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Understanding balance sheets
- 2. Learning Objectives Understand balance terminology Learn how balance sheet accounts are measured, classified and presented Learn how balance sheet information is used Discover how notes to the financial statements aid in the understanding of the firm’s accounting policies, contingent liabilities, subsequent events, related-party transactions, and other disclosures on balance sheet accounts. 2
- 3. Balance Sheet The balance sheet is also known as the statement of financial position or statement of financial condition. The balance sheet discloses, at a specific point in time, what an entity owns (or controls), what it owes, and what the owners’ claims are. Assets = Liabilities + Owners’ equity 3
- 4. 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. 4
- 5. Balance Sheet Format Liquidity For a company overall, its ability to pay for short- term obligations For a particular asset or liability, its “nearness to cash” Balance sheet ordering according to liquidity Companies using U.S. GAAP (e.g., Colgate) order items on the balance sheet from most liquid to least liquid. Companies using IFRS order balance sheet information from least liquid to most liquid. 5
- 6. Current and Noncurrent Assets and Liabilities Balance sheet must distinguish between and present separately current and noncurrent assets current and noncurrent liabilities Exception to the current and noncurrent classifications requirement, under IFRS: Current and noncurrent classifications are not required if a liquidity-based presentation provides reliable and more relevant information. In a liquidity-based presentation, all assets and liabilities are presented in order of liquidity. Liquidity-based presentation are often used by banks. Classified balance sheet: Balance sheet with separately classified current and noncurrent assets and liabilities. 6
- 7. Current and Noncurrent Assets and Liabilities Current assets: Assets expected to be sold, used up, or otherwise realized in cash within one year or one operating cycle of the business, whichever is greater, after the reporting period. Noncurrent assets: Assets not classified as current. Also known as long-term or long-lived assets. Current liabilities: Liabilities expected to be settled within one year or within one operating cycle of the business. Noncurrent liabilities: All liabilities not classified as current. 7
- 8. Balance Sheet: Example Colgate-Palmolive Company (assets) 8
- 9. Balance Sheet: Example Colgate-Palmolive Company (liabilities) 9
- 10. Balance Sheet: Example Colgate-Palmolive Company (equity) 10
- 11. Balance Sheet: Example Henkel AG (assets) 11
- 12. Common-size Balance Sheets 12 ($ 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
- 13. Common-size Balance Sheets 13 (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%
- 14. Common-size Balance Sheets 14 (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%
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- CUSTOMIZATION NOTES: Hyperlinks to the annual reports of companies used in this presentation are provided at the bottom of certain pages. If the presenter saves the annual report to the same computer drive on which the PowerPoint presentation is saved, clicking the hyperlink will take the presenter to the annual report. Note also that the relevant items are bookmarked in each annual report PDF. To navigate to the bookmarked pages, select the bookmark icon once the PDF is open (2nd down on far left of screen when PDF is opened). LEARNING OUTCOMES Describe the elements of the balance sheet: assets, liabilities, and equity. Describe uses and limitations of the balance sheet in financial analysis. Describe alternative formats of balance sheet presentation. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Describe different types of assets and liabilities and the measurement bases of each. Describe the components of shareholders’ equity. Convert balance sheets to common-size balance sheets and interpret the common-size balance sheets. Calculate and interpret liquidity and solvency ratios.
- LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. The balance sheet is also called the statement of financial position or statement of financial condition. IFRS uses the term “statement of financial position” (IAS 1, Presentation of Financial Statements), although U.S. GAAP uses the two terms interchangeably (ASC 210-10-05 [Balance Sheet–Overall–Overview and Background]). The balance sheet discloses what an entity owns (or controls), what it owes, and what the owners’ claims are at a specific point in time. The equation A = L + E is sometimes summarized as follows: The left side of the equation reflects the resources controlled by the company, and the right side reflects how those resources were financed.
- LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. The financial position of a company is described in terms of its basic elements (assets, liabilities, and equity): Assets (A) are what the company owns (or controls). More formally, assets are 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) are what the company owes. More formally, liabilities represent 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. Commonly known as shareholders’ equity or owners’ equity, equity is determined by subtracting the liabilities from the assets of a company. Equations: A – L = Eand A = L + E Depending on the sophistication of the audience, the presenter could use the concept that a company’s equity is analogous to an individual’s net worth: total assets minus total liabilities. For all financial statement items, an item should only be recognized in the financial statements if it is probable that any future economic benefit associated with the item will flow to or from the entity and if the item has a cost or value that can be measured with reliability.
- LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. A company’s ability to pay for its short-term operating needs relates to the concept of liquidity. With respect to a company overall, liquidity refers to the availability of cash to meet those short-term needs. With respect to a particular asset or liability, liquidity refers to its “nearness to cash.” A liquid asset is one that can be easily converted into cash in a short period of time at a price close to fair market value. For example, a small holding of an actively traded stock is much more liquid than an asset like a commercial real estate property in a weak property market. Ordering according to liquidity: In general, financial statements prepared in accordance with IFRS present balance sheet information in the reverse order of liquidity compared with U.S. GAAP. For example, using IFRS, assets are presented starting with noncurrent assets followed by current assets, and equity is presented first, followed by noncurrent liabilities and current liabilities. IFRS does not prescribe the reverse ordering. IAS 1, Presentation of Financial Statements, Paragraph 57: “This Standard does not prescribe the order or format in which an entity presents items.”
- LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. The definition of current/noncurrent is provided later. The separate presentation of current and noncurrent assets and liabilities enables an analyst to examine a company’s liquidity position (at least as of the end of the fiscal period). Both IFRS and U.S. GAAP require that the balance sheet distinguish between current and noncurrent assets and between current and noncurrent liabilities and present these as separate classifications. A balance sheet with separately classified current and noncurrent assets and liabilities is referred to as a classified balance sheet. An exception to this requirement, under IFRS, is that the current and noncurrent classifications are not required if a liquidity-based presentation provides reliable and more relevant information. IAS 1, paragraph 60: “An entity shall present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position in accordance with paragraphs 66–76 except when a presentation based on liquidity provides information that is reliable and more relevant. When that exception applies, an entity shall present all assets and liabilities in order of liquidity.” All three of the companies featured in the previous examples show a subtotal for current assets and current liabilities.
- LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. Assets held primarily for the purpose of trading or expected to be sold, used up, or otherwise realized in cash within one year or one operating cycle of the business, whichever is greater, after the reporting period are classified as current assets. A company’s operating cycle is the average amount of time that elapses between acquiring inventory and collecting the cash from sales to customers. For a manufacturer, this is the average amount of time between acquiring raw materials and converting these into cash from a sale. Examples of companies that might be expected to have operating cycles longer than one year include those operating in the tobacco, distillery, and lumber industries. Even though these types of companies often hold inventories longer than one year, the inventory is classified as a current asset because it is expected to be sold within an operating cycle. Assets not expected to be sold or used up within one year or one operating cycle of the business, whichever is greater, are classified as noncurrent (or long-term or long-lived) assets. Current assets are generally maintained for operating purposes, and these assets include, in addition to cash, items expected to be converted into cash (e.g., trade receivables), used up (e.g., office supplies, prepaid expenses), or sold (e.g., inventories) in the current period. Current assets provide information about the operating activities and the operating capability of the entity. For example, the item “trade receivables” or “accounts receivable” would indicate that a company provides credit to its customers. Noncurrent assets represent the infrastructure from which the entity operates and are not consumed or sold in the current period. Investments in such assets are made from a strategic and longer-term perspective. Similarly, liabilities expected to be settled within one year or within one operating cycle of the business, whichever is greater, after the reporting period are classified as current liabilities. The specific criteria for classification of a liability as current include the following: It is expected to be settled in the entity’s normal operating cycle. It is held primarily for the purpose of being traded. It is due to be settled within one year after the balance sheet date. The entity does not have an unconditional right to defer settlement of the liability for at least one year after the balance sheet date. IFRS specify that some current liabilities, such as trade payables and some accruals for employee and other operating costs, are part of the working capital used in the entity’s normal operating cycle. Such operating items are classified as current liabilities even if they will be settled more than one year after the balance sheet date. When the entity’s normal operating cycle is not clearly identifiable, its duration is assumed to be one year. All other liabilities are classified as noncurrent liabilities. Noncurrent liabilities include financial liabilities that provide financing on a long-term basis. The excess of current assets over current liabilities is called “working capital.” The level of working capital tells analysts something about the ability of an entity to meet liabilities as they fall due. Although adequate working capital is essential, working capital should not be too large because funds may be tied up that could be used more productively elsewhere.
- LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. This slide shows the assets portion of the balance sheet of Colgate-Palmolive. The assets are typical for a manufacturer: cash; receivables; inventories; property, plant, and equipment; goodwill; and intangibles. We will examine the main types of assets in later slides. Asset composition of firms varies depending on industry.
- LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. This slide shows the liabilities portion of the balance sheet of Colgate-Palmolive. The types of liabilities are typical for most companies: accounts payable, notes payable, long-term debt (payable), and accrued income taxes (payable).
- LOS. Describe the elements of the balance sheet: assets, liabilities, and equity. This slide shows the equity portion of the balance sheet of Colgate-Palmolive. Total equity ($2,541) equals total assets ($12,724) minus total liabilities ($10,183). We will examine the main components of equity in later slides.
- LOS. Describe alternative formats of balance sheet presentation. LOS. Distinguish between current and noncurrent assets, and current and noncurrent liabilities. This slide shows the asset portion of the balance sheet of Henkel AG & Co., a German company that prepares its financial statements under IFRS. Henkel has laundry and home care, cosmetics/toiletries, and adhesive technologies businesses. The company has numerous well-known brands, including Persil, Purex, and Dial. Henkel’s balance sheet illustrates the following differences from Colgate’s balance sheet: It illustrates the ordering of assets from least liquid to most liquid, with noncurrent intangible assets at the top and cash at the bottom. It uses the title “consolidated statement of financial position” rather than balance sheet. It presents the older year 2010 to the left of the more recent year 2011. It supplies the number of the relevant footnote on the face of the balance sheet. It presents additional columns showing each line item of assets as a percentage of total assets.
- LOS. Convert balance sheets to common-size balance sheets and interpret the 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.” As the chapter on financial statement analysis discusses, there is another type of common-size analysis, which is known as “horizontal common-size analysis;” it states items in relation to a selected base year value. This discussion pertains to vertical common-size analysis. The example presents partial income statements (through operating profit) for three hypothetical companies operating in the same industry. Company A and Company B, each with $3,250 thousand, are smaller (as measured by assets) than Company C, which has $9,750 thousand in assets. How can an analyst meaningfully compare the financial position of these companies?
- LOS. Convert balance sheets to common-size balance sheets and interpret the 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.” Liquidity: Current assets relative to current liabilities affect the assessment of liquidity. Company A is more liquid than Company B. For Company A, current assets are 77% of assets versus current liabilities at 0%. For Company B, current assets are 68% of assets versus current liabilities at 77%. Referring back to the dollar amounts, Company A shows no current liabilities (its current liabilities round to less than $10 thousand), and it has cash on hand and short-term marketable securities of $1.9 million to meet any near-term financial obligations it might have. In contrast, Company B has $2.5 million of current liabilities, which exceed its available cash and securities of only $200 thousand. How will Company B pay its near-term obligations? Company B will need to collect some of its accounts receivable, sell more inventory, borrow from a bank, and/or raise more long-term capital (e.g., by issuing more bonds or more equity). Company C is also more liquid than Company B. It holds more than 30% of its total assets in cash and short-term marketable securities, and its current liabilities are only 6.2% of the amount of total assets. Composition of current assets affects assessment of liquidity. Most of the assets of Company A and B are current assets; however, Company A has nearly 60% of its total assets in cash and short-term marketable securities, whereas Company B has only 6% of its assets in cash and marketable securities. Solvency: Typically assessed by examining both capital structure and coverage (ability to generate income and cash flow sufficient to cover interest and principal). Because this presentation pertains only to the balance sheet, it examines only capital structure. Company A is more solvent than Company B or C. Less than 1% of Company A’s assets are financed with liabilities. Based on these numbers, it seems very unlikely that Company A would have difficulty paying the interest and principal on its long-term bonds. 98.5% of Company C’s assets are financed with liabilities. If Company C experiences significant fluctuations in cash flows, it may be unable to pay the interest and principal on its long-term bonds. Other observations: Common-size balance sheets can also highlight differences in companies’ strategies. Comparing the asset composition of the companies, Company C has made a greater proportional investment in property, plant, and equipment—possibly because it manufacturers more of its products in-house. Company B’s balance sheet shows goodwill. This signifies that it has made one or more acquisitions in the past. In contrast, the lack of goodwill on the balance sheets of Company A and Company C suggests that these two companies may have pursued a strategy of internal growth rather than growth by acquisition. Company A’s balance sheet has relatively little inventory and no accounts payable. What could explain this composition? It either has not yet established trade credit or is in the process of paying off its obligations in the process of liquidating. It may be in either a start-up or liquidation stage of operations. Caveat: Being more liquid or more solvent does not necessarily translate into “better.” At the extreme, the most liquid and most solvent company would hold only cash as an asset and be financed only with equity (i.e., no debt), but it could not be argued that would be “best.” A wide range of factors affect a company’s liquidity management and capital structure. In practice, differences across companies are more subtle, but the concepts are similar to those illustrated here. An analyst, noting significant differences, would do more research and seek to understand the underlying reasons for the differences and their implications for the future performance of the companies.
- NOTE to Presenter: This is an alternative slide identical to the previous slide but omitting decimal places.