CHAPTER 2.

UNDERSTANDING THE
BALANCE SHEET
_Financial Analysis_
Learning objectives
◦ Define the balance sheet
◦ State the purpose of the balance sheet
◦ Recognize what accounts appear on the balance sheet
◦ Able to analyse the balance sheet
Introduction to the balance sheet
Components of the balance sheet

1. Current assets (short-term): items that are convertible into cash within one year
2. Non-current assets (long-term): items of a more permanent nature
3. Current liabilities (short-term): obligations due within one year

4. Non-current liabilities (long-term): obligations due beyond one year

5. Shareholders’ equity (permanent): shareholders’ investment and retained earnings
Balance Sheet
Assets Liabilities and Equity

Current
liabilities
Current Assets
Non-current
Liabilities

Non-current
Shareholders’
Assets
Equity
Balance sheet Formats
• The account form (horizontal presentation)
• Assets on the left side, and with liabilities and owners’ equity on the right side

• The report form (vertical presentation)

• Assets on the top, followed by the liabilities and equity.
Example of the balance sheet
(In horizontal form)
Example of the
balance sheet
(In vertical form)
 Balance Sheet
Assets Liabilities and Stockholders’ Equity
Current Assets Current Liabilities
• Cash and cash equivalents • Current liabilities
• Marketable securities • Short-term loans from banks
• Accounts receivable • Overdrafts
• Inventories • Interest payable for those loans
• Other current assets • Accounts payable
• Wages payable
• Current portion of long-term debt
• Non-current liabilities
• Long-term loans from banks
• Long-term bonds or other securities
• Deferred tax liability
Non-current Assets Stockholders’ Equity
• Property, plant and equipment • Contributed capital
• Investment property • Preferred stock
• Intangible assets • Treasury stock
• Goodwill • Retained earnings
• Patents, software… • Non-controlling interest
• Participation in other companies • Accumulated other comprehensive income
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 Liquidity Current Assets vs. Non-current Asset
Risk
Opportunity cost

Balance Debt &

Equity
Capital structure

sheet Cost of capital

analysis Retained earning

Value & Market value vs. Book value
Cost
VAS, US GAAP: at cost
IFRS: true market/fair value
Balance sheet analysis
Vertical analysis, or vertical percentage analysis, is based on the percentage
relationship of each line in the balance sheet to the total.

Liquidity ratios represent the ability of a company to convert it’s assets to cash
(current ratio, quick ratio).

Asset management ratios focus on the composition of the firm's assets as well
as changes in the composition of assets over time.

Debt management ratios are the composition ratios drawn from a vertical
analysis of the right side of the balance sheet (debt-to-assets ratio).
I. ASSETS
• Economic resources are controlled by a company and expected to provide
probable economic benefits in the future .
• Assets can be recognized if
• There is economic benefit
• Assets have expense or value of asset can be realizably determined
• Assets are classified into two groups
• Current assets: cash and cash equivalents, short-term financial investment,
account receivables, inventory, other current assets
• Non-current assets: long term receivable, fixed assets, property, long term
financial investment, other non-current assets.
Current assets
Current assets include cash and other assets that will be converted into cash
or used up within one year or the firm’s operating cycle, whichever is greater.
Current assets include:
1. Cash and cash equivalents are short-term, highly liquid investments that are readily
convertible to cash and near enough to maturity that interest rate risk is
insignificant. Cash and cash equivalent are reported on the balance sheet at
amortized cost and fair value.
2. Marketable securities are financial assets that are traded in a public market and
whose value can be readily determined.
Current assets

3. Account receivable are financial assets that represent amounts owed to the firm
by customers for goods or services sold on credit. Accounts receivable are
reported at net realized value, which based on estimated bad debt expense.
• Bad debt expense increase the allowance for doubtful accounts, a contra-asset
account.

• A contra-asset account is used to reduce the value of its controlling account.

Current assets
4. Inventories are goods held for sale to customers or used in manufacture of
goods to be sold.
• Manufacturing firms separately report inventories of raw materials, work-in-
process and finished goods.
• The cost included in inventory include purchase cost, conversion costs, and other
costs necessary to bring the inventory to its present location and condition.
• Costs that are exclude from inventory include abnormal waste of material, labor,
and overhead, storage costs (unless they are necessary as a part of the production
process), administrative overhead, and selling costs.
 Other current assets
• Prepaid expenses are operating costs have been paid in advance.
• Deferred tax assets are created when the amount of taxes payable
exceeds the amount of income tax expense recognized in the income
statement.
Non-current assets
1. Property, plant, and equipment (PP&E) are tangible assets used in the
production of goods and services.
• PP&E includes land and buildings, machinery and equipment, furniture, and
natural resources.
• Under IFRS, PP&E can be reported using the cost model or the revaluation
model.
• Under US.GAAP, only the cost model is allowed.
• Under the cost model, PP&E is reported at amortized cost (historical cost minus
accumulated depreciation, amortization, depletion, impairment losses).
• Under the valuation model, PP&E is reported at fair value less any accumulated
depreciation.
Non-current assets

2. Investment property includes assets that generate rental income or

capital appreciation.
• Under IFRS, investment property can either be reported at amortized
cost or fair value.
• Under the fair value model, any change in fair value is recognized in
the income statement.
Non-current assets
3. Intangible assets are non-monetary assets that lack physical substance.

• Identifiable intangible assets can be acquired separately or are the result of rights
or privileges conveyed to its owner over a finite period such as patents,
trademarks and copy rights. Cost of an identifiable assets is amortized over its
useful life.
• Unidentifiable intangible assets can not be acquired separately and may have
an unlimited life . intangible asset with infinite life are not amortized but are
tested for impairment at least annually (goodwill).
Non-current assets
• Goodwill is the excess of purchase price over the fair value of identifiable
assets and liabilities acquired in a business acquisition.
• Economic goodwill derives from the expected future performance of the
firm
• Accounting goodwill is the result of past acquisition
Example
Wood corporation paid $600 million for the outstanding stock of pine corporation.
At the acquisition date, pine reported the following balance sheet.

Pine corporation Book value (millions)

Current assets 80
Plant and equipment, net 760
Goodwill 30
Liabilities 400
Stockholders’ equity 470
Example (continued)
The fair value of the plant and equipment was $120 million more than its
recorded book value. The fair value of all other identifiable assets and liabilities
were equal to their recorded book values. Calculate the amount of goodwill Wood
should report on its consolidated balance sheet.
Solution
Answer :
• Fair value of net asset
= fair value of plant and equipment, net- fair value of liabilities
= 80+880-400=560 million (USD)
• Goodwill = purchase price-fair value of net assets
= 600-560=40 million USD
Notes:
• Firms can manipulate net income upward by allocating more of the acquisition
price to goodwill and less to the identifiable assets.
• Analyst should eliminate goodwill from balance sheet and goodwill impairment
charges from income statement.
Financial assets

• Financial assets include investment securities (stocks and bonds),

derivatives, loans, and receivables.

• Financial instruments are measured at historical cost (unlisted equity

investments, loans, receivables), amortized cost (held-to-maturity
securities), or fair value (trading securities, available-for-sale
securities and derivatives).
II. LIABILITIES
• Are obligations owned by entity from previous transactions that are expected to
result in an outflow of economic benefits in the future.

• Amount has been received but not been recorded as revenue on the income
statement or will have to be returned.

• Amount has been recorded as expense on the income statement but has not
been paid yet.
Current liabilities
Current liabilities are obligations that will be satisfied within one year or
operating cycle, whichever is greater.
1. Accounts payable are amounts the firm owes to suppliers for goods or services
purchased on credit.
2. Notes payable are obligations in the form of promissory notes owed to creditors
and lenders.
3. Current portion of long-term debt is the principal portion of debt due within one
year or operating cycle, whichever is greater.
Current liabilities
4. Accrued liabilities (accrued expenses) are expenses that have been
recognized in the income statement but are not yet contractually due.

5. Unearned revenue (unearned income, deferred revenue, or deferred

income) is cash collected in advance of providing goods and services.
Non-current liabilities

1. Long-term financial liabilities include bank loans, notes payable,

bonds payable and derivatives.

• If the financial liabilities are not issued at face amount, the liabilities
are usually reported on the balance sheet at amortized cost.

• In some cases, financial liabilities are reported at fair value. (Held-

for-trading liabilities, derivatives liabilities,…)
Non-current liabilities
2. Deferred tax liabilities are the amounts of income taxes payable in future
periods as a result of taxable temporary differences.

• Deferred tax liabilities are created when the amount of income tax expense
recognized in the income statement is greater than taxes payable.

• This can occur when expenses or losses are tax deductible before they are
recognized in the income statement.
III. SHAREHOLDERS’ EQUITY
Stockholders’ equity is the residual interest in asset that remains after subtracting
a firm’s liabilities.
Shareholders’ equity is classified into:
• Contributed capital
• Preferred stock
• Treasury stock
• Retained earnings
• Non-controlling interest
• Accumulated other comprehensive income
III. SHAREHOLDERS’ EQUITY
ü Contributed capital
• Total amount paid in by the common and preferred shareholders
• Par value is a legal value and has no relationship to fair value
• Authorized shares are the number of shares that may be sold under the
firm’s articles of incorporation
• Issued shares are the number of shares that have actually been sold to
shareholders
• Outstanding shares is equal to the issued shares less treasury shares
Components of balance sheet
• Treasury stock is stock that has been reacquired by the issuing firm but not yet retired.
Treasury stock reduces stockholders’ equity and has no voting rights as well as dividends
• Retained earnings are the undistributed earnings (net income) of the firm since
inception
• Minority interest is the minority shareholders’ pro-rata share of equity of a subsidiary
that is not wholly owned by the parent
• Accumulated other comprehensive income (IFRS and U.S GAAP) includes all changes in
stockholders’ equity except for transactions recognized in the income statement (net
income) and transactions with shareholders such as issuing stock, reacquiring stock and
paying dividends. Example : differences from asset revaluation, differences from foreign
exchange
Measurement bases of assets and liabilities
• Historical cost is the value that was exchanged at the acquisition date. Historical
cost is verifiable and objective; however, its relevance to investment analysis
declines over time as prices change.
• Fair value is the amount at which an asset can be bought or sold, or a liability can
be incurred or settled between knowledgeable, willing parties in an arms’ length
transaction. Fair value is relatively subjective.
• Because the mixture of measurement bases, the balance sheet value is not the
value of the firm. Analyst must adjust the balance sheet to better asses a firm’s
investment potential or creditworthiness.
• Inventories
• Capitalizing and expensing
INVENTORIES
Method Assumption COGS consist of… Ending inventory
consists of…
FIFO (US and IFRS) The items first first purchased most recent
purchased are the purchases
first to be sold
LIFO (US only) The items last last purchased earliest purchases
purchased are the
first to be sold

Weighted average Items sold are a mix Average cost of all Average cost of all
cost (US and IFRS) of purchases items item
 Example 1
• Use the inventory data in the following figure to calculate the COGS and ending
inventory under the FIFO, LIFO, and weighted average cost methods.

Inventory Data
January 1 (beginning inventory) 2 units @ $2 per unit
January 7 purchase 3 units @ $3 per unit
January 19 purchase 5 units @ $5 per unit
COGS available 10 units
Units sold during January 7 units
Inventories
FIFO LIFO

COGS Lower Higher

Ending inventory Higher Lower

Gross profit Higher Lower

Tax Higher Lower

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CAPITALIZING AND EXPENSING
• When a firm makes an expenditures, it can either capitalize the costs as an asset
on the balance sheet or expense the cost in the income statement in the period
incurred.
• An expenditure that is capitalized is initially recorded as an asset on the balance
sheet at cost, typically its fair value at acquisition plus any costs necessary to
prepare the asset for use.
• The cost is allocated to the income statement over the life of the asset as
depreciation expense (for tangible assets) or amortization expense (for
intangible assets with finite lives).
Example 2
Northwood corp. Purchased new equipment to be used in its manufacturing plant.
The cost of the equipment was $250,000 including $5,000 freight and $12,000 of
taxes. In addition to the equipment cost, Northwood paid $10,000 to install the
equipment and $7,500 to train its employees to use the equipment. Over the
asset’s life, Northwood paid $35,000 for repair and maintenance. At the end of five
years, Northwood extended the life of the asset by rebuilding the equipment’s
motors at a cost of $85,000. What amounts should be capitalized on Northwood’s
balance sheet and what amounts should be expensed in the period incurred?
Example 3
CAP Inc. And NOW Inc. Start up with $1,000 cash and $1,000 common stock.
Each year the companies receive total revenues of $1,500 cash and pay cash
expenses, excluding an equipment purchase, of $500. At the beginning of
operations, each company spends $900 to purchase equipment. CAP
estimates the equipment will have a useful life of three years and an
estimated salvage value of $0 at the end of the three years. NOW estimates a
much shorter useful life and expenses the equipment immediately. The
companies have no other assets and make no other assets purchases during
the three years period. Assume the companies pay no dividends, earn zero
interest on cash balances, have a tax rate of 30%, and use the same
accounting method for financial and tax purposes.
Example 3
1. Which company reports higher net income over the three years?
Total cash flow? Cash from operations?
2. Based on ROE and net profit margin, how do the two companies'
profitability compare?
3. Why NOW Inc. Report change in cash of $70 in year 1 while CAP
Inc. Reports total change in cash of ($110)?
Solution
CAP Inc. 1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash
Solution
NOW Inc. 1 2 3
Revenue
Cash expenses
Depreciation
Income before tax
Tax
Net income
Cash from operation
Cash used in investing
Total change in cash
Solution
CAP Inc. 1 2 3
Revenue $1,500 $1,500 $1,500
Cash expenses 500 500 500
Depreciation 300 300 300
Income before tax 700 700 700
Tax 210 210 210
Net income $490 $490 $490
Cash from operation 790 790 790
Cash used in investing (900) 0 0
Total change in cash ($110) $790 $790
Solution
NOW Inc. 1 2 3
Revenue $1,500 $1,500 $1,500
Cash expenses 1,400 500 500
Depreciation 0 0 0
Income before tax 100 1,000 1,000
Tax 30 300 300
Net income 70 700 700
Cash from operation 70 700 700
Cash used in investing 0 0 0
Total change in cash $70 $700 $700
Solution
Question 1
Neither company reports higher net income nor total cash flow over the three
years. The sum of net income over the three years is identical ($1,470 total)
whether the $900 is capitalized or expensed.
The sum of the change in cash ($1,470 total) is identical under either scenario.
CAP inc. Reports higher cash from operation by an amount of $900 because,
under the capitalization scenario, the $900 purchase is treated as an investing
cash flow.
Solution
CAP 0 1 2 3
Retained earning 0 490 980 1,470
Common stock 1,000 1,000 1,000 1,000
Total shareholders’ equity 1,000 1,490 1,980 2,470
ROE 39% 28% 22%
Net profit margin 33% 33% 33%
Solution
NOW 0 1 2 3
Retained earning 0 70 770 1,470
Common stock 1,000 1,000 1,000 1,000
Total shareholders’ equity 1,000 1,070 1,770 2,470
ROE 7% 49% 33%
Net profit margin 5% 47% 47%
Solution
Question 2
• Capitalizing results in higher profitability ratios in the first year, and lower
profitability ratios in the subsequent years.
• Now’s superior growth in net income between year 1 and year 2 is not
attributable to superior performance but rather to a different accounting
decision.
• As a corollary, now’s income and profitability exhibit greater volatility across
the three years, not because of more volatile performance but rather
because of the different accounting decision.
Solution
Question 3
• Now reports change in cash of $70 in year 1, while CAP reports total change in
cash of $110 because now’s taxes were $180 lower than CAP.
Capitalization of interest costs
Financial Statement Effects of Capitalizing vs. Expensing

Capitalizing Expensing
Total assets
Shareholders’ equity
Income variability
Net income (first year)
Net income (subsequent years)
Cash flow from operations
Cash flow from investing
Debt ratio & Debt to equity
Interest coverage (first year)
Interest coverage (subsequent years)
Financial Statement Effects of Capitalizing vs. Expensing

Capitalizing Expensing
Total assets Higher Lower
Shareholders’ equity Higher Lower
Income variability Lower Higher
Net income (first year) Higher Lower
Net income (subsequent years) Lower Higher
Cash flow from operations Higher Lower
Cash flow from investing Lower Higher
Debt ratio & Debt to equity Lower Higher
Interest coverage (first year) Higher Lower
Interest coverage (subsequent years) Lower Higher
Exercise: Constructing a Balance Sheet

Construct a balance sheet for Gap, Inc. (GPS) using the following list of jumbled accounts
for January 31, 2009. Identify the firmʼs total assets and net working capital: