We’re going to jump right into the Balance Sheet for this post but won’t be able to wrap up our review of the three financial statements until next Monday’s post on the Statement of Cash Flows. Please see last Monday’s post for a review of the income statement and some general tips.
Again, PLEASE don’t think this is everything you need to know about the three statements for the Level I CFA exam. I’ve tried to put together a summary of the concepts, a couple of pages that will give you an idea of what you are looking at so the detailed reading is a little clearer.
This part of the curriculum, on the level I exam, is fairly conceptual. You need to understand what each general line item represents, how it’s valued and how it relates to the other two statements. Further on in the Level I curriculum, you get into a little more detail for specific line items like inventories and taxes.
Balance Sheet
Unlike the other two statements, the balance sheet is a ‘snapshot’ in time. The figures reflect the state of accounts at that moment, the last day of the quarter or year. The other two statements represent activity over the period. For this reason, and this is very important, when you perform ratio analysis comparing numbers across the statements you will take an average of the beginning and ending figures for balance sheet accounts. For example, the cash debt coverage is cash-flow from operations divided by average total debt from beginning and ending balance sheet dates.
You’re going to get tired of people saying, “Assets = Liabilities + Equities.” This is the basic balance sheet equation and around which much of the material will revolve. Understand what it shows when you change around the equation (i.e. A-L = E) and you’ll get the importance of the concept.
Account Valuations
One of the most important topics on the statement is valuation. Some accounts are shown at historical or amortized price, while others are shown at fair (market) value. Obviously this makes a big difference in overall valuation and when comparing numbers. Further, analysts often will adjust the numbers to arrive at a number they feel is more realistic or comparable. You aren’t asked to do this but just to understand where it might be needed and why. The definitions below will each describe the method of valuation for the account.
Assets
Assets represent a future probable economic benefit and could be accumulated items, amounts spent but not yet expensed (matched with revenues) or amounts earned but not yet received (accounts receivable).
Current assets are the most liquid and are accumulated or planned to be used in the ‘current’ operating period. Normally recorded at fair market value.
Cash or cash equivalents- is usually short-term money market, CDs, commercial paper or treasuries that can be converted to cash quickly. This is used in all your liquidity ratios and is valued at market.
Accounts receivable- Sales made on credit but not yet collected, usually offset by an allowance for uncollectable (estimated) but shown net realizable (fair) value. Trends in AR are an important indication of performance and estimates.
Inventories- A key item and one you’ll spend a lot of time on through the curriculum. Reported at lower of cost or market on the balance sheet but estimated through different practices (LIFO, FIFO, or average). Could be broken down into three sub-accounts: raw materials, work-in-process, and finished goods.
Prepaid expenses- Where the company has paid in advance for a service or product, i.e. insurance and rent. Valued at market with an adjustment when they are expensed through the income statement.
Long-term assets have a useful life of more than a year (or operating cycle) and are usually not going to be sold to customers. These accounts are usually recorded at cost and then depreciated or amortized over the estimated life.
Property, Plant, & Equipment – valued at cost and depreciated over its estimated useful life, shown as net. These are also referred to as ‘tangible’ assets because they generally have physical substance and are easily counted.
Goodwill & other intangibles- Goodwill is the amount paid for acquisitions above their market value. It is basically a premium paid for things like brand and proprietary technology. It is recorded at cost and tested annually for impairment, which is an estimation of the value that no longer exists.
Liabilities
Liabilities are future probable sacrifices from obligations or transactions and could be: amounts received but not earned yet as revenue, amounts received that must be repaid or amounts expensed on the income statement but not yet paid (accounts payable, accruals, etc).
Current liabilities are those that will be paid or settled in the ‘current’ operating cycle.
Accounts Payable- suppliers have sold something to the company on credit that must be repaid. As with AR, you’ll look for trends in this to see that the company is not taking longer to pay. Valued at market.
Accrued liabilities- Those items expensed in the current period but that will not be paid until the next period, kind of a carry-over effect of timing, i.e. wages and interest owed but not paid yet. Valued at market.
Short-term debt- includes lines of credit and notes with an original maturity of less than a year (negotiated debt) and is recorded at market value.
Current portion of long-term debt – principal portion of long-term notes including any capital lease obligations.
Unearned revenue- sales collected in advance but not yet earned so they sit here until delivered or performed. Settled as revenue on the income statement instead of through a cash adjustment.
Long-term liabilities is often a single line item for debt but can also be broken out into items like: bonds and notes payable, long-term lease obligations, deferred taxes and pension liabilities. These are recorded as face value of the bond and then adjusted each period by the discount or premium by amortization to interest expense.
Stockholder’s Equity
Equity is the residual after assets and liabilities and that which is due the owners of the company. It includes: capital contributed by owners through stock, recognized on the income statement but not yet paid out to owners (retained earnings) and adjustments to assets or liabilities that did not go through the income statement (see other comprehensive income in prior post).
Contributed capital- is supplied by stockholders and broken into common, preferred and additional paid-in-capital.
Minority interest – This is the cumulative, noncontrolling ownership held in other companies.
Retained earnings- accumulated net income due to owners but not yet paid out.
Treasury stock – amount paid to repurchase company stock usually shown as a negative number because it decreases equity.
Off-balance Sheet Issues
You won’t get to involved in these at level I, other than to know what they are and that you should look in the MD&A and footnotes for disclosures. These are items and agreements that affect the balance sheet but not explicitly detailed except in notes. Items include: off-balance sheet financing, operating lease information, contingent assets & liabilities and details on derivatives operations.
Balance Sheet Analysis and Ratios
Common-sized analysis will be used with the other statements and is simply dividing each line item by a ‘common’ denominator to find the relative proportion. In the balance sheet, the most common approach is to take everything relative to total assets. This is then compared through time and against other companies.
Liquidity ratios (current, quick, cash) are the most basic formulas you’ll need to know here but will also get into efficiency measures and long-term asset estimates later on in the FRA material at level one. Be sure to know what is included in each of the liquidity measures and the level of conservatism (current ratio least conservative- cash ratio most conservative).
We’ll finish up with the statement of cash flows and hit on some other important topics in the next post.
Let me know if you’ve got any questions or want to see anything covered in a future post,
Joseph Hogue, CFA