Library/CFA (Chartered Financial Analyst)/JuiceNotes 2024 Financial Statement Analysis CFA Level I/Analyzing Balance Sheets

Analyzing Balance Sheets

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Elements and Structure of the Balance Sheet5 min

The balance sheet is built on the fundamental equation: Assets = Liabilities + Shareholders' Equity. It represents the financial position at a single point in time. Assets are resources controlled as a result of past transactions yielding future benefits. Liabilities are obligations arising from past events. Equity is the residual claim. The presentation can be 'Classified' (grouping current and non-current items) or 'Liquidity-based' (ordering items by liquidity, often used in banking under IFRS). Current items are those expected to be realized or settled within one year or one operating cycle, whichever is greater.

Key Points

Fundamental Equation: Assets = Liabilities + Equity.
Assets are resources; Liabilities are obligations.
Classified balance sheets distinguish current from non-current items.
Liquidity-based presentation is permitted under IFRS for reliable relevance.
Current assets/liabilities horizon: 1 year or operating cycle.

Asset and Liability Classifications6 min

Current assets include Cash and Cash Equivalents (highly liquid, <3 months maturity), Marketable Securities (traded in public markets), Accounts Receivable (net of bad debt estimates), and Inventories. Inventories are measured at the lower of cost or Net Realizable Value (IFRS) or Market (US GAAP). Non-current assets include Property, Plant, and Equipment (PPE), Investment Property, and Intangible Assets. Current liabilities encompass Accounts Payable, Notes Payable, Accrued Liabilities (expenses incurred but not paid), and Unearned Revenue (cash received before service delivery).

Key Points

Cash equivalents are short-term, highly liquid assets.
Accounts Receivable reported at Net Realizable Value (NRV).
Inventories reported at lower of cost or NRV (or Market).
Unearned Revenue is a liability (obligation to deliver).
Accrued Liabilities represent unpaid expenses like wages or taxes.

Shareholders' Equity Components5 min

Equity includes Contributed Capital (funds from shareholders), Preferred Stock (equity with fixed dividends, senior to common stock), and Retained Earnings (cumulative net income minus dividends). Treasury Stock represents shares repurchased by the firm; it is a contra-equity account that reduces total equity. Accumulated Other Comprehensive Income (AOCI) captures gains/losses not reported in net income, such as unrealized gains on certain securities or foreign currency translation adjustments. Minority Interest represents the portion of a subsidiary's equity not owned by the parent.

Key Points

Contributed Capital: Amount paid by shareholders.
Retained Earnings: Cumulative earnings not distributed as dividends.
Treasury Stock: Contra account; reduces equity.
AOCI: Includes unrealized gains/losses and FX adjustments.
Minority Interest: Pro-rata share of subsidiary equity held by outsiders.

Analysis Techniques and Ratios5 min

Common-size analysis converts the balance sheet into percentages of Total Assets, facilitating comparison across firms of different sizes. Ratio analysis is critical for evaluating financial health. Liquidity ratios measure short-term obligation capacity: Current Ratio (CA/CL), Quick Ratio ((Cash + Marketable Securities + Receivables)/CL), and Cash Ratio ((Cash + Marketable Securities)/CL). Solvency ratios assess long-term stability: Debt-to-Equity, Debt-to-Assets, and Financial Leverage (Assets/Equity).

Key Points

Common-size Balance Sheet: All items as % of Total Assets.
Liquidity Ratios: Current, Quick (Acid-Test), Cash.
Quick Ratio excludes inventory and prepaids.
Solvency Ratios: Debt-to-Equity, Financial Leverage.
Financial Leverage Ratio = Average Total Assets / Average Total Equity.

Questions

Question 1

Which of the following best describes the fundamental accounting equation?

Analyzing Balance Sheets

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