Understanding Balance Sheets. In this reading, we
talk about the components and format of the balance
sheet, Current Assets, and Current Liabilities, Non-Current
Assets, Non-Current Liabilities, Equity and finally,
Analysis of the Balance Sheet. Under IFRS, the balance
sheet is referred to as the statement of financial
position--balance sheet is generally a US GAAP term.
The balance sheet provides information on a company's
resources which are the assets, and its sources of
capital (liability and equity). The concept is fairly
straightforward. The assets typically shown on
the left side of the balance sheet tell us what resources
a company has, and obviously we need to account for
where these resources came from, and that accounting
comes on the right, in the sense that the money for
these assets either comes through debt or equity.
Liabilities represent the debt based financing,
and Equity represents the equity-based financing. So,
to purchase these assets either owners need to contribute
money, which is equity, or money needs to be borrowed
in some form and that is liability. The total amount
of assets has to equal the money that comes through
liabilities or through equity. Different items
of assets and liabilities may be measured differently.
Some items might be shown at fair value, other items
may be shown at historical cost, and one aspect of
this reading as well as subsequent readings is to
understand the measurement basis of various items
on the balance sheet. Components and Format of the
Balance Sheet. Here is material that you have seen
in an earlier reading. I will not read this for you.
You need to simply pause the video, and make sure you
go through this, but essentially assets are the resources
of a company which would provide future benefits,
liabilities are the obligations, and equity represents
the differential between assets and liabilities.
The balance sheet shows a company's assets, liabilities,
and equity on a particular date, which is typically
the last date of a reporting period. As mentioned before,
the measurement basis varies across items. This
makes life interesting for the financial analyst
who needs to understand the measurement basis for
every single item on the balance sheet. Some items are
shown at current fair value, and obviously the current
value is the value at the end of the reporting period which
will be shown in the title of the balance sheet. So,
that's the current value on say, 31st December 2010
if that is the end of the reporting, and not the value
you as an analyst are looking at the balance sheet.
Important elements of a company's ability to generate
future cash flows are not shown on the balance sheet.
If you take a Services Company, such as McKinsey,
obviously their value or their ability to generate cash
flows comes primarily from the human capital of
the company, and elements such as human capital are
not shown on the balance sheet. The balance sheet
can be presented in different ways, either we can
show assets and liabilities as current and non-current.
This presentation is called a classified balance
sheet, or we can have a liquidity based presentation.
What you are looking at here is a simple classified
balance sheet where the assets are shown as current
assets. So, that's a classification, then long-term
investments, property, plant and equipment and so
on--all these are non-current assets. Liabilities
are also shown as current liabilities and non-current
or long-term liabilities. So, this is a classified
balance sheet. Often banks present their balance
sheet, using a liquidity based presentation. Here, with a
liquidity based presentation, assets and
liabilities are shown based on liquidity. So, here
we are looking at assets shown from most liquid to
least liquid. Generally banks present their balance
sheets using a liquidity based format. Moving now
to Current Assets. Current assets are those assets held primarily for trading
or expected to be sold, used up, or otherwise realized
in cash within one year or one operating business
cycle. Here are the classic examples of current
assets that you need to memorize. Cash and Cash Equivalents.
Cash equivalents are highly liquid, short-term
investments that are so close to maturity. The risk
is minimal that their value will change significantly
with changes in interest rates. So, key is that they
are highly liquid. Cash equivalents are generally
financial assets. They are reported at fair value or amortized
cost. The concept of amortized cost is something
that we will cover later in this topic. Marketable
Securities, are also financial assets and include publicly
traded debt and equity instruments. So, these would be
bonds issued by companies, as an example, and these
would be stocks. Trade receivables or accounts receivables, are
another form of a current asset. We need to also understand
the concept of Allowance for Doubtful Accounts.
We looked at these from an expense perspective earlier.
Here, we are taking a balance sheet perspective. Let's say that
customers owe you a 100, this would be an accounts receivable.
You have made the sale, and it's a credit sale so the
receivables is a 100. However, there is an allowance
for doubtful accounts because you expect that out
of this 100, 5 will not be paid. This 5 is
the allowance for doubtful accounts. This is called
a contra-asset account, because it reduces the value
of the asset. So, your net accounts receivable is,
95. Inventories are also considered a current asset,
and this item inventories will be discussed in a
lot more detail in a later reading. Other current
assets, such as prepaid expenses are also shown on
the balance sheet as a current asset. If you have
a rent expense for a given period, and that rent is be paid right
up front, that is an asset, because now you do not need
to pay that expense once it has been paid. Current
Liabilities. These are liabilities which are expected
to be settled within one year or one operating business
cycle. Here are the classic current liabilities that
you need to memorize.