UNDERSTANDING THE BALANCE SHEET
LOS 33.i: Interpret balance sheets, common-size balance sheets, the statement of changes in equity, and commonly used balance sheet ratios
The statement of changes in stockholders' equity summarizes all transactions that increase or decrease the equity accounts for the period. The statement includes transactions with shareholders, and a reconciliation of the beginning and ending balance of each equity account, including capital stock, additional paid-in-capital, retained earnings, and accumulated other comprehensive income. In addition, the components of accumulated other comprehensive income are disclosed (i.e., unrealized gains and losses from available-for-sale securities, cash flow hedging derivatives, foreign currency translation, and adjustments for minimum pension liability).
Astatement of changes in stockholders' equity is illustrated in Figure 5.
Figure5: Sample Statement of Changes in Stockholders' Equity Retained
Accumulated Other Common Stock Earnings
Comprehensive Total (in
thousands) Income (loss)
Beginning balance $49,234 $26,664 ($406) $75,492
Ner income 6,994 6,994
Ner unrealized loss on (40) (40)
available-for-sale securiLies
Ner unrealizedlosson cash (56) (56)
flow hedges
Minimum pension liabiliry (26) (26)
Cumularive uanslarion 42 42
adjusrmem
Comprehensive income 6,914
Issuance of common stock 1,282 1,282
Repurchases of common srock (6,200) (6,200)
Dividends J2..,.lGQ) J2.3..6.Q)
Ending balance $44.316 $31.298 ($486) 575,128
Page96 ©2008Schweser
Study Session 8 Cross-Reference to CFA Institute Assigned Reading#33 - Understanding the Balance Sheet Common-Size Balance Sheets
As with the income statement, common-size balance sheets and ratios can facilitate analysis of a firm.
A common-size balance sheet expresses each balance sheet account as a percentage of total assets. This format is known as vertical common-size analysis and allows the analyst to evaluate the balance sheet items over time (time-series analysis), as well as to compare a firm's balance sheet items to those of other firms, industry averages, and sector data (cross-sectional analysis). Several commercial services provide data for comparison.
Commonly Used Balance Sheet Ratios
Liquidity ratios and solvency ratios are considered pure balance sheet ratios since both the numerator and denominatOr are from the balance sheet. Liquidity ratios measure the firm's ability to satisfy shorr-term obligations when due. Solvency ratios measure the firm's ability to satisfy long-term obligations.
Liquidity ratios
The current ratio is the best known measure of liquidity.
current assets current ratio= - - - -
current liabilities
A current ratio of less than one means that the firm has negative working capital and may be facing a liquidity crisis. Working capital is equal to current assets minus current liabili ties.
The quick ratio (acid test ratio) is a more conservative measure of liquidity because it excludes inventories and less liquid current assets from the numerator.
. k . cash-+-marketable securities-+-receivables qUlC ratio=
current liabilities
The cash ratio is the most conservative measure of liquidity.
h . cash+marketable securities cas ratio= - - - -
current liabilities
The higher the liquidity ratios, the more likely the firm will be able to pay its shorr- term bills when they are due. The ratios differ only in the assumed liquidity of the curren t assets.
Solvency ratios
The following ratios measure tlnancial risk and leverage. With all four ratios, the higher the ratio, the greater the leverage and the greater the risk.
©2ll08 Sdnveser Page 97.
Srudy Session 8
Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet
The long-term debt-to-equity ratio measures long-rerm financing sources relative to rhe equiry base.
roral long-rerm debr [ong-rerm debr-ro-equir)" = L .
toral equity
The debt-to-equity ratio measures roral debr relarive to rhe equiry base.
. total debr debr-to-equlry = .
total equlry
The total debt ratio measures rhe exrenr to which assers are financed by creditors.
. toral debr toral debr rano= - - - -
toral assets
The financial leverage ratio is a variation of the debr-to-equiry rario rhar is used as a componenr of rhe DuPonr model.
financial leverage toral assets wral equiry
Professor:' Note: M01"e detail on the precise definitions and calculation of common~J'used financial ratios is presented in a subsequent topic review.
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Usefulness and limitations of ratio analysis
Even in forward-looking "efficienr markers" (where securiries prices reflecr all available informarion), financial rarios based on backward-looking dara provide useful
informarion to analysrs. Specifically, ratios provide rhe following:
Insights inro rhe financial relarionships rhar are useful in forecasring furure earnings and cash flows.
Informarion abour rhe financial flexibiliry of the firm.
A means of evaluaring managemenr's performance.
Financial ratios are nor wirhour limirarions:
Rarios are nor useful when viewed in isolarion.
Comparisons wirh orper companies are made more difficulr because of differenr accounring merhods. Some of the more common differences include inventory merhods (FIFO and LIFO), depreciarion merhods (accelerated and srraighr-line), and lease accounring (capiral and operating).
There may be difficulry in locaring comparable rarios when analyzing companies rhar operare in mulriple indusrries.
Conclusions cannor be made from viewing one ser of rarios. Rarios musr be viewed relarive to one anorher over rime, berween companies or relarive to benchmark values.
Judgmenr is required. Derermining rhe rarger or comparison value for a rario is difficulr and may acrually be some range of acceprable values rarher rhan a single rarger val ue.
©2008 Schweser
Study Session i)
Cross-Reference to CFA Institute Assigned Reading #33 - Understanding the Balance Sheet
- , ' , ' , - , ' , ' f , , - : ' .
KEY CONCEPTS ' , . . . ' " .. , , ,',"
~, ~ , . . , > ~ .. • { " • ~ . ''
1. Assets are probable future economic benefits owned or controlled by an entity as a result of previous transactions.
2. Liabilities are obligations owed by an entity from previous transactions that are expected to result in an outflow of economic benefits in the future.
3. Stockholders' equity is the residual interest in assets that remains after subtracting an entity's liabilities, Equity=assets - liabilities.
4, Assets and liabilities are created from business transactions and because of the accrual method of accounting.
5. Current and noncurrent classifications are based on a I-year period or the firm's operating cycle, whichever is greater.
6. The balance sheet is a mixture of historical costs and fair values.
7. Accounts receivable are reponed at net realizable value (based on management's estimates of collectibility).
8, Inventory is reponed at the lower of cost or net realizable value.
9. Noncurrent assets are reported at their historical costs less accumulated depreciation.
10. Accounting goodwill is equal to the excess of purchase price minus the fair value of the net assets acquired in a business acquisition, Goodwill is not amortized but is tested for impairment at least annually,
11. Held-to-maturity securities are reponed at amonized cos(.
12. Trading securities are reponed at fair value, and any unrealized gains and losses are reponed in net income.
13. Available-for-sale securities are reponed at fair value, and the unrealized gains and losses are reponed as a component of stockholders' equity.
14. Retained earnings are the cumulative undistributed earnings of the firm since inception.
15, Accumulated other comprehensive income includes all changes to equity from sources other than net income and transactions with shareholders.
16. A common-size balance sheet expresses each balance sheet item as a percentage of total assets.
17. Liquidity ratios include the current ratio, the quick ratio. and the cash ratio.
18, Solvency ratios include the long-term debt-to-equitv ratio. the debt-eo-equitv ratio, the debt ratio, and the financial leverage ratio.
19. Comparisons of ratios among firms may be difficult because of ditIerent accounting methods and the iudgment and esti mates that are involved.
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StlIchScs"ion I'
Cross-Reference to CFA Institute Assigned Reading#33 - Understanding the Balance Sheet