CHAPTER 3

Analysis of Balance Sheets

Understanding assets, liabilities, equity, intangibles, and financial instruments analysis

1

INTRODUCTION TO THE BALANCE SHEET

The Balance Sheet is a financial snapshot of a company's financial position at a specific point in time. It follows the fundamental equation:

Assets = Liabilities + Shareholders' Equity

For analysts, the balance sheet is essential for assessing:

Liquidity

Can the company pay its short-term bills?

Solvency

Can it meet long-term obligations?

Financial Health

Is the company over-leveraged or under-invested?

Analysts use balance sheet ratios to compare companies and track trends over time.

2

STRUCTURE OF THE BALANCE SHEET

A classified balance sheet groups similar items together. Here is a detailed breakdown of its typical structure.

Component Description
Assets (What the company owns)
Current Assets Assets expected to be converted to cash or used up within one year.
Cash & Cash Equivalents The most liquid assets, including currency, bank deposits, and short-term money market instruments.
Marketable Securities Short-term debt or equity investments that are readily marketable.
Accounts Receivable Money owed to the company by customers for goods or services already delivered.
Inventory Raw materials, work-in-process goods, and finished goods held for sale.
Non-Current Assets Long-term assets not expected to be converted to cash within one year.
Property, Plant & Equipment (PP&E) Tangible, long-lived assets used in operations, such as land, buildings, and machinery.
Intangible Assets Non-physical assets like patents, trademarks, and copyrights.
Goodwill Arises from acquiring another company for more than the fair value of its net assets.
Liabilities (What the company owes)
Current Liabilities Obligations due within one year.
Accounts Payable Money owed to suppliers for goods or services received on credit.
Short-Term Debt Loans and other borrowings due within one year.
Accrued Expenses Expenses that have been incurred but not yet paid (e.g., salaries, rent).
Non-Current Liabilities Obligations due after one year.
Long-Term Debt Loans and other borrowings with maturities of more than one year.
Bonds Payable Long-term debt securities issued to investors.
Deferred Tax Liabilities Taxes that will likely be paid in a future period.
Shareholders' Equity (Owners' claim on net assets)
Common Stock / Paid-in Capital The amount invested by shareholders to purchase stock from the company.
Retained Earnings Cumulative net income that has been retained for reinvestment, not paid out as dividends.
Treasury Stock Stock that the company has repurchased from the open market (a contra-equity account).
3

INTANGIBLE ASSETS

WHAT ARE INTANGIBLE ASSETS?

Intangible assets are non-physical, non-monetary assets that provide future economic benefits. Examples include:

Patents & Copyrights

Licenses & Franchises

Software & Customer Lists

To be recognized on the balance sheet, an intangible must be:

  • Identifiable (separable or arising from legal rights), and
  • Controlled by the company

ACCOUNTING TREATMENT: IFRS VS. U.S. GAAP

Topic IFRS U.S. GAAP
Internally Created Intangibles Research costs: Expensed
Development costs: Can be capitalized if criteria met
All costs: Expensed (including R&D)
Measurement Models Choice: Cost model or Revaluation model Only Cost model allowed
Note: Costs for brands, start-up activities, and general overhead are always expensed under both standards.

AMORTIZATION AND IMPAIRMENT

Finite-Life Intangibles

Amortized over useful life (e.g., patent with 10-year life)

∞ Indefinite-Life Intangibles

Not amortized. Must be tested for impairment annually (e.g., trademarks)

Patent Amortization

A company capitalizes a $100,000 patent with a 10-year life.

Annual amortization = $100,000 / 10 = $10,000/year
4

GOODWILL

UNDERSTANDING GOODWILL

Goodwill arises only in a business acquisition. It's the excess of the purchase price over the fair value of the net identifiable assets acquired.

Goodwill = Purchase Price Fair Value of Net Identifiable Assets

Accounting Goodwill

Recorded on the balance sheet after an acquisition

💼 Economic Goodwill

Not on the balance sheet — reflects brand strength, customer loyalty, or superior management

POST-ACQUISITION ACCOUNTING

  • Not amortized under IFRS or U.S. GAAP
  • 🔍 Tested for impairment annually
  • 📈 Impairment loss is recorded on the income statement as a non-cash expense
  • 📉 Reduces net income, total assets, and ROA

Goodwill Impairment

A company has $50M in goodwill. After a market downturn, the recoverable amount is $40M.

Impairment loss = $50M $40M = $10M — reduces net income and assets

ANALYST ADJUSTMENTS

Because goodwill is subjective, analysts often adjust financials:

  • Exclude goodwill from total assets when calculating ROA or debt ratios
  • Exclude impairment losses to assess core profitability
5

FINANCIAL INSTRUMENTS

CLASSIFICATION BASED ON BUSINESS MODEL AND INTENT

Under both IFRS 9 and U.S. GAAP, financial assets are classified based on the entity's business model and the contractual cash flow characteristics. Below is a clear comparison of the three primary classifications.

Classification Typical Assets Intent / Business Model Measurement Basis Interest/Dividends Unrealized Gains/Losses
Held-to-Maturity (HTM)
(U.S. GAAP)

Amortized Cost
(IFRS)
Bonds (debt securities) Hold to maturity; collect contractual cash flows Amortized cost Income Statement n/a — No recognition
Trading
(Both U.S. GAAP & IFRS)
Stocks, bonds, derivatives Active trading for short-term profit Fair Value Through Profit or Loss (FVPL) Income Statement Income Statement
Available-for-Sale (AFS)
(U.S. GAAP)

FVOCI
(IFRS)
Bonds, equities (non-trading) May sell before maturity, but not actively traded Fair Value Through Other Comprehensive Income (FVOCI) Income Statement Other Comprehensive Income (OCI) — Balance Sheet (AOCI)
Note:
  • • Under U.S. GAAP, equity investments cannot be classified as HTM (no maturity date)
  • • Under IFRS, equity investments can be irrevocably designated as FVOCI (with recycling prohibited)
  • • "Available-for-Sale" is not used under IFRS — replaced by FVOCI
  • • Interest/dividend income is always recognized in P&L regardless of classification

KEY DIFFERENCES SUMMARY

Feature U.S. GAAP IFRS
Equity Investments Generally FVPL unless designated as AFS Can be FVOCI (irrevocable election)
Debt Instruments HTM, AFS, Trading Amortized Cost, FVOCI, FVPL
Reclassification Permitted between AFS and Trading (rare) Generally prohibited
OCI Recycling Yes (for AFS debt) No (for equity FVOCI); Yes (for debt FVOCI)

Bond Classification Decision

A company buys corporate bonds expecting to hold them until maturity to receive interest payments. It does not plan to trade them.

Classification: Held-to-Maturity (U.S. GAAP) or Amortized Cost (IFRS)

Impact: Unrealized price changes do not affect net income — only interest income is reported.

6

NON-CURRENT LIABILITIES

Non-current liabilities are obligations due beyond one year or the operating cycle.

LONG-TERM DEBT

Includes long-term loans, bonds payable. Usually measured at amortized cost.

Exceptions (measured at fair value):

Held-for-trading liabilities

Derivative liabilities

Hedged non-derivative liabilities

DEFERRED TAX LIABILITIES (DTL)

A DTL arises when accounting income > taxable income due to temporary timing differences.

Cause

Lower taxes paid now than reported on income statement

Common Example

Using accelerated depreciation for tax purposes but straight-line for financial reporting

The difference reverses in the future, creating a tax obligation.

Deferred Tax Liability

A company uses straight-line depreciation ($10K/year) for financials but accelerated ($15K/year) for taxes.

  • • Year 1: Pre-tax income (financials) = $100K; (tax) = $95K
  • • Tax expense (financials) = $25K (25%)
  • • Taxes payable (tax return) = $23.75K
  • DTL created = $25K $23.75K = $1.25K
7

COMMON-SIZE ANALYSIS AND RATIOS

COMMON-SIZE BALANCE SHEET

Each item is expressed as a percentage of total assets.

✨ Useful for:

  • • Tracking changes in asset/liability structure over time
  • • Comparing companies of different sizes
  • • Identifying business models (e.g., high PPE = manufacturer; high goodwill = acquisitive firm)

KEY BALANCE SHEET RATIOS

💧 Liquidity Ratios

CURRENT RATIO
Current Ratio = Current Assets / Current Liabilities

Interpretation: Higher = better short-term liquidity

QUICK RATIO (ACID-TEST)
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

Why? Excludes inventory — more conservative measure

CASH RATIO
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

Most conservative — only the most liquid assets included

Solvency Ratios

DEBT-TO-EQUITY RATIO
D/E = Total Debt / Total Equity
8

KEY FORMULAS AND EXAM FOCUS

Exam Weight & Critical Areas

Balance Sheet analysis typically accounts for 6-9% of Level I FSA weight. Master these areas:

  • • Financial Instruments Classification - HTM vs. Trading vs. AFS/FVOCI and their impact on financials
  • • Liquidity & Solvency Ratios - Current ratio, quick ratio, debt-to-equity calculations
  • • Goodwill & Intangibles - Impairment testing, amortization vs. no amortization
  • • Deferred Tax Liabilities/Assets - Understanding temporary vs. permanent differences
  • • IFRS vs. U.S. GAAP differences - Intangibles, financial instruments, revaluation

ESSENTIAL FORMULAS

Accounting Equation:
Assets = Liabilities + Shareholders' Equity
Current Ratio (Liquidity):
Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid-Test):
Quick Ratio = (Cash + Marketable Securities + A/R) / Current Liabilities
Cash Ratio:
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Debt-to-Equity Ratio (Solvency):
D/E = Total Debt / Total Shareholders' Equity
Goodwill (Acquisition):
Goodwill = Purchase Price - Fair Value of Net Identifiable Assets

COMMON PITFALLS

Financial Instruments Classification: Trading securities have unrealized gains/losses recognized in net income. AFS/FVOCI securities have unrealized gains/losses in OCI. HTM/Amortized Cost has no recognition of unrealized changes.

Goodwill vs. Intangible Assets: Goodwill is never amortized under IFRS or U.S. GAAP - only tested for impairment annually. Finite-life intangibles are amortized over useful life. Indefinite-life intangibles are not amortized but tested for impairment.

Quick Ratio: Excludes inventory because it takes time to convert to cash. Only includes cash, marketable securities, and accounts receivable.

Deferred Tax Liability: Created when accounting income exceeds taxable income, often due to accelerated depreciation for tax but straight-line for books. This means paying more taxes later.

Internally Generated Intangibles: U.S. GAAP expenses all R&D including development. IFRS expenses research but can capitalize development if criteria are met. Neither standard allows capitalization of internally generated brands.