Analyzing Balance Sheets

The balance sheet tells an analyst what a company owns, what it owes and how it is financed, but it mixes historical costs, amortized costs and fair values, and it leaves out some valuable assets entirely. This module explains how assets and liabilities are classified and measured, how intangible assets, goodwill and financial instruments are reported, what the components of equity mean, and how common-size balance sheets and liquidity and solvency ratios are used to assess financial strength.

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What you will learn

1. Describe how assets and liabilities are classified and measured on the balance sheet, and calculate working capital.

Current: realized, consumed or settled within one year or the operating cycle, whichever is longer.
The current portion of long-term debt is a current liability.
IFRS allows a liquidity-based presentation when it is more relevant, as for banks.
Balance sheets mix historical cost, amortized cost, fair value and net realizable value; book equity is not market value.
Working capital = current assets - current liabilities.

2. Explain how intangible assets and goodwill are recognized, measured and tested for impairment, calculate goodwill, and evaluate the analytical implications.

Acquired intangibles are recognized at fair value; most internally generated intangibles are expensed.
IFRS capitalizes development costs that meet criteria; US GAAP generally expenses R&D.
Goodwill = consideration - fair value of identifiable net assets acquired.
Goodwill and indefinite-lived intangibles are not amortized; they are tested at least annually, and impairments are never reversed.
Use tangible book value and adjust for capitalization differences when comparing companies.

3. Describe the classification and measurement of financial assets under IFRS and US GAAP, and determine where changes in their fair value are reported.

IFRS 9: amortized cost, FVOCI (debt recycles; elected equity never recycles), FVPL.
US GAAP debt: held-to-maturity (amortized cost), available-for-sale (OCI), trading (net income).
US GAAP equity securities: fair value through net income, no OCI option.
Interest and dividends always go to profit or loss.
Unrealized losses on amortized-cost portfolios appear only in the notes; read the fair value disclosures.

4. Describe the main non-current liabilities and the components of shareholders' equity, and calculate equity attributable to common shareholders and book value per share.

Long-term debt is usually at amortized cost; the part due within 12 months is current.
Equity = share capital + paid-in capital + retained earnings + accumulated OCI - treasury shares (+ NCI for total equity).
Treasury shares reduce equity and shares outstanding; they receive no dividends or votes.
NCI is part of total equity but not of equity attributable to the parent's shareholders.
Buybacks can produce negative book equity at profitable firms, making equity-based ratios meaningless.

5. Prepare and interpret common-size balance sheets, and calculate and interpret liquidity and solvency ratios.

Common-size balance sheet: every item as a percentage of total assets.
Current > quick > cash ratio; the quick ratio excludes inventories and prepaid expenses.
Total debt = interest-bearing borrowings (including the current portion and usually leases), not trade payables.
Debt-to-capital = debt / (debt + equity); financial leverage = average assets / average equity.
Interpret ratios against history, peers and the business model.

Module at a glance

Current items are realized or settled within one year or the operating cycle; the current portion of long-term debt is current.
Balance sheets mix measurement bases, so book equity is not market value.
Acquired intangibles are recognized at fair value; goodwill = consideration - fair value of identifiable net assets, tested for impairment and never amortized.
IFRS capitalizes qualifying development costs; US GAAP generally expenses R&D.
Financial assets: amortized cost, FVOCI or FVPL (IFRS); HTM, AFS or trading for debt and FVNI for equity (US GAAP).
Equity = contributed capital + retained earnings + accumulated OCI - treasury shares; NCI is shown separately.
Use common-size balance sheets and liquidity and solvency ratios, with total debt meaning interest-bearing borrowings.

This free module has 5 lessons, 15 practice questions with full explanations.

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