Understanding Balance Sheets: Components and Format | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Now that we have a deeper understanding of the income statement, we move on to the topic of understanding balance sheets. In this first part, we start with a basic understanding of the balance sheet – its main components and the presentation formats.

Elements of a Balance Sheet

The balance sheet can be viewed as a snapshot of a firm’s financial position. It consists of 3 elements:

• Assets, which are resources controlled by the firm. This includes cash that the firm is holding.
• Liabilities, which are amounts owed to creditors and lenders.
• Owner’s Equity, which is the owners’ residual claim on the company’s assets after deducting its liabilities.

It is called the balance sheet because the amount of assets must always be equal to the sum of liabilities and owner’s equity.

Classification of Assets and Liabilities

Assets and liabilities can be classified based on their expected timeframes:

• Current Assets and Non-current Assets
• Current Liabilities and Non-current Liabilities

They are classified as current or non-current based on their expected timeframes. Assets or liabilities are non-current when they have a timeframe that is beyond 1 year, or 1 operating cycle. The operating cycle is the time it takes to produce or purchase inventory, sell the product, and collect the cash.

Current Assets

Current assets include cash and other assets that will likely be converted into cash or used up within the period. They are usually presented in the order of their liquidity, with cash being the most liquid. Current assets reveal information about the operating activities of the firm.

Current Liabilities

Current liabilities are obligations that are expected to be satisfied within one year or one operating cycle, whichever is greater. Liabilities that are held primarily for trading purposes are also considered current, and so is any liability that the firm does not have an unconditional right to defer settlement for more than a year. Current liabilities provide information of a firm’s Short Term Obligations.

Non-current Assets

Non-current assets do not meet the definition of current assets because they will not be converted into cash or used up within one year or operating cycle. They provide information about the firm’s investing activities, which form the foundation upon which the firm operates.

Non-current Liabilities

Non-current liabilities do not meet the criteria of current liabilities. They provide information about the firm’s long-term financing activities.

Analysis of Balance Sheets

The balance sheet can be used to assess a firm’s liquidity, ability to pay dividends to shareholders, and solvency.

Liquidity is the ability to meet short-term obligations, and solvency is the ability to meet long-term obligations.

Classified Balance Sheet: IFRS and US GAAP

Both IFRS and US GAAP require firms to separately report their current and noncurrent assets, and current and noncurrent liabilities. This is known as a classified balance sheet.

Under IFRS, firms can choose to use a liquidity-based format if the presentation is more relevant and reliable. Liquidity-based presentations, which are often used in the banking industry, present assets and liabilities in the order of liquidity.

Balance Sheet Valuation and Limitations

Regardless of the format, the book value reflected in the balance sheet should not be interpreted as market value or intrinsic value. For most firms, the balance sheet consists of a mixture of values:

• Some assets are reported at historical cost
• Some at amortized cost
• Others at fair value

There are numerous valuation bases. Even if the balance sheet was reported at fair value, the value may have changed since the balance sheet date.

Also, there are a number of assets and liabilities that do not appear on the balance sheet but certainly have value. For example, the value of a firm’s brand recognition and workforce is not reported on the balance sheet.

And that concludes this quick introduction to balance sheets. From the next lesson, we will be discussing in detail each of the major items in a typical balance sheet, starting with current assets.