UNDERSTANDING
BALANCE SHEET
Chapter 4
SUPTOPICS
o Elements of the Balance Sheet
o Assets
o Liabilities
o Equity
o Uses and Limitations of the Balance Sheet in Financial Analysis
o Alternative Formats of Balance Sheet Presentation
o Classified Balance Sheet
o Liquidity-based Presentation
o Types of Assets, Liabilities, and Equity and its measurements
o Analysis of Balance Sheet
LEARNING
OUTCOMES
o Identify the elements of a balance sheet.
o Classify assets, liabilities, and equity accounts
according to the Standard.
o Analyze the content of the balance sheet.
o Interpret the result of balance sheet analysis.
Understanding Balance Sheet
BALANCE SHEET
Snapshot of a company’s resources or
assets, and sources of capital, i.e.,
liabilities and shareholder’s equity, at a
specific point in time.
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KEY ELEMENTS
1. Assets (A): Resources which a company owns or controls because of
past events and from which future economic benefits are expected to flow.
2. Liabilities (L): Anything which the company owes and which is
expected to result in an outflow of economic benefits.
3. Equity (E): Owners’ residual interest in the company’s assets after
subtracting liabilities. Also called shareholders’ equity or owners’
equity.
Accounting equations: A – L = E or A = L + E
Understanding Balance Sheet
USES AND LIMITATIONS OF
BALANCE SHEET
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✓ The balance sheet can assist analysts in assessing a company’s ability to:
o Pay for its near-term operating needs (liquidity position);
o Meet future debt obligations; and
o Make distributions to shareholders.
USES
❖A balance sheet may not have a uniform measurement method.
o Some may be measured at market value; others at historical cost.
❖ Balance sheets are always historical.
❖ They leave out important aspects such as management skills.
LIMITATIONS
Understanding Balance Sheet
ALTERNATIVE FORMATS OF
BALANCE SHEET PRESENTATION
✓ Statements in accordance with International Financial
Reporting Standards, IFRS – PFRS, Philippine Financial
Reporting Standards
✓ Statements in accordance with Philippine Accounting
Standards (PAS).
1. Classified Balance Sheet – items distinguished as current
and non-current
2. Liquidity- based Balance Sheet – items are presented in
order of liquidity
2.
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2.
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CURRENT AND NONCURRENT
Current assets
• Cash
• Cash equivalents
• Marketable
securities
• Receivables
• Inventories
• Short-term
financial assets
Noncurrent
assets
Current
liabilities
• Property, plant, and
equipment
• Trade payables
• Investment
Property
• Deferred income
• Goodwill
• Intangibles
• Long-term
financial assets
• Accrued expenses
Noncurrent
liabilities
• Deferred tax
liabilities
• Long-term debt
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CURRENT ASSETS
# Cash and cash equivalents : highly-liquid, short-term investments
so close to maturity that the risk of significant change in value from
changes in interest rates is minimal.
❖ Examples : Demand de pos its with banks
❖ Highly liquid inve s tme nts with maturities of 3 mo nths or les s , e.g.,
T-bills
# Marketable se curitie s : Investments in debt or rquity securities that
are traded in a public market, and whose value can be
determined from prices that are obtained in a public market.
❖ Examples : Treas ury bills, note s , bonds and e q uity se c urities
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CURRENT ASSETS
# Trade Rece ivables or accounts rece ivable: amounts that are owed to
an entity by its customers for products and services that have already
been delivered.
❖ They are usually reported at net realizable value, which is an approximation of
fair value that is bases on estimates of collectability.
❖ Allowance of doubtful accounts: shoes the company’s estimate of the amount of
receivable that will be eventually uncollectible.
❖ Additions to doubtful allowance in a particular period are reflected as bad
debts expenses and balance of the allowance for doubtful accounts reduces
the gross receivables amount to a net amount that is an estimate of net realizable
value.
❖ Allowance of doubtful accounts is called a contra account – it is deducted from
the balance of accounts receivable (asset account).
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CURRENT ASSETS
# Inve nto rie s : Physical products which a company intends to sell to its
customers, either in the form of finished goods or as inputs into a
manufacturing process.
❖ Under IFRS, inventories are measured at the lower cost and net realizable value, while
under US GAAP, they are measured at the lower of cost of market value.
❖ Costs of inventories include: Cost of purchase, cost of conversion and other costs
incurred to bring the inventory to their present condition and location.
❖ Net realizable value is estimated selling price less cost of completion and costs needed
to complete the sale.
❖ When inventory is sold, cost of the respective inventory is reported as an expense,
denoted as “cost of goods sold” on the income statement.
❖ Method of valuing cost of inventory varies with accounting standards:
❖ IFRS: FIFO. Weighted average cost and specific identification.
❖ US GAAP: All in IFRS and additionally LIFO.
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CURRENT ASSETS
# Othe r current ass e ts : assets not sufficiently material to require
a separate balance sheet line item.
❖They include prepaid expenses and deferred tax assets
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NONCURRENT ASSETS
# Prope rty, plant, and equipme nt (PPE): Tangible assets,
including land, buildings, and machinery, that are used in an
entity’s operations and expected to provide economic benefits
over more than one financial year.
❖ IFRS allows PPE to be reported using the cost model or revaluation model – a
company must apply same model to all assets within a particular class of assets. US
GAAP permits cost model only.
❖ Cost model reports PPR at amortized cost – historical cost less any accumulated
depreciation, and less any impairment losses.
❖ Under Revaluation model, PPE at fair value at the date of the revaluation less
any subsequent accumulated depreciation.
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NONCURRENT ASSETS
# Inve s tme nt prope rty: Property used solely to earn rental
inco me , capital appreciation or both.
# US GAAP does not include any particular definition of investment
property.
# IFRS gives companies a choice to report investment property using
either cost model or revaluation model (similar to PPE) – must apply a
chosen model to all investment property.
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NONCURRENT ASSETS
# Intangible ass e ts: Patents, licenses, and trademarks, or any
other asset which is non-monetary, has no physical substance
but is able to be identified.
# IFRS allows intangible assets to be reported using cost model or
revaluation model (similar to PPE). Revaluation model can only be used
when there is active market for intangible asset.
# US GAAP permits cost model only.
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NONCURRENT ASSETS
# Goo dwill: Excess value created when the purchase price of a
company exceeds that acquirer’s interest in the fair value of the
identifiable assets and liabilities that were acquired.
❖Under both IFRS and US GAAP, goodwill resulting from acquisitions
is capitalized.
❖Goodwill is not amortized but it is annually tested for impairment – if
it is impaired, impairment loss is charged against income in the
current period.
❖Impairment loss is a non- cash item.
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NONCURRENT ASSETS
# Financial ass e ts : A financial instrument is defined as a
contract which gives rise to a financial asset of one entity and a
financial liability or equity instrument of another.
# Two basis alternative of measurement subsequent to
acquisition:
1. Fair value
2. Amortized cost
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CURRENT LIABILITIES
# Trade payables or accounts payable: amounts which an entity
owes its suppliers for goods and services that have been purchased.
# Important: Trend in overall levels of trade payables relative to
purchase could indicate credit relationships between the companies
and the suppliers.
# Accrued expe ns e s: expenses that have been recognized on an
entity’s income statement, have not yet been paid as of the balance
sheet’s date.
# Also called accrued expenses payable, accrued liabilities and
other non- financial liabilities.
# Defe rre d inco me : occurs whenever an entity receives payment
prior to delivering goods and services that it was paid to provide.
# Also called deferred revenue or unearned revenue
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NONCURRENT LIABILITIES
# Long-te rm financial liabilitie s: Include loans and notes or
bonds payable
# 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.
# Defe rre d tax liabilitie s : arises from temporary timing
differences between an entity’s reported income (for financial
statement purposes) and its taxable income (for tax purposes)
# 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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SHAREHOLDERS’ EQUITY
• Represents the owners’ residual claim on an entity’s assets after
deducting liabilities
Treasury
shares
Retained
earnings
Preferred
shares
Common
Stock
Accumulated
OCI
Shareholders
’ Equity
Noncontrolling
interest
Understanding Balance Sheet
SHAREHOLDERS’ EQUITY
• Common stock: Amount of contribution to the company by the
owners.
•
•
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•
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also called capital contributed by the owners, or issued capital
May be issued with par value or as no par shares
Number of authorized shares: Shares that may be sold by the company
Number of issued shares: Shares sold to investors
Number of outstanding shares: issued shares less treasury shares
• Preferred stock: Have superior rights compared to common stock –
dividend payments and receipt of assets if the company is liquidated
• May be classified as equity or financial liability depending on their
characteristics rather than the legal form.
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SHAREHOLDERS’ EQUITY
• Treasury stock: Shares that have been repurchased by the company
and held as treasury shares instead of being cancelled.
• Also called treasury stock or own share repurchased.
• If reissued, the company does not recognize profit or loss on the
income statement.
• Non- voting and do not receive the declared dividends
• Retained earnings: Total amount of earnings reported on a
company’s income statement which have not been paid to the owners
of the company as dividends.
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SHAREHOLDERS’ EQUITY
• Accumulated other comprehensive income (other reserves):
cumulative amount of other comprehensive income or loss
• Comprehensive income = Net income + Other comprehensive
income (reflected in accumulated other comprehensive
income)
• Noncontrolling interest (minority interest): refers to the equity
interest of the minority shareholders in subsidiary companies that
have been incorporated by the parent company but not wholly owned
by the parent company
Understanding Balance Sheet
FROM PROCTER & GAMBLE’S 2017 ANNUAL REPORT
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Understanding Balance Sheet
COMMON SIZE BALANCE SHEET
• A balance sheet that displays both the numeric value and relative
percentage for total assets, total liabilities and equity accounts.
• Common sizing is done for analytical purposes. It’s not an
accounting requirement.
• It can assist with cross-sectional analysis by looking across companies
in the same industry or sector.
• Common sizing can take one of two forms:
1. Vertical common sizing: each balance sheet item as a percentage of
total assets
2. Horizontal common sizing: quantities in balance sheet in terms of
a base-year value of choice
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LIQUIDITY RATIOS
Ratio Name
Calculation
Current Ratio
Current Assets
Current Liabilities
Indication
A company’s ability to meet its
short term obligations
Quick Ratio
(Acid test)
Cash + Marketable Securities Satisfies the same purpose as the
+ Receivables
current ratio, but it’s considered a
Current Liabilities
tougher measure as inventory is
excluded
Cash Ratio
Cash + Marketable Securities Tests a company’s ability to meet
Current Liabilities
its short-term obligations using
extremely liquid assets
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SOLVENCY RATIOS
Ratio Name
Calculation
Total long term debt
Total Equity
Indication
Financial leverage and financial
risk
Debt- to- equity
Total debt
Total equity
Financial leverage and financial
risk
Total Debt
Total debt
Total assets
Financial leverage and financial
risk
Financial
Leverage
Total assets
Total equity
Financial leverage and financial
risk
Long- term Debtto- equity
Understanding Balance Sheet
SUMMARY
Balance sheet shows the snapshot of a company’s
finances. It contains current and noncurrent
assets, current and noncurrent liabilities, and
equity, which can be presented as classified or
liquidity-based. Analyzing the balance sheet
measures the liquidity and solvency of the
company, and whether it has a positive net
worth. It also gives reason to investors as to
whether to invest or not.
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