Chapter 3.SV

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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.
5 Copyright © 2013 CFA

Accounting Equation
 Assets – Liabilities = Equity
 Assets = Liabilities + Equity
Reflects the
resources Reflects how those resources were
controlled by the financed
company
www.themegallery.com
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-term)
(Short-term) Noncurrent
Noncurrent (Long-
(Long-
Assets
Assets term)
term) Assets
Assets
Resources
Resourcesor orclaims
claimstoto Resources
Resourcesor orclaims
claimsto to
resources
resourcesthatthat are
are resources
resourcesthat
that are
are
expected
expectedto tobebesold,
sold, expected
expectedto tobe
besold,
sold,
collected,
collected, ororused
used within
within collected,
collected, or
orused
usedthat
that
one
oneyear
year or
orthe
theoperating
operating extend
extendbeyond
beyondoneoneyear
year
cycle
cycleof
of the
thebusiness.
business. or
orthe
theoperating
operatingcycle
cycleof of
the
thebusiness.
business.
Current assets
 Cash & cash equivalents
 Other financial assets (short-term marketable
securities)
 Receivables
 Inventories
 Prepaid expenses
DAC
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.
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
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.
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
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
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)
Long-term assets
 Investments
 Tangible fixed assets (Property, plant &
Equipments)
 Intangible assets (i.e. patents, copyrights,
trademarks, goodwill)
 Financial leases
 Deffered charges
Kinhdo Kinhdo31-54
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.
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.
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.
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.
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.

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).

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)

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
 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.
 Retained earnings: 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 (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
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.
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).
 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).

Statement of Change in Equity
 Presents information about the increases or
decreases in a company’s equity over a period
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.

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.”

($ thousands) A B C
ASSETS
Cash, cash equivalents, marketable securities 1,900 200 3,300
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 9,600
Total shareholders’ equity 3,240 740 150
Total liabilities and shareholders’ equity 3,250 3,250 9,750

(percent of total assets) A B C

ASSETS
Cash, cash equivalents, marketable securities 58.46% 6.15% 33.85%
Accounts receivable 15.38% 32.31% 15.38%
Inventory 3.08% 29.23% 3.08%
Total current assets 76.92% 67.69% 52.31%
Property, plant, and equipment, net 23.08% 23.08% 47.69%
Goodwill 0.00% 9.23% 0.00%
Total assets 100.00% 100.00% 100.00%
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable 0.00% 76.92% 6.15%
Total current liabilities 0.00% 76.92% 6.15%
Long-term bonds payable 0.31% 0.31% 92.31%
Total liabilities 0.31% 77.23% 98.46%
Total shareholders’ equity 99.69% 22.77% 1.54%
Total liabilities and shareholders’ equity 100.00% 100.00% 100.00%

(percent of total assets) A B C
ASSETS
Cash, cash equivalents, marketable securities 58% 6% 34%
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%
Total assets 100% 100% 100%
LIABILITIES AND SHAREHOLDERS’ EQUITY
Accounts payable 0% 77% 6%
Total current liabilities 0% 77% 6%
Long-term bonds payable 0% 0% 92%
Total liabilities 0% 77% 98%
Total shareholders’ equity 100% 23% 2%
Total liabilities and shareholders’ equity 100% 100% 100%

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.

Balance sheet Ratios: liquidity ratios
Liquidity ratios indicate a company’s ability to meet

current liabilities.
Ratio Calculation
Current Current assets /Current liabilities
Quick (acid test) (Cash + Marketable securities + Receivables) /
Current liabilities
Cash (Cash + Marketable securities) /

Current liabilities

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 as Total debt  Total assets
debt to assets)
Debt to capital Total debt  (Total debt + Total equity)
Financial leverage Total assets  Total equity

Liquidity Solvency
 A company’s ability  A company’s ability
to meet short-term to meet long-term
obligations. obligations.
 Are the company’s  What is the
current assets company’s capital
adequate to its structure?
current liabilities?  Is the company able
 How much of cash to pay borrowings’
does the company interests and
generate from principals when come
operations? due?
II. LIQUIDITY ANALYSIS
CAN NOT MEET SHORT TERM OBLIGATION!
Lê Thu Hằng
II. LIQUIDITY ANALYSIS
Current assets
Current ratio =
Current liabilities
Cash + ST investment + Accounts

Quick ratio = 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

 Cash
 Receivables
 Inventory
 Other
QUICK RATIO
Cash + ST investments + Receivables
Quick ratio =
Current liabilities

 Cash
 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 Lower ratio –> safer.
 Debt to total capital 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 assets Average total equity
ratio
Coverage ratios
Interest coverage EBIT Interest payments
Fixed charge EBIT + Lease Interest payments + Lease
coverage payments 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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“ Add your company slogan ”

2 Measurement Bases of Assets and Liabilities

4 Uses and Analysis of the Balance Sheet

 To help users answer:

 Assets (A): resources controlled by the company as a

 Liabilities (L): obligations of a company arising from

 Equity (E): represents the owners’ residual interest in the

5 Copyright © 2013 CFA

 Assets – Liabilities = Equity

 Assets = Liabilities + Equity

 “Resourses controlled by a company for the

 The amount of cash and cash equivalents will be

 Marketable securities are other short-term

 Are physical products that will eventually be sold

 Reflects items that are individually not material

 PPE are tangible assets that are used in

 Are indefinable non-monetary assets without

 A deferred charge is a long-term

 “an obligation of an entity arising

 Current liabilities: are liabilities expected to be

 Trade payables, also known as accounts payable: Amounts that a

24 Copyright © 2013 CFA

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

 Deferred tax liabilities: Amount of income taxes payable in

25 Copyright © 2013 CFA

 Capital contributed by owners (or common stock or

26 Copyright © 2013 CFA

 Capital contributed by owners (common stock,

 Treasury shares (or treasury stock or own

 Fair value. Fair value is the amount at which an

 The balance sheet is a mixed model with respect

33 Copyright © 2013 CFA

35 Copyright © 2013 CFA

−Common-size balance sheets show each line item on the

36 Copyright © 2012 CFA

37 Copyright © 2013 CFA

(percent of total assets) A B C

38 Copyright © 2013 CFA

39 Copyright © 2013 CFA

40 Copyright © 2013 CFA

Liquidity ratios indicate a company’s ability to meet

Cash (Cash + Marketable securities) /

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Solvency ratios indicate financial risk and financial leverage and

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CAN NOT MEET SHORT TERM OBLIGATION!

Cash + ST investment + Accounts

 Current assets include:

Measure a firm’s ability to pay short-term

 Current assets include:

 Current assets include:

Measure a company’s ability to pay its current liabilities

 High proportion in current asset

Liquidity Liquidity ratios. How well is the firm positioned to

Profitability Profitability ratios. How much and how is the firm

 Calculate the liquidity and the activity ratios of a

Liquidity Liquidity ratios. How well is the firm positioned to

Profitability Profitability ratios. How much and how is the firm

Debt ratios: How has the company financed itself?

Coverage ratios: Degree to which earnings or cash flow can

Solvency ratios Numerator Denominator

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

59 Copyright © 2013 CFA

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