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Principles of Finance

5.2 The Balance Sheet

Principles of Finance5.2 The Balance Sheet

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Outline the purpose and importance of the balance sheet.
  • Identify the structure and key elements of the balance sheet.

The Accounting Equation and the Classified Balance Sheet

Recall that the income statement shows the performance of a firm over the course of time. The classified balance sheet shows the financial state of a company as of a specific point in time. It is a key distinction between the two statements. The classified balance sheet is prepared in sections that align with the accounting equation.

Remember, the accounting equation reflects the assets (items owned by the organization) and how they were obtained (by incurring liabilities or provided by owners). Liabilities are debts owed to other parties. Stated differently, every asset has a claim against it—by creditors and/or owners.

Assets=Liabilities+OwnersEquityAssets=Liabilities+OwnersEquity

The classified balance sheet is thus broken down into three sections; assets, liabilities, and owner’s equity. If prepared correctly, the total assets on the balance sheet equals the total liabilities and owner’s equity sections of the balance sheet.

The classified balance sheet is considered or termed classified when the assets and liabilities within the balance sheet are grouped into even smaller sections: current and noncurrent (see Figure 5.6). Both assets and liabilities are broken down on the balance sheet into current and noncurrent classifications in order to provide more detail and transparency as well as abide by the convention of reporting in descending order of liquidity. Current assets are those that can be used or converted to cash within a year. Common examples of current assets include cash, inventory, accounts receivable, and short-term investments. Assets that will be in use longer than a year are considered noncurrent. Common examples of noncurrent assets include notes receivable, machinery and equipment, buildings, and land.

Just as we noted a few key differences in the income statements based on the type of firm, you may also notice a few slight differences in the balance sheet depending on the firm type. Clear Lake Sporting Goods is a retailer. Thus, you will see that their inventory for resale on their balance sheet is simply called “Inventory.” This is the goods they have purchased for resale but have not yet sold. A manufacturer, like Apple, Inc. in the Link to Learning sections, will have a variety of inventory types including raw materials, work in progress, and finished goods inventory. These represent the various states of the inventory (ready to use, partially complete, and fully completed product). A service firm, on the other hand, may not have inventory at all. If it does, it may be simple goods it uses to help deliver its service. For example, a cleaning company may keep an inventory of cleaning supplies.

Graphical Representation of the Accounting Equation of Clear Lake Sporting Goods. It shows assets as well as liabilities as current and noncurrent. All assets equal the sum of liabilities and owner’s equity.
Figure 5.6 Graphical Representation of the Accounting Equation Both assets and liabilities are categorized as current and noncurrent.

Clear Lake Sporting Goods has cash, accounts receivable, inventory, short-term investments, and equipment. It rents its facilities, so it has no buildings on its balance sheets. Of all its assets, only the equipment is long term. The assets section for Clear Lake’s classified balance sheet is shown in Figure 5.7.

Comparative Year-End Balance Sheet for Clear Lake Sporting Goods showing asset section of classified balance sheet for the previous year and current year. Its current assets are cash, accounts receivable, inventory, and short-term investments. Its noncurrent assets are equipment. The total assets for the year are calculated by adding the value of the current and noncurrent assets together.
Figure 5.7 Assets Section of Classified Balance Sheet

Think It Through

Current and Noncurrent Assets

Visit the Apple, Inc. Annual Report for 2020 and locate the company’s balance sheet (the balance sheet begins on page 33). What types of current assets does the company have? What types of noncurrent assets does it have? How has the total of each type of asset changed over time?

We’ve covered the assets side of the accounting equation; now let’s turn our attention to the other side of the equation and the other two sections of the balance sheet: liabilities and equity. Just like the assets section, the liabilities section is broken down between current and noncurrent. Current liabilities are those that will be due within a year. Common examples of current liabilities include accounts payable, wages payable, and unearned revenue. Noncurrent liabilities are those that are due more than a year into the future. Notes payable is a common noncurrent liability.

Clear Lake Sporting Goods has accounts payable and has collected payments from a few customers that it hasn’t yet shipped its product to (unearned revenue). It also owes money on a note payable. Its accounts payable and unearned revenue are both current liabilities. The note payable is not due for several years, thus making it a noncurrent liability (see Figure 5.8).

Comparative Year-End Balance Sheet of Clear Lake Sporting Goods showing the liability section of classified balance sheet for the current and prior year. On the balance sheet, accounts payable and unearned revenue are listed first under the current liabilities header and summed to calculate total current liabilities. In a separate section under noncurrent liabilities, notes payable is listed, and that figure is added to the total current liabilities amount to derive total liabilities in the last row.
Figure 5.8 Liability Section of Classified Balance Sheet

Think It Through

Current and Noncurrent Liabilities

Visit the Apple, Inc. Annual Report for 2020 and locate its balance sheet (the balance sheet begins on page 33). What types of current and noncurrent liabilities does the company have? How has the total of each type of liability changed over time?

The stockholders’ equity section of the balance sheet for corporations contains two primary categories of accounts. The first is contributed capital, which is funds paid in by owners. The second category is earned capital, which is funds earned by the corporation as part of business operations. On the balance sheet, retained earnings is a key component of the earned capital section, while the stock accounts such as common stock, preferred stock, and additional paid-in capital are the primary components of the contributed capital section.

Clear Lake Sporting Goods has just one contributed capital account—common stock—and one earned capital account—retained earnings. The equity section of its balance sheet is shown in Figure 5.9.

Comparative Year-End Balance Sheet of Clear Lake Sporting Goods showing stockholder equity for the current and prior years. Total stockholder’s equity is calculated by adding the values for common stock and ending retained earnings. This number is then added to the total liabilities that was calculated in Figure 5.8 to determine the total liabilities and stockholder equity.
Figure 5.9 Stockholders’ Equity Section of Classified Balance Sheet

Think It Through

Assets, Liability, and Equity

Visit the Apple, Inc. Annual Report for 2020 and locate the company’s balance sheet (the balance sheet begins on page 33). What is the amount of the company’s total assets for the most recent year? What is the amount of its total liabilities and equity?

Importance of the Balance Sheet

Now that we have gone to all the work to carefully assemble a classified balance sheet, what do we use it for? The answer lies within the accounting equation itself. Think of the accounting equation from a “sources and claims” perspective. Under this approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, every asset has a claim against it—by creditors and/or owners. The balance sheet shows us what the firm has (its assets), who owns them (equity), and who the firm owes (its liabilities).

Limitations of the Balance Sheet

The balance sheet is indeed a very helpful financial statement, but it also poses challenges. First, assets on the balance sheet, under generally accepted accounting principles (GAAP), are recorded at historical cost. Historical cost is simply the cost paid for the item at the time it was purchased. Changes in market value of big-ticket items like land or buildings are not reflected in the balance sheet. Land remains at historical cost, and depreciable items like buildings are reflected at their current book value (historical cost less accumulated depreciation). If the asset has appreciated over time, the higher market value of the assets would not be seen on the balance sheet.

Estimates are another limitation of the balance sheet. Items on the balance sheet such as allowance for doubtful accounts and allowance for bad debt are based on estimates. The useful lives for calculating depreciation is another common estimate. If these estimates are incorrect, the net value of the asset can be under- or overstated.

Another key limitation is the fact that a balance sheet reflects balances at only one given point in time. This means that the account value could have been quite different on the day before or the day after the date of the balance sheet. For example, if a firm were concerned with certain ratios or investor/lender expectations of its cash balance, it could choose to not pay several vendor payments in the last week of December. Thus, on December 31, the firm reflects a high cash balance on its balance sheet. However, by the end of the first week of January, it has caught up on late vendor payments and again shows a low cash balance.

Finally, there are many possible things of value that are not recorded on the balance sheet. Internally generated assets and the firm’s human capital are two common examples. Internally generated assets can be anything from a website, a process, to an idea.

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