FINANCIAL STATEMENT

CFA LEVEL 1 ANALYSIS

CHAPTER 4
“CRAFTING YOUR
CFA TRIUMPH
WITH EFFECTIVE
SUMMARIES.”
CONCEPT NOTES
Understanding Balance Sheets
-Balance sheet basics 1
-Presentation formats 3

-Current assets 5

-Current liabilities 6

-Non current assets 7

-Intangible assets 8

-Marketable securities 10

-Non current liabilities 13

-Shareholders’ equity 14

-Common size balance sheet 16

TABLE OF
CONTENTS
Understanding Balance Sheets
What is a balance sheet?
A balance sheet is a financial statement that provides a snapshot of a company's
financial position at a specific moment in time, typically at the end of an
accounting period, such as a quarter or fiscal year. It presents a summary of a
company's assets, liabilities, and equity, which helps stakeholders, including
investors, creditors, and management, assess the financial health and stability of
the business.
Key components of a balance sheet are:

ASSETS

Assets are everything that a company owns and has value. This includes
cash, accounts receivable, inventory, etc. They are typically categorized
as current assets (those expected to be converted to cash within one
year) and non-current assets (providing long-term benefits).

LIABILITIES

Liabilities are the company's financial obligations or debts. They can

include accounts payable, loans, bonds, etc. Like assets, liabilities are
categorized as current liabilities (due within one year) and non-current
liabilities (due beyond one year).

EQUITY

Equity represents the owner's interest in the company's assets after

deducting its liabilities. It is often referred to as owner's equity or
shareholder's equity, depending on the ownership structure of the
company. It includes investments by shareholders, retained earnings
(profits reinvested in the business), and other equity-related items.

1 | CFA L1 NOTES
The balance sheet follows the fundamental accounting equation:
Assets = Liabilities + Equity
This equation ensures that a company's resources (assets) are financed either by
external sources like creditors (liabilities) or internal sources like shareholders
(equity). The balance sheet is a critical tool for assessing a company's financial
strength, its ability to meet its obligations, and its overall financial performance.

What balance sheet values convey us?

Balance sheet values provide valuable insights in the context of financial
statement analysis.
Liquidity and Working Capital: The composition of current assets and
current liabilities on the balance sheet helps assess a company's short-term
liquidity. A higher ratio of current assets to current liabilities suggests better
liquidity and the ability to cover short-term obligations.
Debt Levels: The balance sheet reveals the extent of a company's debt by
showing long-term and short-term liabilities. High levels of debt can
indicate increased financial risk and interest expense.
Asset Quality: The types and proportions of assets on the balance sheet
can reveal the nature of a company's operations. For instance, a technology
company may have a significant portion of its assets in intangible assets like
patents and software, while a manufacturing company may have substantial
investments in physical assets.
Equity and Ownership: Equity on the balance sheet reflects the owners'
stake in the company. By examining changes in equity over time, you can
track the company's profitability and the extent to which it retains earnings
or distributes them to shareholders.

"Balance sheets are like snapshots of a company's

financial soul, capturing its assets, liabilities, and
equity at a single moment in time, revealing the
essence of its financial health."

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What are the common presentation formats for balance sheet?
The presentation format of a balance sheet can vary depending on the
accounting standards and reporting preferences of a company. Two common
presentation formats are the classified balance sheet format and the liquidity-
based format:
Classified Balance Sheet Format:
Assets and Liabilities Classification: In a classified balance sheet,
assets and liabilities are categorized into two main categories: current and
non-current (or long-term).
Current Assets: Current assets are those expected to be converted into
cash or used up within one year or the operating cycle of the business,
whichever is longer. Common examples include cash, accounts receivable,
inventory, and prepaid expenses.
Non-Current Assets: Non-current assets, also known as long-term assets,
are assets that are not expected to be converted into cash or used up within a
year. These can include property, plant, equipment, intangible assets, and
long-term investments.
Current Liabilities: Current liabilities are obligations expected to be
settled within one year or the operating cycle. Examples include accounts
payable, short-term loans, and accrued expenses.
Non-Current Liabilities: Non-current liabilities are obligations due
beyond one year and often include long-term debt, deferred tax liabilities,
and other long-term obligations.
Equity: Equity, representing the ownership interest in the company, is
typically presented below the liabilities section on the balance sheet.
Total: The balance sheet ensures that the total assets equal the total
liabilities and equity, in accordance with the fundamental accounting
equation (Assets = Liabilities + Equity).
The classified balance sheet provides a structured view of a company's financial
position bifurcating the line items into prescribed categories and sub-categories
for better understanding of the business position.

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Liquidity-Based Format:
Assets Classification by Liquidity: In a liquidity-based format, assets
are presented in order of their liquidity, with the most liquid assets listed
first. This format provides a clear picture of how quickly assets can be
converted into cash.
Current vs. Non-Current Focus: While a classified balance sheet
separates current and non-current items, a liquidity-based format prioritizes
liquidity over the time horizon. Therefore, current assets are still presented
at the top, but they are arranged in order of liquidity, followed by non-
current assets.
Liquidity Ratios: This format can be particularly useful for analyzing
liquidity ratios, such as the current ratio (current assets divided by current
liabilities), as it emphasizes the most liquid assets available to cover short-
term obligations.
Decision-Making: The liquidity-based format can be beneficial for
assessing a company's ability to meet short-term financial needs and
obligations quickly. It highlights the readily available resources.
The liquidity-based format emphasizes the liquidity of assets for short-term
decision-making specifically, but is also used to make future projections
regarding long-term sustainability. It is important to note that certain industries
prefer this format such as banking, insurance and investment
companies since for them, liquidity is a crucial aspect.

"Classified balance sheets classify a company's

financial snapshot into neat categories, while
liquidity-based balance sheets reveal the
financial fluidity of its assets."

A real estate investment trust (REIT) might prefer a

liquidity-based format for showcasing its ability to
quickly buy and sell real estate, which is essential
for meeting distribution requirements to investors.

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What are current assets?
Current assets are a category of assets on a company's balance sheet that
represent resources expected to be converted into cash or used up within one
year or the company's operating cycle, whichever is longer. They are an essential
component of a company's liquidity and short-term financial health. Current
assets are typically listed on the balance sheet in the order of their liquidity, with
the most liquid assets appearing first. Here are some common types:
Cash and Cash Equivalents: This category includes physical cash, as well
as highly liquid assets that are easily convertible into cash within a short
period, typically with maturities of three months or less. Examples include
cash on hand, bank deposits, and money market instruments.
Accounts Receivable: Accounts receivable represent amounts owed to
the company by its customers or clients for goods or services that have been
delivered but not yet paid for. They are usually expected to be collected
within a short time frame, often within 30 to 90 days.
Inventory: Inventory comprises goods or products held by the company for
sale or for use in the production of goods for sale. It includes raw materials,
work-in-progress, and finished goods. Inventory is expected to be sold or
used in the production process within the operating cycle of the business.
Prepaid Expenses: Prepaid expenses are payments made in advance for
goods or services that the company will receive in the future. As these
expenses are incurred, they are gradually recognized as expenses on the
income statement. Common examples include prepaid rent, insurance
premiums, and prepaid advertising.
Short-Term Investments: Some short-term investments, such as
marketable securities, are classified as current assets if they are readily
convertible into cash and have a maturity date within one year. These
investments are often considered highly liquid and low-risk.
Other Current Assets: This category may include a variety of smaller,
short-term assets that don't fit into the above categories. Examples could be
deposits, advances to suppliers, or other receivables that are expected to be
realized within the short term.

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What are current liabilities?
Current liabilities are financial obligations or debts that a company is expected to
settle within a relatively short period, typically within one year or one operating
cycle, whichever is longer. These obligations arise as a result of day-to-day
business operations and are an essential part of a company's balance sheet,
which provides a snapshot of its financial health at a specific point in time.
Understanding current liabilities is crucial for assessing a company's liquidity
and short-term financial stability. Here are some common types:
Accounts Payable: These are amounts owed to suppliers and vendors for
goods and services received but not yet paid for. Accounts payable can
include invoices, bills, and other payable amounts.
Short-Term Loans: These are loans or credit arrangements with a
maturity of less than one year. Companies often use short-term loans to
finance working capital needs or bridge temporary cash flow gaps.
Accrued Liabilities: These are expenses that have been incurred but have
not yet been paid. Examples include accrued salaries and wages, accrued
interest, and accrued taxes. These obligations are recognized on the balance
sheet to match expenses with revenue recognition principles.
Income Taxes Payable: Companies owe income taxes on their profits,
and the portion that is expected to be settled within the next year is classified
as a current liability.
Deferred Revenue (Unearned Revenue): This arises when a company
receives advance payments from customers for goods or services that have
not yet been delivered. As the company fulfills its obligations, the deferred
revenue is gradually recognized as revenue.
Short-Term Portion of Long-Term Debt: Long-term loans or bonds
may have a portion that is due within the next year. This portion is classified
as a current liability, while the remainder is considered long-term debt.
Other Current Liabilities: This category may include various other
short-term obligations, such as warranty liabilities, legal settlements, and
short-term lease obligations.

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What are non-current assets?
Non-current assets, also known as long-term assets or fixed assets, are items of
value that a company holds for more extended periods, typically exceeding one
year or one operating cycle. These assets are essential for a company's operations
and are not intended for immediate sale. Non-current assets represent the more
permanent or durable aspects of a company's resources and are recorded on the
balance sheet as they provide future economic benefits. Here are some common
types:
Property, Plant, and Equipment (PP&E):
Land: The cost of acquiring land and any improvements made to it.
Buildings: The cost of constructing or acquiring buildings used for
business operations.
Machinery and Equipment: The cost of machinery, equipment, and
tools used in production or operations.
Vehicles: The cost of company-owned vehicles used for business
purposes.
Furniture and Fixtures: The cost of office furniture, fixtures, and
fittings.
Intangible Assets:
Goodwill: The excess of the purchase price over the fair market value
of tangible assets and liabilities in a business acquisition. Goodwill
represents the intangible value of a company's brand, reputation,
customer relationships, and other non-physical assets.
Patents: Exclusive rights granted to inventors for their inventions,
providing protection from unauthorized use for a specified period.
Trademarks and Brands: Identifiable symbols, names, and logos
associated with a company's products or services.
Copyrights: Exclusive rights granted to authors and creators to protect
their original works of authorship.
Software: The cost of acquiring or developing software used in the
business.

7 | CFA L1 NOTES
 Investments:
Long-Term Investments: These include investments in stocks,
bonds, and other securities that a company intends to hold for an
extended period, often with the expectation of earning a return on
investment or influencing another company's operations.
Investment in Subsidiaries, Associates, and Joint Ventures:
When a company has a significant ownership interest in other entities, it
records these investments as non-current assets using the equity
method or cost method.
Deferred Charges and Other Non-Current Assets:
This category may include various items that don't fit into the above
categories but have a long-term value. For example, prepaid expenses
that will benefit the company over an extended period, like prepaid
insurance or prepaid rent.
Non-current assets are crucial for a company's long-term growth and stability.
They play a significant role in generating revenue and supporting day-to-day
operations. The value of these assets may change over time due to factors like
depreciation, impairment, or market fluctuations. Investors and analysts closely
monitor non-current assets to assess a company's ability to generate future cash
flows, its overall financial health, and its potential for long-term success.

What are intangible assets?

Identifiable Intangible Assets and Unidentifiable Intangible Assets are two
categories of intangible assets that companies may have on their balance sheets.
These assets lack physical substance but can still hold significant value for a
business.
(1) Identifiable Intangible Assets:
Identifiable intangible assets are intangible assets that can be separated from a
company and sold, transferred, or licensed. They are typically acquired through
purchase, legal rights, or contractual arrangements. These assets have specific
characteristics:
Definite Useful Life: Identifiable intangible assets have a finite or
determinable useful life.

8 | CFA L1 NOTES
This means that the asset's value is expected to decline or be used up over a
specific period. Common examples of identifiable intangible assets with definite
useful lives include patents, copyrights, trademarks, and customer lists.
Measurable Cost: The cost of acquiring or developing identifiable
intangible assets can be reliably measured. This cost is typically recorded on
the company's balance sheet and amortized over the asset's useful life,
reflecting the gradual consumption of its value.
Amortization: Identifiable intangible assets are subject to amortization,
which is the systematic allocation of their cost as an expense over their
estimated useful lives. The amortization expense is recorded on the
company's income statement.
Recognized on the Balance Sheet: Identifiable intangible assets are
recognized as assets on the company's balance sheet and are subject to
regular impairment testing. If the asset's value has been impaired (i.e.,
decreased), the company must adjust its carrying amount accordingly.
(2) Unidentifiable Intangible Assets (Goodwill):
Unidentifiable intangible assets, often referred to as "goodwill," represent
intangible assets that cannot be separately identified or separated from a
company. Goodwill arises from business combinations, such as mergers and
acquisitions, when the purchase price exceeds the fair value of identifiable
tangible and intangible assets acquired minus liabilities assumed. Key
characteristics of unidentifiable intangible assets (goodwill) include:
Indefinite Useful Life: Goodwill is considered to have an indefinite useful
life because it cannot be reliably estimated when it will be consumed or
become worthless.
Not Amortized: Unlike identifiable intangible assets, goodwill is not
subject to amortization. Instead, it is tested for impairment at least annually
or more frequently if certain triggering events occur. If the carrying amount
of goodwill exceeds its implied fair value, the company must record an
impairment charge to reduce its value on the balance sheet.
Reported on the Balance Sheet: Goodwill is recorded as an asset on the
balance sheet, representing the premium paid for the acquisition of another
business. However, it is subject to periodic impairment.

9 | CFA L1 NOTES
What are marketable securities?
Marketable securities, also known as marketable securities or short-term
investments, are financial instruments that a company invests in with the
intention of converting them into cash relatively quickly, typically within one
year. These are classified into three categories on financial statements: trading
securities, available-for-sale securities, and held-to-maturity securities.
Trading Securities:
Trading securities are investments in financial instruments like stocks
and bonds that are bought and held primarily for the purpose of selling
them in the near term to generate a profit.
They are considered short-term investments and are reported at their
fair market value on the balance sheet.
Changes in the fair value of trading securities are recorded on the
income statement, which can result in gains or losses depending on
market conditions.
Available-for-Sale Securities:
Available-for-sale securities are investments in financial assets that a
company holds with the intent to sell them in the future if needed or
when market conditions are favorable.
They are reported on the balance sheet at their fair market value, similar
to trading securities.
Changes in the fair value of available-for-sale securities are also recorded
on the balance sheet, specifically in a separate account called the
"accumulated other comprehensive income" or "unrealized gain/loss on
available-for-sale securities."
Unlike trading securities, changes in the fair value of available-for-sale
securities are not immediately recognized on the income statement but
are recorded as comprehensive income until they are actually sold.
Held-to-Maturity Securities:
Held-to-maturity securities are investments in debt securities (e.g.,
bonds) that a company intends to hold until they mature, rather than
selling them in the open market.

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 They are reported on the balance sheet at their amortized cost, which is
typically the original purchase price plus or minus any applicable
adjustments for interest income, amortization, or impairment.
Changes in the fair value of held-to-maturity securities are generally not
recognized on the income statement, as the company intends to hold
them until maturity.

How unrealized gains & losses from marketable securities are

reported?
An unrealized gain or loss on a marketable security is a change in the value of an
investment that has not been realized through a sale. It represents the difference
between the current market value of the security and its original purchase price.
If the market value has increased, it's an unrealized gain; if it has decreased, it's
an unrealized loss. These gains and losses are "unrealized" because they have not
been locked in by selling the security.
Unrealized gains and losses from held-to-maturity securities, available-for-sale
securities, and trading securities are reported differently on a company's
financial statements due to the accounting treatment for each category of
investment.
Trading Securities:
Unrealized gains and losses on trading securities are reported on the income
statement, specifically in the "income" or "net income" section.
Any increase in the fair market value of trading securities is recognized as a
gain, which contributes to the company's reported net income.
Conversely, any decrease in the fair market value of trading securities is
recognized as a loss, which reduces the company's net income.

If the value of a trading security increases during a

reporting period, the company will report unrealized gains
on its income statement, increasing its net income. If the
value decreases, the company will report unrealized
losses, reducing its net income.

11 | CFA L1 NOTES
Available-for-Sale Securities:
Unrealized gains and losses on available-for-sale securities are reported
differently from trading securities.
These unrealized gains and losses are not reported on the income statement
but are recorded in a separate account known as "accumulated other
comprehensive income" (AOCI), which is a component of shareholders'
equity on the balance sheet.
Unrealized gains and losses on available-for-sale securities do not affect the
company's net income directly. Instead, they are reported as a separate line
item within shareholders' equity.
These gains and losses remain on the balance sheet until the securities are
sold.

If the fair value of available-for-sale security increases,

the company records an unrealized gain in the AOCI. This
gain doesn’t affect net income but affects. When the AFS
security is eventually sold, the cumulative gains or losses
in the AOCI are then reclassified to the income statement.

Held-to-Maturity Securities:
Unrealized gains and losses on held-to-maturity securities are typically not
recognized on the income statement or in the AOCI.
Held-to-maturity securities are generally reported on the balance sheet at
their amortized cost, which is the original purchase price adjusted for any
amortization of premium or discount.
Changes in the fair value of held-to-maturity securities are usually not
recognized on the income statement or balance sheet unless there is
evidence of an impairment. In case of impairment, the loss is recognized as
an expense on the income statement.
Trading securities affect net income directly, available-for-sale securities impact
shareholders' equity through AOCI, and held-to-maturity securities are generally
not subject to frequent revaluation and only incur impairment losses if any.

12 | CFA L1 NOTES
What are non-current liabilities?
Non-current liabilities, also known as long-term liabilities or non-current
liabilities, are financial obligations that a company expects to settle or pay off
beyond the next operating cycle or beyond one year from the balance sheet date.
These liabilities represent the company's long-term financial commitments and
are an important part of a company's capital structure. The most common types
are:
Long-term Debt: This includes loans, bonds, and other forms of
borrowing that extend beyond one year. Long-term debt often involves
scheduled interest payments and a principal repayment at maturity.
Deferred Tax Liabilities: These arise when a company has recognized
tax expenses in its financial statements but has not yet paid these taxes to tax
authorities. They represent future tax obligations.
Pension Obligations: If a company has a defined benefit pension plan, it
may have non-current liabilities associated with the future pension
payments to retirees.
Lease Obligations: Under accounting standards like ASC 842 (US GAAP)
and IFRS 16, lease liabilities are recognized on the balance sheet for leases
with terms longer than one year.
Contingent Liabilities: These are potential liabilities that may arise from
future events, such as lawsuits or warranties, but their exact amount and
timing are uncertain.
These interest expenses on long-term debt are recognized on the income
statement and reduce the company's net income. Non-current liabilities affect a
company's financial ratios and its overall financial health. High levels of non-
current liabilities can indicate a significant debt burden and impact metrics like
debt-to-equity ratio and interest coverage ratio.

"Non-current liabilities are like promises made

to the future, defining the long-term
commitments that shape a company's financial
destiny."

13 | CFA L1 NOTES
What is shareholders’ equity and its components?
Shareholders' equity, also known as stockholders' equity or owner's equity, is a
crucial section of a company's balance sheet. It represents the residual interest in
the company's assets after deducting its liabilities. In simpler terms, it shows the
portion of the company's assets that belongs to the owners (shareholders) rather
than creditors. Shareholders' equity is a measure of a company's net worth and
financial health.
Here are the key components of shareholders' equity typically shown on the
balance sheet:
Common Stock: Common stock represents the ownership interest in the
company held by common shareholders. When investors purchase common
stock, they become partial owners of the company and have voting rights.
The balance of common stock on the balance sheet reflects the total value of
common shares issued to shareholders.
Preferred Stock: Preferred stock is a separate class of stock that may be
issued by some companies. Preferred shareholders typically have certain
privileges, such as a fixed dividend rate, preference in receiving dividends
over common shareholders, and, in some cases, voting rights. The balance of
preferred stock on the balance sheet represents the total value of preferred
shares issued.
Additional Paid-In Capital (APIC): APIC, also known as "paid-in
capital in excess of par value," represents the amount of money that
investors have paid to the company for common and preferred stock that
exceeds their nominal or par value. It reflects the additional capital
contributed by shareholders when the company issues stock at a premium.
Retained Earnings: Retained earnings are the cumulative net profits
earned by the company over its history, minus any dividends paid to
shareholders. This represents the portion of profits that the company has
retained and reinvested in the business rather than distributing to
shareholders. Retained earnings play a crucial role in funding future growth
and investments.
Treasury Stock: Treasury stock represents shares of the company's stock
that have been repurchased by the company itself.

14 | CFA L1 NOTES
These shares are held in the company's treasury and are not considered
outstanding shares. The balance of treasury stock is subtracted from total
shareholders' equity because it represents a reduction in the ownership interest
of shareholders.
Accumulated Other Comprehensive Income (AOCI): AOCI is a
component of shareholders' equity that includes unrealized gains or losses
on certain investments and other comprehensive income items that are not
part of net income. Examples include changes in the fair value of available-
for-sale securities and foreign currency translation adjustments. AOCI
reflects fluctuations in the company's equity that have not yet been realized.
Non-controlling Interest (Minority Interest): If a company has
subsidiary entities in which it does not own 100% of the equity, the portion
of ownership attributable to external shareholders is classified as non-
controlling interest. This represents the equity interest held by minority
shareholders in the consolidated subsidiary's net assets.
The formula for calculating total shareholders' equity is:

Shareholders’ Equity

Common Stock

Preferred Stock

Additional Paid-in Capital

Retained Earnings

Accumulated OCI

Non-controlling Interest

Treasury Stock

15 | CFA L1 NOTES
What is a common-size balance sheet?
Common-size balance sheets are financial statements that express each line item
as a percentage of total assets. These percentages make it easier to analyze and
compare a company's financial data, allowing for a more meaningful assessment
of its financial structure and performance. Two common approaches to
common-size balance sheets are vertical common-size and horizontal common-
size balance sheets:
(1) Vertical Common-Size Balance Sheet:
In a vertical common-size balance sheet, each line item is presented as a
percentage of the total assets. This approach highlights the composition of a
company's assets and liabilities in relation to its total asset base.
The formula for calculating the common-size percentage for each line item
is:

Common-size percentage

Line-item amount
100
Total assets

This approach is useful for understanding the relative proportion of different

assets and liabilities on a company's balance sheet.
It allows for easy comparison of the structure of a company's assets and
liabilities across different periods or with other companies of varying sizes.
Example: If a company has total assets of $1,000,000, and its accounts
receivable is $200,000, the common-size percentage for accounts receivable
would be (200,000 / 1,000,000) * 100 = 20%.
(2) Horizontal Common-Size Balance Sheet:
In a horizontal common-size balance sheet, each line item is presented as a
percentage of a common base year or period. This approach is used to track
the changes in the composition of assets and liabilities over time, focusing on
how each line item has grown or declined relative to the base period.

16 | CFA L1 NOTES
The formula for calculating the common-size percentage for each line item
in a specific year is:

Common-size percentage

Line-item (Current year)

100
Line-item (Base year)

This approach helps identify trends and shifts in a company's financial

structure and is useful for spotting changes in relative proportions of assets
and liabilities.
It allows for a more detailed analysis of how specific line items have changed
over time, which can be valuable for identifying areas of concern or
improvement.
Example: If a company's accounts receivable in the base year (e.g., the
previous year) was $150,000, and in the current year, it is $200,000, the
common-size percentage for accounts receivable for the current year relative
to the base year would be (200,000 / 150,000) * 100 = 133.33%.

Enron: The Crooked Balance Sheet

One of the most infamous cases of balance sheet analysis is the

Enron scandal. Enron, once a prominent energy company, used
off-balance sheet entities to hide debt and inflate assets. Skilled
analysts noticed this discrepancy via balance sheet, leading to
investigations that ultimately revealed a massive accounting
fraud, leading to Enron's bankruptcy in 2001.

17 | CFA L1 NOTES
CFA L1 Notes

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Published: October 2023