1. Chapter Four
The Balance Sheet

2. The Balance Sheet
Provides information about the financial position of a company at a specific point in time
Also called the statement of financial position
Follows the form of the accounting equation: Assets = Liabilities + Owners’ Equity (or Stockholders’ Equity)
Copyright © Houghton Mifflin Company.All rights reserved

3. Balance Sheet Elements
Stockholders’ equity:
Residual interest in the assets of a firm that remains after deducting its liabilities (for a corporation)
Assets:
Probable future economic benefits obtained or controlled by a firm as a result of past transactions or events
Liabilities:
Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or perform services to other firms in the future as a result of past events
Copyright © Houghton Mifflin Company.All rights reserved

4. Classification of Balance Sheet Elements
Assets:
Liabilities:
Stockholders’
Equity:
Current:
Obligations that come due within the fiscal year
Current:
Cash
Short-term investments
Receivables
Inventory
Contributed capital accounts
Retained earnings
Other equity adjustment accounts
Noncurrent:
Investments
Operating assets
Intangible assets
Other assets
Noncurrent:
Investments
Operating assets
Intangible assets
Other assets
Noncurrent:
Obligations that come due outside the fiscal year
Copyright © Houghton Mifflin Company.All rights reserved

5. Current Assets and Liabilities
Cash and other assets that are reasonably expected to be realized in cash, sold, or consumed during the normal operating cycle or within one year of the balance sheet date, whichever is longer
Current Liabilities:
Economic obligations that are expected to be liquidated using current assets or refinanced by other current liabilities during the normal operating cycle or within one year of the balance sheet date, whichever is longer
Copyright © Houghton Mifflin Company.All rights reserved

6. Types of Noncurrent Assets
Operating assets (Property, plant, and equipment) – carried at acquisition cost less accumulated depreciation
Capital leases—financial arrangement in which the lessee assumes most of the risk and rewards of ownership; lessee records the asset on the balance sheet
Intangible assets—long-term assets with no physical substance but have value based on rights, privileges, or advantages belonging to the owner
Copyright © Houghton Mifflin Company.All rights reserved

7. Types of Noncurrent Assets
Long-term investments—investments and funds set aside for long-term use; not available to settle current liabilities. Normally carried at fair value
Other assets—Might include deferred charges or assets not currently used in operations
Copyright © Houghton Mifflin Company.All rights reserved

8. Types of Noncurrent Liabilities
Might include bonds payable, mortgage payable, long-term notes payable, pension obligations, capital lease obligations, and long-term deferred taxes
Obligations that will be paid over a period longer than one year
Copyright © Houghton Mifflin Company.All rights reserved

9. Off-Balance-Sheet Financing
Controversial practice in which a firm enters into transactions that obligate it to make future payments, but the payments are not recorded as actual liabilities at their present value on the balance sheet.
Instead, the payments are expensed as they are paid.
Critics contend that this treatment produces a balance sheet that does not adequately reflect the true financial position of the firm.
Copyright © Houghton Mifflin Company.All rights reserved

10. International Standards and the Balance Sheet
Variations on format of non-U.S. balance sheets:
Separate current assets from noncurrent assets and current liabilities from noncurrent liabilities (most common format used in U.S.)
Present assets and liabilities in order of liquidity (or reverse liquidity); no current/noncurrent categories
Net asset presentation (assets minus liabilities)
Long-term financing approach: Fixed Assets + Current Assets – Short-Term Payables = Long-Term Debt + Equity
Copyright © Houghton Mifflin Company.All rights reserved

11. Stockholders’ Equity Contributed Capital Retained Earnings
Capital Stock
Additional Paid-In Capital
Retained Earnings
Accumulated earnings less dividends or distributions
Accumulated Other
Comprehensive Income
Income from external events
Copyright © Houghton Mifflin Company.All rights reserved

12. Statement of Changes in Stockholders’ Equity
Summarizes the transactions that affected stockholders’ equity over the accounting period
Components often include: common stock, paid-in capital, preferred stock, retained earnings, treasury stock
Some firms also include comprehensive income
Copyright © Houghton Mifflin Company.All rights reserved

13. Analyzing the Balance Sheet
Ratio Analysis
Benchmarking
Percentage Analysis
Horizontal Analysis
Copyright © Houghton Mifflin Company.All rights reserved

14. Percentage Analysis
Express each item on a financial statement in a given period as a proportion of a base figure
For example, each item on a balance sheet could be divided by the total asset amount, thus expressing each item as a percentage of a whole
Allows for comparisons over time for the same company
Allows for comparisons with other companies
Also called vertical analysis
Copyright © Houghton Mifflin Company.All rights reserved

15. Horizontal Analysis Compare data on a financial statement for two
or more time periods. Express change as a
percentage of the first time period.
Helps investors see trends over time; also called trend analysis
Compute the difference between two accounts from one period to the next and divide the difference by the figure from the earlier period.
Copyright © Houghton Mifflin Company.All rights reserved

16. Horizontal and Percentage Analysis: Home Depot
Copyright © Houghton Mifflin Company.All rights reserved

17. Ratio Analysis
Examines meaningful relationships between components of financial statements
Liquidity ratios:
Assess a firm’s ability to meet its financial obligations in the short term
Leverage ratios:
Provide data about the long-term solvency of a firm
Activity ratios:
Assess the efficiency with which a firm uses its assets
Profitability ratios:
Examine how successful a firm is in using its operating processes and resources to earn income
Copyright © Houghton Mifflin Company.All rights reserved

18. Liquidity Ratios Current Ratio: Quick Ratio: Working Capital:
The amount of current assets on hand that can be used to continue business operations
Compares the amount of all current assets to the amount of current liabilities
Compares only the most liquid of current assets to the amount of current liabilities
Copyright © Houghton Mifflin Company.All rights reserved

19. Leverage Ratios Total liabilities to total assets:
Total debt to total equity :
Times interest earned:
Shows what percentage of a firm’s total assets has been financed
Measures a firm’s debt exposure
Measures a firm’s ability to meet its interest payments as they come due
Copyright © Houghton Mifflin Company.All rights reserved

20. Activity Ratios Accounts receivable turnover ratio:
Inventory turnover ratio:
Asset turnover ratio:
Measures how quickly a firm collects its accounts receivable
Measures the number of times inventory is sold during the year
Measures how much in total assets a firm must have to generate its sales
Copyright © Houghton Mifflin Company.All rights reserved

21. Profitability Ratios Operating margin percentage
Indicates how much operating income is generated by each dollar of sales
Profit margin on sales
Indicates how much net income is earned on each dollar of sales
Return on total assets
Shows how well management is using its assets
Return on stockholders’ equity
Indicates how much income was earned on each dollar invested by a common stockholder
Copyright © Houghton Mifflin Company.All rights reserved

22. Benchmarking
Compares one company’s financial results with those of another company or with an industry average
EdgarScan is one online benchmarking tool provided by PricewaterhouseCoopers
Hoover’s Online is a subscription-based service that supplies competitive analysis, company profiles, in-depth financials, and more
Copyright © Houghton Mifflin Company.All rights reserved

23. In most categories, Home Depot receives superior (1) rankings
Benchmarking: Sample
EdgarScan Benchmarking Report (Excerpt)
Home Depot, Inc. (2003)
Item Value Rank
Cash 2,826,000,
Inventory 9,076,000,000 1
Total Debt 1,365,000,000 1
Operating Income 6,846,000,000 1
Asset Turnover Ratio
Current Ratio
Net Income Growth
In most categories, Home Depot receives superior (1) rankings
Copyright © Houghton Mifflin Company.All rights reserved

24. Limitations of the Balance Sheet
Based on principles of historical cost, conservatism, and objectivity
Does not reflect networking activities of a firm that may enhance its value
Does not reflect unexecuted obligations that may give rise to future obligations
Does not recognize intangible assets that may provide future benefits to a firm
Does not reflect the risk exposures associated with interest-rate changes, foreign exchange rate changes, or economic or political conditions
Copyright © Houghton Mifflin Company.All rights reserved

25. Check Your Understanding
Explain the concept of off-balance-sheet financing.
A firm enters into transactions that obligate it to make future payments, but those payments are not recorded as actual liabilities at their present value on the balance sheet. Instead the payments are expensed when paid.
Copyright © Houghton Mifflin Company.All rights reserved

26. Check Your Understanding
What type of accounts commonly make up total stockholders’ equity?
Common Stock, Preferred Stock, Paid-in Capital, Retained Earnings, Treasury Stock. Sometimes Comprehensive Income is included.
Copyright © Houghton Mifflin Company.All rights reserved

27. Check Your Understanding
Explain how percentage analysis might be calculated for a company’s balance sheet.
Express each amount on the balance sheet as a percentage of a base figure. For example, each line item could be divided by total assets (a base figure) and expressed as a percentage.
Copyright © Houghton Mifflin Company.All rights reserved

28. Check Your Understanding
What type of ratios might be used to assess a firm’s ability to meet its short-term financial obligations?
Liquidity ratios (current ratio, quick ratio, working capital)
Copyright © Houghton Mifflin Company.All rights reserved

29. Check Your Understanding
Name several accounts that would be classified as noncurrent liabilities on the balance sheet.
Bonds Payable, Mortgage Payable, Long-Term Notes Payable, Pension Obligations, Capital Lease Obligations, and Long-Term Deferred Taxes.
Copyright © Houghton Mifflin Company.All rights reserved