Part 4. Understanding Balance Sheets Flashcards
Balance sheet
This reports the firms financial position at a point in time, which consists of assets, liabilities and equity.
Assets
Resources controlled as a result of past transactions that are expected to provide future economic benefits.
Liabilities
Obligations as a result of past events that are expected to require an outflow of economic resources.
Equity
The owners residual interest in assets after deducting liabilities, sometimes referred to as ‘net assets’.
Uses of balance sheet
To assess a firms liquidity, solvency and ability to make distributions to shareholders.
Liquidity = the ability to meet short term obligations. Solvency = the ability to meet long term obligations.
Classified balance sheet
Both IFRS and US GAAP require firms to separately report their current assets and noncurrent assets and current and noncurrent liabilities.
This is useful in evaluating liquidity.
Liquidity based format
If the presentation is more relevant and reliable, often used in the banking industry, present assets and liabilities in order of liquidity.
Current assets
It include cash and others assets that will likely be converted into cash or used up within one year or one operating cycle, whichever is greater.
Usually presented in order of their liquidity, with cash being most liquid, and reveal information about operating activities of the firm.
Operating cycle
The time it takes to produce or purchase inventory, sell the product and collect the cash.
Current liabilities
Obligations that will be satisfied within one year or one operating cycle, whichever is greater.
A liability that meets any of the following criteria is considered current:
- settlement is expected during the normal operating cycle.
- settlement is expected within one year.
- held primarily for trading purposes.
- there is no unconditional right to defer settlement for more than one year.
Working capital
= Current assets - current liabilities
- Lack of working capital may indicate liquidity problems.
- Too much working capital may be an indication of inefficient use of assets.
Non current assets
It does not meet the definition of current assets as they will not be converted into cash or used up within 1 year or operating cycle.
- To provide information about firms investing activities, which form the foundation upon which the firm operates.
Non current liabilities
Does not meet the criteria of current liabilities, to provide information about the firm’s long-term financing activities.
Intangible assets
These are non-monetary assets that lack physical substance, which are either identifiable or unidentifiable.
Identifiable intangible assets
These can be acquired separately or are the result of rights or privileges conveyed to their owner.
e.g. patents, trademarks, copyrights
Unidentifiable intangible assets
These cannot be acquired separately and may have unlimited life, such as goodwill.
Expense incurred through intangible assets (under IFRS & US GAAP):
- Startup and training costs
- Administrative overhead
- Advertising and promotion costs
- Relocation and reorganisation costs
- Termination costs
Goodwill
- The excess of purchase price over fair value of identifiable net assets (assets - liabilities) acquired in a business acquisition, where acquires are willing to pay more than fair value as target may not have assets reported on balance sheet.
- Only created in purchase acquisition, internally generated goodwill is expensed as incurred.
- This is not amortised but must be tested for impairment at least annually if impaired goodwill is reduced and loss is recognised in income statement. The impaired loss does not affect cashflow; if goodwill is not impaired it can remain on balance sheet indefinitely.
- Not amortised so firms can manipulate net income upward allocating more acquisition price to goodwill, resulting in less depreciation and amortisation expense resulting in higher net income.
- Economic goodwill = the expected future performance of firm, while accounting goodwill is a result of past acquisitions.
Financial instruments
These are contracts given to rise both financial asset of one entity and financial liability or equity instrument of another entity, found on the asset and liability side of balance sheet.
Measured at historical cost, amortised cost or fair value.
Financial asset
This includes investment securities (stocks and bonds), derivatives, loans and recievables.
Held-to-maturity securities
Under US GAAP, debt securities with intent hold them until mature and measured at amortised cost.
amortised cost = (original issue price - any principal payment) + any amortised discount or - any amortised premium - impairment losses.
Mark to market
Financial assets measured at fair value, including trading securities, available for sale securities and derivatives.
Trading securities
These are debt securities acquired with intent to sell them over the near term, reported on the balance sheet at fair value, and unrealised gains and losses are recognised in income statement.
Equity security holding treated in the same manner.
Derivative instruments treated the same as trading securities.
Available for sale securities
Debt securities that are not expected to be held to maturity or traded in near term, reported on balance sheet at fair value, but unrealised gains or losses are not recognised in income statement, reported as other comprehensive income part of shareholders equity.
- All financial securities, dividend, and interest income and realised gains and losses are recognised in income statement.
Long term financial liabilities (Non-Current Liabilities)
These include bank loans, notes payable, bonds payable, and derivatives, if not issued at face amount they are reported as an amortised cost.
In some cases reported at fair value, e.g. include held-for-trading liabilities such as short position in a stock (ST liability), derivative liabilities, non-derivative liabilities with exposure hedged by derivatives.
Deferred tax liabilities
The amounts of income taxes payable in future periods as a result of taxable temporary differences.
Created when amount of income tax expense is recognised in income statement greater than taxes payable.
Created when revenues/gaisn recignised in income statement before taxable.
Owners equity
The residual interest in assets that remian after subtracting an entity’s liability.
This includes:
- contributed capital
- preferred stock
- treasury stock
- retained earnings
- non-controlling interest
- accumulated other comprehensive income
Contributed capital
The amount contributed by equity shareholders.
Par value
The stated or legal value with no relationship to fair value, which exists and is reported separately in stockholders equity.
e.g. total proceeds from issuing an equity security are par value of issued shares plus additional paid in capital.
Authorised shares
The number of shares may be sold under the firms articles of incorporation.
Issued shares
The number of shares that have actually been sold to shareholders.
Outstanding shares
Equal to issued shares less shares that have been reacquired by the firm (i.e. treasury stock)
Preferred stock
This has certain rights and privledges not conferred by common stock.
e.g. preferred shareholders paid dividends at specific rate usually expressed as % of par value, and have priority over claims of common shareholders in event of liquidation.
This can be classified as debt or equity.
This calls for mandatory redemption in fixed amounts is considered a financial liability.
Noncontrolling interest
The minority shareholders pro-rata share of net asstes of a subsidiary not wholly owned by the parent.
Retained earnings
The undistributed earnings (net income) of firms since inception, the cumulative earnings that have not been paid out to shareholders as dividends.
Treasury stock
The stock that has been reacquired by issuing firm but not yet retired, this reduces stockholders equity, and not represent investment in firm.
This has no voting rights and does not receive dividends.
Accumulated other comprehensive income
This includes all changes in stockholders equity except for transactions recognised in income statement (net income), and transactions with shareholders such as issuing stock, reacquiring stock and paying dividends.
Statements of changes in stockholders equity
This summarises all transactions that increase or decrease equity accounts for the period.
This includes:
- Transactions with shareholders
- Reconciles begin and end balance of each equity account including capital stock, add. paid in capital, retained earnings & accumulated other comprehensive income.
Vertical common-size balance sheet
This expresses each item of balance sheet as a percentage of total assets, which allows for comparison overtime and standaises the balance sheet to eliminate effects of size.
Allows for:
- Time series analysis
- Cross sectional analysis
Liquidity ratios
Measures the firms ability to satisfy its short term obligations as they come due.
This includes:
- current ratio
- quick ratio
- cash ratio
Solvency ratios
This measures the firms abilitiy to satisfy its LT obligations.
This includes:
- LT debt to equity ratio
- Total debt to equity ratio
- Debt ratio
- Financial leverage ratio
Limitations of balance sheet ratio analysis:
- Comparisons with peer firms limited by differences in accounting standards and estimates.
- Lack of homogeneity as firms operate in different industries.
- Interpretation of ratios requires significant judgement.
- Balance sheet data are only measured at a single point in time.
