LM03 Analyzing Balance Sheets 2024 Level I Notes

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LM03 Analyzing Balance Sheets

1. Introduction ...........................................................................................................................................................2
2. Intangible Assets ..................................................................................................................................................3
3. Goodwill ..................................................................................................................................................................4
4. Financial Instruments ........................................................................................................................................5
5. Non-Current Liabilities......................................................................................................................................7
6. Ratios and Common-Size Analysis ................................................................................................................7
Summary................................................................................................................................................................... 10

This document should be read in conjunction with the corresponding reading in the 2023 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.

Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of
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LM03 Analyzing Balance Sheets 2024 Level I Notes

1. Introduction
The balance sheet presents the financial position of a company on a particular date, in terms
of three elements: assets, liabilities, and equity.
• Assets (A) are what the company owns. They are the resources controlled by the
company as a result of past events and they are expected to provide future economic
benefits.
• Liabilities (L) are what the company owes. They represent the obligations of a
company arising from past events, the settlement of which is expected to result in a
future outflow of economic benefits from the entity.
• Equity (E) represents the owners’ residual interest in the company’s assets after
deducting its liabilities. It is also known as shareholders’ equity. The accounting
equation for determining equity is: E = A – L
Limitations of the balance sheet in financial analysis
• Some assets and liabilities are measured based on historical cost while some are
measured based on fair value, which represents its current value as of the balance
sheet date. These differences can have significant impact on reported figure.
• The value of an item reported on the balance sheet is the value at the end of the
reporting period. If we are analyzing the company at a later date, these values may
have changed.
• Some assets and liabilities are difficult to quantify and are not reported on the balance
sheet. For example, brand, customer loyalty, human capital, etc.
A sample balance sheet is presented below:

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LM03 Analyzing Balance Sheets 2024 Level I Notes

Current assets are those assets that are expected to be used up or converted to cash within
one year or in one operating business cycle, whichever is greater. When the entity’s normal
operating cycle cannot be clearly identifiable, its duration is assumed to be one year.
All assets that are not classified as current are considered to be non-current or long-term
assets.
Current liabilities are those liabilities which are expected to be settled within one year or in
one operating business cycle, whichever is greater.
All liabilities that are not classified as current are considered to be non-current or long-term
liabilities
This learning module covers the financial reporting and disclosure requirements related to:
• Intangible assets
• Goodwill
• Financial instruments
• Non-current liabilities
Finally, we will also learn how to analyze a balance sheet using financial ratios and common-
size analysis.
2. Intangible Assets
Intangible assets refer to identifiable non-monetary assets that lack physical substance.
Examples include patents, licenses, and trademarks.
IFRS allows companies to report intangible assets using either a cost model or a revaluation
model. US GAAP allows only the cost model.
For each intangible asset, a company determines whether its useful life is finite or indefinite.
• An intangible asset with a finite useful life is amortized on a systematic basis over the
best estimate of its useful life. The amortization and useful life estimate is reviewed at
least annually.
• The principles of impairment for an intangible asset with a finite useful life are the
same as for property, plant and equipment (PP&E).
• An intangible asset with an indefinite useful life is not amortized. Instead, it is tested
for impairment at least annually.
Intangible Assets Developed Internally
Costs to internally develop intangible assets are generally expensed when incurred, although
there are exceptions.
For internally developed intangible assets, there are two phases: the research phase and the
development phase.

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LM03 Analyzing Balance Sheets 2024 Level I Notes

Research phase refers to the period during which commercial feasibility of an intangible
asset is yet to be established. It is defined as “original and planned investigation undertaken
with the prospect of gaining new scientific or technical knowledge and understanding.”
Development phase refers to the period during which the technical feasibility of completing
an intangible asset has been established with the intent of either using or selling the asset.
The treatment for the two phases varies slightly under IFRS and US GAAP as outlined below:
Under IFRS:
• Research costs are expensed.
• Development costs can be capitalized if technical feasibility and the intent to sell the
asset are established.
Under US GAAP:
• Both research and development costs are expensed.
Intangible Assets Purchased Externally
In contrast to internally created intangibles, acquired or purchased intangible assets are
capitalized and reported as separately identifiable intangibles as long as they are based on
contractual rights (such as a licensing agreement), other legal rights (such as patents), or can
be separated and sold (such as a customer list).
3. Goodwill
Goodwill is an unidentifiable intangible asset. It is created when one company is purchased
by another company. If the purchase price is greater than fair value at acquisition, then the
excess amount is recognized as an asset on the acquirer’s balance sheet and referred to as
goodwill.
Let us consider a simple example. Company A buys Company T for $100 million. The book
value of Company T’s assets and liabilities are $125 million and $75 million respectively.
The fair value of Company T’s assets and liabilities are $160 million and $75 million
respectively. What is the goodwill? In this case, the purchase price is $100 million and the
net fair value is $160 - $75 million = $85 million. Hence, goodwill is ($100 million - $85
million) $15 million. Note that the book values of assets and liabilities are not used in the
goodwill calculation.
Under both IFRS and US GAAP, goodwill is capitalized (i.e., shown as an asset on the balance
sheet). Goodwill is not amortized but is tested for impairment annually. If goodwill is
impaired, it is written down and the impairment loss is shown on the income statement.
The recognition and impairment of goodwill can have a significant impact on the
comparability of financial statements between companies. Therefore, analysts often make
adjustments to remove the impact of good will such as:

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LM03 Analyzing Balance Sheets 2024 Level I Notes

• Excluding goodwill from balance sheet used to compute financial ratios

• Excluding goodwill impairment losses from income data used to examine income
trends.
4. Financial Instruments
IFRS defines a financial instrument as a contract that gives rise to a financial asset of one
company and a financial liability or equity instrument of another entity. Financial assets
include stocks and bonds, derivatives, loans and receivables.
Financial assets can be measured either at fair value or amortized cost. The measurement
basis depends on how financial asset is categorized. The major categories for financial assets
are:
• Measured at Cost or Amortized Cost: Under IFRS, financial assets are measured at
amortized cost if the asset’s cash flows occur on specified dates and consist solely of
principal and interest, and if the business model is to hold the asset to maturity. For
example, investment in a long-term bond. Unrealized gains and losses are not
recorded anywhere.
• Measured at Fair value through profit or loss (FVTPL) under IFRS or Held-for-Trading
under US GAAP: This category of asset is acquired primarily for the purpose of selling
in the near term and is likely to be held for only a short period of time. Unrealized
gains and losses are shown in the income statement.
• Measured at Fair value through other comprehensive income (FVTOCI) under IFRS or
available-for-sale under US GAAP: This category of asset is expected neither to be held
till maturity nor traded in the near term. Unrealized gains and losses are shown in
other comprehensive income.
Unlike IFRS, the US GAAP category available-for-sale applies only to debt securities
and is not permitted for investments in equity securities.
The table below summarizes where gains and losses associated with the financial asset are
recognized in the financial statements of the company.
Asset Category Treatment
Measured at Fair Value • Measured at fair value.
through Profit and Loss • Unrealized gains shown on Income Statement.
Measured at Fair Value • Measured at fair value.
through Other • Unrealized gains/losses shown in other comprehensive
Comprehensive Income income (OCI).
Measured at Cost or • Measured at cost or amortized cost.
Amortized Cost • Unrealized gains not recorded anywhere.

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LM03 Analyzing Balance Sheets 2024 Level I Notes

Realized gains for all categories are shown on the income statement of the company. An
important concept related to these assets is mark-to-market. It is the process whereby the
value of a financial instrument is adjusted to reflect current value based on market prices.
Let us illustrate the different accounting treatments for each of these categories through a
simple example.
Example
Company owners contribute $100,000, which is invested in a 20-year bond with a 5%
coupon paid semi-annually. After six months, the company receives the first coupon
payment of $2,500. At this stage, the market price has increased to $102,000. Show the
balance sheet and income statement treatment under each of the three categorizations.
Solution:
The accounting treatment under the three categories is summarized below:
Measured at Fair Measured at Fair Measured at Cost or
Value through Value through Amortized Cost
Profit and Loss Other
Comprehensive
Income
Balance Sheet
Cash $2,500 $2,500 $2,500
Cost of securities $100,000 $100,000 $100,000
Unrealized $2,000 $2,000
gains/losses
PIC $100,000 $100,000 $100,000
RE Up by $4,500 Up by $2,500 Up by $2,500
OCI Up by $2,000
Income Statement
Interest income $2,500 $2,500 $2,500
Unrealized gain $2,000
For Measured at Fair Value through Profit and Loss, unrealized gains and cash from coupon
payments are shown on the asset side of the balance sheet. On the equity side, paid-in capital
remains the same at $100,000. Retained earnings increase by $4,500 (sum of coupon
payment of $2,500 and unrealized gain of 2,000). On the income statement unrealized gain
of $2,000 and interest income of $2,500 is recognized.

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LM03 Analyzing Balance Sheets 2024 Level I Notes

For Measured at Fair Value through Other Comprehensive Income, the accounting treatment
is the same as HFT except for unrealized gains. For AFS, the unrealized gain is shown as part
of other comprehensive income (OCI). It is not shown on the income statement.
For Measured at Cost or Amortized Cost, the asset is valued at amortized cost. Therefore, the
unrealized gain of $2,000 is not shown on the balance sheet or income statement. Only the
coupon payment of $2,500 is shown on the balance sheet as cash and on the income
statement as interest income.
5. Non-Current Liabilities
All liabilities that are not classified as current are considered to be non-current or long-term
liabilities.
Long-term financial liabilities - Include loans, notes and bonds payable. These are usually
reported at amortized cost on the balance sheet.
For example, if a company issues $10 million in bonds at 97.50% of par value (i.e., at a
discount to par), the bonds will be reported as a liability of $9.75 million on the date of issue.
The $250,000 discount will be amortized over the bond's life, resulting in a book value of
$10 million at maturity.
Deferred tax liabilities - Arise from temporary timing difference between a company’s
taxable income and reported income. They are defined as the amounts of income taxes
payable in future periods due to temporary taxable differences.
6. Ratios and Common-Size Analysis
Common-Size Analysis of the Balance Sheet
Balance sheet analysis can help us evaluate a company’s liquidity and solvency. A balance
sheet can be used to analyze a company’s capital structure and ability to pay liabilities.
In a vertical common-size balance sheet, all balance sheet items are expressed as a
percentage of total assets. Common-size statements are useful in comparing a company’s
balance sheet composition over time (time-series analysis) and across companies in the
same industry. An example of a common-size balance sheet is shown below for a fictitious
company - Everest Inc.
ASSETS 2021 2020
Cash and cash equivalents 10.81% 13.12%
Short-term marketable securities 1.24% 0.62%
Other financial assets 1.24% 1.21%
Accounts receivable 7.50% 4.80%
Inventory 25.32% 25.97%
Other current assets 3.37% 2.14%

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LM03 Analyzing Balance Sheets 2024 Level I Notes

Property, plant and equipment 38.76% 40.06%

Investment property 6.18% 6.22%
Intangible assets 0.22% 0.35%
Deferred tax assets 0.11% 0.08%
Goodwill 0.91% 1.09%
Long-term loans 4.32% 4.32%
Other non- current assets 0.03% 0.02%
Total 100.00% 100.00%
EQUITY and LIABILITIES
Short-term borrowing 0.46% 0%
Accounts payable 6.49% 6.22%
Accrued expenses 4.22% 3.38%
Deferred revenue 1.30% 1.21%
Other current liabilities 24.29% 24.42%
Long-term borrowings 0.23% 0.31%
Deferred tax liabilities 4.01% 4.20%
Other long-term liabilities 0.12% 0.13%
Stockholder's equity 58.88% 60.13%
Equity and Liabilities 100.00% 100.00%
Balance Sheet Ratios
Balance sheet ratios are those involving balance sheet items only. Liquidity ratios tell us
about a company’s ability to meet current liabilities, while solvency ratios tell us about a
company’s ability to meet long-term and other obligations. They also help us evaluate a
company’s financial risk and leverage. The following table summarizes some liquidity ratios.
The last column shows the relevant ratios for Everest Inc. for 2021.
Ratios for
Liquidity
Calculation Everest Inc. for
Ratios
2021
Current Current assets ÷ Current liabilities 1.35
Quick (acid (Cash + Marketable securities + Receivables) ÷ Current 0.53
test) liabilities
Cash (Cash + Marketable securities) ÷ Current liabilities 0.33

Solvency ratios help to evaluate:

• a company’s ability to meet long-term and other liabilities.

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LM03 Analyzing Balance Sheets 2024 Level I Notes

• a company’s financial risk and leverage. The following table summarizes some
solvency ratios:
Ratios for
Solvency Ratios Calculation Everest Inc. for
2021
Long-term debt- 0.004
Total long-term debt ÷ Total equity
to-equity
Debt-to-equity Total debt ÷ Total equity 0.012
Total debt-to- 0.007
Total debt ÷ Total assets
assets
Financial 1.69
Total assets ÷ Total equity
leverage
It is important for analysts to remember that ratio analysis requires judgment. For example,
current ratio is only a rough measure of liquidity. In addition, ratios are sensitive to end of
period financing and operating decisions that can potentially impact current asset and
current liability amounts. Analysts should also evaluate ratios in the context of a company’s
industry. This requires an examination of the entire operations of a company, its
competitors, and the external economic and industry setting.

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LM03 Analyzing Balance Sheets 2024 Level I Notes

Summary
LO: Explain the financial reporting and disclosures related to intangible assets.
Intangible assets refer to identifiable non-monetary assets that lack physical substance.
For each intangible asset, a company determines whether its useful life is finite or indefinite.
• An intangible asset with a finite useful life is amortized on a systematic basis over the
best estimate of its useful life. The amortization and useful life estimate is reviewed at
least annually.
• The principles of impairment for an intangible asset with a finite useful life are the
same as for property, plant and equipment (PP&E).
• An intangible asset with an indefinite useful life is not amortized. Instead, it is tested
for impairment at least annually.
For internally developed intangible assets,
Under IFRS:
• Research costs are expensed.
• Development costs can be capitalized if technical feasibility and the intent to sell the
asset are established.
Under US GAAP:
• Both research and development costs are expensed.
LO: Explain the financial reporting and disclosures related to goodwill.
Goodwill arises when one company is purchased by another company. If the purchase price
is greater than fair value at acquisition, then the excess amount is recognized as an asset on
the acquirer’s balance sheet and referred to as goodwill. Under both IFRS and U.S. GAAP,
accounting goodwill is capitalized.
Goodwill is not amortized; instead, it is tested for impairment at least annually.
LO: Explain the financial reporting and disclosures related to financial instruments.
Financial assets include investment securities, derivatives, loans, and receivables. The
following table summarizes measurement of different categories of financial assets:
Asset Category Treatment
Measured at Fair Value • Measured at fair value.
through Profit and Loss • Unrealized gains shown on Income Statement.
Measured at Fair Value • Measured at fair value.
through Other • Unrealized gains/losses shown in other comprehensive
Comprehensive Income income (OCI).

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LM03 Analyzing Balance Sheets 2024 Level I Notes

Measured at Cost or • Measured at cost or amortized cost.

Amortized Cost • Unrealized gains not recorded anywhere.

LO: Explain the financial reporting and disclosures related to non-current liabilities.
Long-term financial liabilities such as loans, notes and bond payables are reported at
amortized cost on the balance sheet.
Deferred tax liabilities arise from temporary timing difference between a company’s taxable
income and reported income. They are defined as the amounts of income taxes payable in
future periods due to temporary taxable differences.
LO: Calculate and interpret common-size balance sheets and related financial ratios.
In a common-size balance sheet, all balance sheet items are expressed as a percentage of
total assets. Common-size statements are useful in comparing a company’s balance sheet
composition over time and across companies in the same industry.
Balance sheet ratios are those involving balance sheet items only. Liquidity ratios tell us
about a company’s ability to meet current liabilities while solvency ratios tell us about a
company’s ability to meet long-term and other obligations. The following table summarizes
these ratios:

Liquidity Ratios Calculation

Current Current assets ÷ Current liabilities
(Cash + Marketable securities + Receivables) ÷ Current
Quick (acid test)
liabilities
Cash (Cash + Marketable securities) ÷ Current liabilities
Solvency Ratios Calculation
Long-term debt-to-equity Total long-term debt ÷ Total equity
Debt-to-equity Total debt ÷ Total equity
Total debt-to-assets Total debt ÷ Total assets
Financial leverage Total assets ÷ Total equity

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