
Liquidity Liquidity ratios. How well is the firm positioned
to meet short-term obligations?
Solvency Solvency ratios. How well is the firm
positioned to meet long-term obligations?

Profitability Profitability ratios. How much and how is the

firm achieving returns on its investments?
Valuation Valuation ratios. How does the firm’s
performance or financial position relate to its
market value?
 Practice

Calculate the liquidity and the activity

ratios of a company that listed on stock
market
Analyze these ratios
 Discussion by category

Category Description
Activity Activity ratios. How efficient are the firm’s
operations and the firm’s management of
assets?
Liquidity Liquidity ratios. How well is the firm positioned
to meet short-term obligations?
Solvency Solvency ratios. How well is the firm
positioned to meet long-term obligations?

Profitability Profitability ratios. How much and how is the

firm achieving returns on its investments?
Valuation Valuation ratios. How does the firm’s
performance or financial position relate to its
market value?
Solvency: How well positioned is the firm to
meet its long-term liabilities?

Debt ratios: How has the company financed itself?

Debt to total assets
Debt to equity
Debt to total capital} Lower ratio –> safer.
Higher cushion against
potential creditor losses
Coverage ratios: Degree to which earnings or cash
flow can decline without affecting firm’s ability to pay
interest.
EBIT interest coverage = (EBT + Interest
payments)/Interest payments
Fixed charge coverage = (EBIT + Lease
payments)/(Interest payments + Lease payments)
 Common solvency ratios

Solvency ratios Numerator Denominator

Debt ratios
Debt-to-assets ratio Total debt Total assets
Debt-to-capital ratio Total debt Total debt + Total
shareholders’ equity
Debt-to-equity ratio Total debt Total shareholders’
equity
Financial leverage Average total Average total equity
ratio assets

Coverage ratios
Interest coverage EBIT Interest payments
Fixed charge EBIT + Lease Interest payments +
coverage payments Lease payments
 summary

Balance Sheet: what an entity owns (or controls),

what it owes, and what the owners’ claims are at
a specific point in time.
Balance sheets usually present current and
noncurrent assets and liabilities.
Accounting issues relate primarily to
measurement (historical cost versus fair value).
Tools for balance sheet analysis include common-
size analysis and balance sheet ratios.
Balance sheet ratios indicate liquidity and
solvency.

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