Analyzing of

THE BALANCE SHEET

 THE BASIC OF ELEMENTS OF BALANCE SHEET

 The Statement of Financial Position

 The balance sheet, also called the statement of financial position, is
the expanded expression of the accounting equation.

 Remember that the basic accounting equation states that

assets equal the sum of liabilities and owners' equity.
Assets = Liabilities + Owners’ Equity

 The balance sheet is the cumulative result of the firm's past

activities.
 ASSETS, LIABILITIES AND
OWNER’S EQUITY

 Assets are probable future economic benefits obtained or

controlled by a particular entity as a result of past
transactions or events.

 Liabilities are probable future sacrifices of economic benefits

arising from present obligations of a particular entity to
transfer assets or provide services to other entities in the
future as a result of past transactions or events.

 Owners' equity is the residual interest in the assets of an

entity after deducting liabilities.
ASSETS

 Current assets are those assets which will typically become

cash or be consumed in one year or one operating cycle,
whichever is greater.

 Noncurrent assets are assets used in the conduct of the

business and for which the replacement cycle is longer than
one year.
CURRENT ASSETS

 Liquidity reflects the ability of the firm to generate sufficient

cash to meet its operating cash needs and to pay its
obligations as they become due.

 Because of the liquidity focus, current assets are generally

valued at the lower of their acquisition costs or present resale
values.

 Current assets include cash and cash equivalents, accounts

receivable, inventories, and prepaid expenses.
CASH AND CASH EQUIVALENTS

 Cash and cash equivalents include currency, bank deposits,

and various marketable securities that can be turned into
cash on short notice merely by contacting a bank or broker.

 Cash is often considered to be any item which a bank will

accept at face value for deposit.

 Cash equivalents are only securities purchased within ninety

days of their maturity dates.
INVENTORY

 Inventory represents items that have been purchased or

manufactured for resale to customers.
 Some students feel that inventory should be reported as a
noncurrent asset, but ask yourself this question:
 Does a business, which earns money by selling goods, really
want its inventory to remain unsold for over one year?
 Remember that stores have sales in order to move out slowly
moving inventory.

 Just as is true for accounts receivable, a fast turnover period

for inventory is very desirable.
The Operating Cycle and Liquidity
 The operating cycle of a business is the time which elapses
from the purchase of inventory, to the exchange of inventory
for accounts receivable, to the collection of that receivable.

 It is sometimes called the cash-to-cash cycle because it is the

time which elapses from the time a company spends money
to purchase inventory to the time it receives cash for that
inventory.

 Some businesses have a very short operating cycle, a week or

two.
 The Operating Cycle and Liquidity

Collections
Cash

Cash Sales

Purchases
Accounts
Receivable

Inventory
Credit Sales
Noncurrent Assets
 Noncurrent assets are assets used in the conduct of the
business and for which the replacement cycle is longer than
one year.

 While the focus for current assets is their liquidity, the focus
for noncurrent assets is on the operating capacity of the firm.

 Property, plant, and equipment comprises the most common

type of noncurrent assets.
Property, Plant, and Equipment

 Property usually represents the land upon which the firm's

offices, factories, and other facilities are located.

 Property is valued on the balance sheet at its historical

acquisition cost.

 Because of the age of the land, it is often the most out of

date in terms of current market values.

 Buildings or plant may include buildings, warehouses,

hospitals, and myriad other assets.
Property, Plant, and Equipment
 Equipment includes office furniture, tools, computers, and
the like.

 Buildings and equipment are the primary productive assets of

any organization.
Depreciation
 Because property, plant, and equipment assets wear out over
time, they must be reported on the balance sheet at their net
book value.
 This reduction in the reported value during a period is called
depreciation expense.

 Depreciation is a rational and systematic allocation of an

asset's cost to expense over the asset's life.
Depreciation
 It has nothing to do with writing assets up or down to market
value or attempting to accumulate cash for the purpose of
replacing the asset.

 Accumulated depreciation is the total amount of

depreciation expense that has been recognized to date.
 If an asset's cost is $10,000 and the Accumulated Depreciation
account shows a balance of $2,000, then the net book value is
$8,000.
Intangible Assets
 Intangible assets lack physical substance and yet are
important resources in the regular operations of a business.

 Patents, which protect invention, copyrights, which protect

artistic works, and goodwill are examples of intangible
assets.
Goodwill
 Goodwill denotes the economic value of an acquired firm in
excess of the value of its identifiable net assets.
 Pooky Company has assets of $500,000 and liabilities of
$300,000.
 Therefore, its net assets are $200,000.
 If Cassie Company pays $250,000 to buy Pooky Company, then
there is goodwill of $50,000 ($250,000 - $200,000).
Goodwill
 Goodwill may only be recorded when one business buys
another business.

 Internally generated goodwill may not be recorded in the

accounting records.

 Very often the most important asset of a business is its

personnel, or human resources, but human resources does
not appear on the balance sheet as an asset class.
Goodwill
 There are also other assets which do not appear on the
balance sheet, such as customers and suppliers.

 Externally acquired goodwill arises when one business buys

another business.
Liabilities
 Liabilities include any probable obligation that the firm has
incurred as a consequence of its past activities.

 While some liabilities involve a specific dollar amount on a

specific date, others involve estimates.

 Liabilities are either current or noncurrent.

Liabilities
 Current liabilities are short-term obligations that are
expected to utilize cash or other current assets within a year
or an operating cycle, whichever is longer.

 Noncurrent liabilities represent obligations that generally

require payment over periods longer than a year.
Current Liabilities
 Current liabilities include accounts payable, notes payable,
warranty obligations and accrued expenses.

 Accounts payable represent debts that the firm incurs in

purchasing inventories and supplies for manufacturing or
resale purposes.
 Accounts payable also include anything that a firm purchases
on credit.
Notes Payable
 Notes payable are more formal current liabilities than the
accounts payable.
 Notes are usually written documents which involve payment
of interest.

 Warranty obligations represent the firm's estimated future

costs to fulfill its obligations for repair or refund guarantees.
Warranty Obligations
 Warranties are reported on estimates because a company
cannot know for sure how many items will be returned for
warranty work.
Accrued Expenses

 Accrued expenses represent liabilities for services already

consumed but not yet paid for or included elsewhere in
liabilities.
Taxes Payable

 Taxes payable represent unpaid taxes owed to a

governmental unit and will be paid within one year.
 Noncurrent Liabilities

 Noncurrent liabilities represent obligations that generally

require payment over periods longer than a year.
 They are contracts to repay debt at specified future dates and
often place some restrictions on the activities of the firm until
the debt is fully repaid.
Bonds Payable
 Bonds payable are a major source of funds for larger
companies.
 A company usually issues bonds when the amount it is
borrowing is too large to borrow from one source.
 When it issues bonds, a company obligates itself to make
periodic interest payments and to pay back the entire
principal at the maturity date.
Mortgage Payable
 A mortgage payable also involves payment of principal and
interest, but it also represents a pledge of certain assets that
will revert to the lender if the debt is not paid.

 A company sometimes has liabilities which do not appear on

the face of the balance sheet.
 They may only be disclosed in the notes to the financial
statements.
 An example is a lawsuit.
Owners’ Equity
 Owners’ equity represents the owners’ claims on the assets
of the business.
 Arithmetically, it is the difference between assets and liabilities.
Owner’s Equity = Assets – Liabilities

 A corporation’s shareholders’ equity consists of two items:

 Paid-in capital represents the direct investments by the owners
of the firm.
 Retained earnings represent the earnings of the firm that have
been reinvested in the business.
Owners’ Equity
 An important point to remember is that retained earnings do
not represent cash available for the payment of dividends.

 The retained earnings account is the cumulative story of all

the income the firm has earned, all the losses it has incurred,
and all the dividends it has paid out to shareholders.
 COMMON-SIZE ANALYSIS

Common-size analysis is the restatement of financial

statement information in a standardized form.
 Horizontal common-size analysis uses the amounts in accounts in a specified year
as the base, and subsequent years’ amounts are stated as a percentage of the base
value.
 Useful when comparing growth of different accounts over time.

 Vertical common-size analysis uses the aggregate value in a financial statement

for a given year as the base, and each account’s amount is restated as a percentage
of the aggregate.
 Balance sheet: Aggregate amount is total assets.
 Income statement: Aggregate amount is revenues or sales.

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 COMMON-SIZE ANALYSIS

Consider the CS Company, which reports the following financial information:

1. Create the vertical common-size analysis for the CS Company’s assets.

2. Create the horizontal common-size analysis for CS Company’s assets, using 2008 as the
base year.

Year 2008 2009 2010 2011 2012 2013

Cash $400.00 $404.00 $408.04 $412.12 $416.24 $420.40

Inventory 1,580.00 1,627.40 1,676.22 1,726.51 1,778.30 1,831.65

Accounts receivable 1,120.00 1,142.40 1,165.25 1,188.55 1,212.32 1,236.57

Net plant and equipment 3,500.00 3,640.00 3,785.60 3,937.02 4,094.50 4,258.29

Intangibles 400.00 402.00 404.01 406.03 408.06 410.10

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Total assets $6,500.00 $6,713.30 $6,934.12 $7,162.74 $7,399.45 $7,644.54

 COMMON-SIZE ANALYSIS

Vertical Common-Size Analysis:

Year 2008 2009 2010 2011 2012 2013

Cash 6% 6% 5% 5% 5% 5%
Inventory 23% 23% 23% 23% 22% 22%
Accounts receivable 16% 16% 16% 15% 15% 15%
Net plant and equipment 50% 50% 51% 51% 52% 52%
Intangibles 6% 6% 5% 5% 5% 5%
Total assets 100% 100% 100% 100% 100% 100%

100%
80%
Proportion 60%
of Assets 40%
20%
0%
2008 2009 2010 2011 2012 2013
Fiscal Year

Cash Inventory Accounts receivable

Net plant and equipment Intangibles
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 COMMON-SIZE ANALYSIS

Horizontal Common-Size Analysis (base year is 2008):

Year 2008 2009 2010 2011 2012 2013

Cash 100.00% 101.00% 102.01% 103.03% 104.06% 105.10%
Inventory 100.00% 103.00% 106.09% 109.27% 112.55% 115.93%
Accounts receivable 100.00% 102.00% 104.04% 106.12% 108.24% 110.41%
Net plant and equipment 100.00% 104.00% 108.16% 112.49% 116.99% 121.67%
Intangibles 100.00% 100.50% 101.00% 101.51% 102.02% 102.53%
Total assets 100.00% 103.08% 106.27% 109.57% 112.99% 116.53%

130%
Percentage 120%
of Base 110%
Year 100%
Amount
90%
2008 2009 2010 2011 2012 2013
Fiscal Year

Cash Inventory Accounts receivable Net plant and equipment Intangibles Total assets
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 Financial Ratio Analysis

 16 Financial Ratios for Analyzing a Company’s Strengths and

Weaknesses

 Over the years, investors and analysts have developed numerous analytical tools,
concepts and techniques to compare the relative strengths and weaknesses of
companies. These tools, concepts and techniques form the basis of fundamental
analysis.

 Ratio analysis is a tool that was developed to perform quantitative analysis on

numbers found on financial statements. Ratios help link the three financial statements
together and offer figures that are comparable between companies and across
industries and sectors. Ratio analysis is one of the most widely used fundamental
analysis techniques.
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 Financial Ratio Analysis

 Activity Ratios

 Liquidity Measurement
Ratios
 Profitability Indicator Ratios

 Debt Ratios

 Operating Performance
Ratios
 Investment Valuation Ratios

 Cash Flow Indicator Ratios

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 Financial Ratio Analysis
Liquidity Measurement Ratios

 A company’s liquidity is its ability to meet its short-term

financial obligations.

Liquidity ratios attempt to measure a company's ability to

pay off its short-term debt obligations.

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BALANCE SHEET

38
INCOME STATEMENT

39
 USE OF FINANCIAL RATIOS

 Financial ratio- An index that relates two accounting

numbers and is obtained by dividing one number by the
other.

To evaluate a firm’s financial condition and performance, the

financial analyst needs to perform “checkups” on various
aspects of a firm’s financial health. A tool frequently used
during these checkups is a financial ratio, or index, which
relates two pieces of financial data by dividing one quantity
by the other.

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FINANCIAL RATIOS

41
 BALANCE SHEET RATIOS

Liquidity Ratios
 Liquidity ratios are used to measure a firm’s ability to meet short-
term obligations. They compare short-term obligations with short-
term (or current) resources available to meet these obligations. From
these ratios, much insight can be obtained into the present cash
solvency of the firm and the firm’s ability to remain solvent in the
event of adversity.

1. CURRENT RATIO

2. QUICK RATIO

3. .CASH RATIO

42 FIN3000, Liuren Wu
 BALANCE SHEET RATIOS
Liquidity Ratios
 CURRENT RATIO- It shows a firm’s ability to cover its current
liabilities with its current assets.

CR= CURRENT ASSETS / CURRENT LIABILITIES

For Aldine Manufacturing Company, this ratio for year-end

20X2 is:

$2,241,000 / $823,000= 2.72

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 BALANCE SHEET RATIOS
Liquidity Ratios
 QUICK RATIO- This ratio is the same as the current ratio except that it excludes
inventories – presumably the least liquid portion of current assets – from the numerator.

CR= (CURRENT ASSETS- INVENTORIES) / CURRENT LIABILITIES

For Aldine Manufacturing Company, this ratio for year-end

20X2 is:

($2,241,000 - $1,329,000)/ $823,000= 1.11

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 BALANCE SHEET RATIOS

Liquidity Ratios
 CASH RATIO- This ratio aims to show the ability of the company to meet
its current liabilities from its more realizable current assets, i.e. its cash,
marketable securities and receivables. This ratio specifically excludes
inventories from the numerator (top line) as they may be difficult to realize .

CR= (CASH + MARKETABLE SECURITIES) / CURRENT LIABILITIES

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 FINANCIAL LEVERAGE (DEBT) RATIOS

A leverage ratio is any one of several financial measurements that look

at how much capital comes in the form of debt (loans), or assesses the
ability of a company to meet its financial obligations.

debt-to-equity ratio = Total debt / Shareholders’ equity

! A high debt/equity ratio generally indicates that a company has been

aggressive in financing its growth with debt. This can result in volatile
earnings as a result of the additional interest expense. If the company's
interest expense grows too high, it may increase the company's
chances of a default or bankruptcy.

$1,454,000 / $1,796,000 = 0.81

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 FINANCIAL LEVERAGE (DEBT) RATIOS

Debt-to-Total-Assets Ratio. = Total debt / Total Assets

! The ratio that defines the total amount of debt relative to assets.
This metric enables comparisons of leverage to be made across
different companies. The higher the ratio, the higher the degree of
leverage (DoL) and, consequently, financial risk. The total debt to total
assets is a broad ratio that includes long-term and short-term debt
(borrowings maturing within one year), as well as all assets – tangible
and intangible.

$ 1,454,000 / $ 3,250,000 = 0.45

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 FINANCIAL LEVERAGE (DEBT) RATIOS

 In addition to the two previous debt ratios, we may wish to compute

the following ratio, which deals with only the long-term capitalization
of the firm:

Long-term debt/ total capitalization

 ! where total capitalization represents all long-term debt and

shareholders’ equity.

$631,000 / $2,427,000= 0.26

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 Summary of Financial Ratios

 Ratios help to:

 Evaluate performance
 Structure analysis
 Show the connection between activities and performance

 Benchmark with
 Past for the company
 Industry

 Ratios adjust for size differences

THANK YOU FOR YOU ATTENTION!

QUESTIONS?