What is it? What is Assets = Liabilities + Equity?
Balance Sheet is a statement which presents a company’s financial position at a specific point in time, by disclosing their assets (resources companies own), liabilities (obligations to lenders and creditors), and owner’s equity (excess of assets over liabilities, which is the residual interest/claim).
An asset must (i) have probable future economic value, (ii) be controlled by a particular entity, and (iii) result from past transaction and/or events. A liability must (i) have probable future sacrifice of economic benefit, (ii) present obligations of an entity's asset, and (iii) result from past transaction and/or events.
Specifically, current assets can be converted to cash in less than one year, while non-current assets require a year or more to receive the benefit. Conversely, current liabilities are obligations that must be met in less than one year, while non-current liabilities extend the one year. IFRS and GAAP require a company to distinguish between current and non-current assets and liabilities; however, only GAAP requires liquidity based presentation, where the accounts must be listed from most to least liquid.
Noteworthy Current Assets include the following:
· Cash and Cash Equivalents are the most liquid and include short-term investments that are close to maturity. They are financial assets which are reported at either amortized cost or fair value.
· Marketable Securities are financial assets which include investments in debt or equity securities that are traded in a public market (and the value can be determined from the public price information). Examples include T-bills, notes, bond, and equity securities.
· Trade Receivables are known as accounts receivables (“AR”). They are reported as net realizable value (approximation of fair value), based on the estimates of collectability. Relevant aspects to AR are (i) AR relative to sales, (ii) allowance for doubtful accounts, and (iii) credit risk. Allowance for doubtful account is a contra account to AR and is listed as a net basis (allowance for doubtful accounts is not listed in a separate line but shows up as “less allowances” next to the AR line).
· Inventories are physical products that will eventually be sold to the company’s customers. This includes materials at their current form (finished goods) or inputs into a process of the final product (raw materials and work in process). Excluded from the inventory costs are (i) abnormal amounts of wasted materials or labor, (ii) storage costs, unless necessary to final process, (iii) administrative overheads, and (iv) selling costs. These costs are expensed typically as SG&A.
· A Prepaid Expense results from an entity advancing payments on a good or service, before delivery. Value would later be expensed in the income statement. Accrued Revenue results from an entity selling or completing an order or service without billing or receiving cash. Value would later be recognized as a debit to equity when receiving the revenue.
· Other current assets reflect items that individually, are not material enough to require a separate line item, and therefore, aggregated to a single amount. The components of this aggregate line item are disclosed in the notes of the financial statement.
Noteworthy Current Liabilities include the following:
· Trade payables, also known as accounts payable (“AP”), are amount that a company owes its vendors for purchases of goods and services (unpaid amount of the company’s purchase on credit).
· Notes payables are financial liabilities owed by a company to creditors, through formal loan agreements (i.e. loans or note payables due within the year).
· Accrued expenses are expenses that have been recognized on a company’s income statement, without the balance sheet cash transaction. Deferred (unearned) income is when a company receives cash payments in advance of the delivery of goods, and the revenue would be recorded upon the completion of the transaction.
Noteworthy Non-Current Assets include the following (must be greater than one year):
· Property, Plant, and Equipment (“PPE”) are tangible assets used in company operation and expected to provide economic benefit over more than one fiscal period. PPE is presented on the balance sheet while net of depreciation or depreciation expense is recognized in the income statement. Depreciation is a contra asset account, meaning that it decreases the value of the asset. Impairment losses are an unanticipated decline of value and a non-cash item, which occurs when the asset’s recoverable amount is less than the carrying amount. Impairments are recognized in the income statement.
·Intangible assets are identifiable non-monetary assets, without physical substance. Similar impairment principles as PPE apply, amortization is applied similarly as depreciation to PPE (but intangible assets with indefinite useful lives are not amortized, where the reasonableness of the indefinite useful life assumption is reviewed and tested for impairments annually).
· Goodwill is the excess of the fair value purchase price of identifiable assets – liabilities (from a company’s acquisition). A company may pay more than fair value for the following reasons: (i) certain items not recognized in a company’s financial statement have value, (ii) target company’s expenditures in R&D may not have resulted in a separately identifiable asset, or (iii) value of the acquisition may be in the strategic positioning or from perceived synergies. Accounting standards for recognizing goodwill is (i) total cost to purchase of a target company is determined, (ii) acquiree’s identifiable assets are measured at fair value, and (iii) goodwill arising from the purchase is the excess of (a) cost to purchase the target company and (b) the net identifiable assets acquired. Under IFRS and GAAP, goodwill arising from acquisitions can be capitalized. Goodwill is not amortized but is tested annually for impairments, and if impaired, the loss would be charged against income for the current period and reduce earnings. Proponents of goodwill recognition assert that goodwill is the present value of excess returns (analogous to determining the present value of future cash flows associated from another project). Critics state that goodwill is based on unrealistic expectations, leading to potential write-offs. Goodwill can affect the comparability of financial statements for cross-sectional analysis; therefore, analysts often adjust companies’ impacts by removing the impact of goodwill.
· Financial assets includes: (i) held-to-maturity refers to financial assets where cash flows occur on specified dates and consist solely of principal and interest, and the business model is to hold them until they mature; (ii) held for trading refers to a category of financial assets that is acquired primarily for the purpose of selling in the near term; (ii) available-for-sale refers to financial assets that are not classified as held for trading, but are available to sold.
Noteworthy Non-Current Liabilities include the following (must be greater than one year):
· Long-term financial liabilities include loans and notes payable (or bonds payable). Liabilities as loans or bonds payable are reported at amortized cost.
· Deferred tax liabilities result from temporary timing differences between a company’s income as reported for tax purposes and income as reported for financial statement (accounting) purposes. This occurs when taxable income and payable is less than the reported financial statement income (i.e. tax depreciation may be more accelerated than the accounting depreciation, meaning the higher expense on the tax depreciation means less taxes paid now, which renders a deferred tax liability).
Components that comprise total owners’ equity are the following (the “CPTRAN” approach):
· Capital contributed by owners (Common Stock)
· Preferred Shares - equities with higher claim priority
· Treasury shares - shares that have been issued and subsequently repurchased
· Retained Earnings – The residual amount available after reducing contributed capital
· Accumulated OCI (Other Comprehensive Income) – Items that are classified as OCI are (i) foreign currency translation adjustment, (ii) unrealized gains or losses on derivatives contracts accounted for as hedges, (iii) unrealized holding gains and losses on available-for-sale securities, and (iv) certain costs of a company’s defined benefit post-retirement plans not recognized in the current period.
· Non-controlling interest - interests of minority shareholders in the subsidiary companies that have been consolidated by the parent company, but are not wholly owned.
Analysis of the Balance Sheet
Common size analysis lists items as a percentage of assets; they are useful for both time-series and cross-sectional (companies within the same industry) analysis. Some general observations made from this type of analysis includes: (i) energy and utility companies have the largest amount of PPE, (ii) financial companies typically have the largest amounts of liabilities and financial leverage, (iii) telecommunications services have the lowest level of receivables, (iv) consumer retailers typically have the largest inventory levels, and (v) IT has the least amount of leverage.
Balance Sheet ratios include (i) liquidity and (ii) solvency: It is important to note that ratio analysis requires a significant amount of judgment and require further interpretation.
Mainstay liquidity ratios include:
· Current = Current Assets/ Current Liabilities,
· Quick (Acid Test) = (Cash + Marketable Securities + AR)/ Current Liabilities
· Cash = (Cash + Marketable Securities)/ Current Liabilities
Mainstay solvency ratios include:
· Long Term = Long-Term Debt/Equity
· Debt-to-Equity = Total debt/ Equity
· Financial Leverage = Assets/Equity