Following on from Topic 8, this is the second topic where we will discuss financial statement analysis. This time we shall focus on balance sheets. The balance sheet is a document that provides a snapshot view of the financial situation of a business. In other words, it is an ‘as at date’ document that gives an image about the business’s financial position at a point in time. Unlike the income statement, which covers an entire financial years’ performance, the balance sheet consists of three (3) main components – assets, liabilities and owners’ equity – where total assets (current and non-current) have to be equal to total liabilities (current and non-current liability) plus owners’ equity.
Welcome to Topic 9: Financial Statement Analysis – Balance Sheet. In this topic, you will learn about:
- The balance sheet
- The basic accounting equation
- Balance sheet ratios.
These relate to the Subject Learning Outcomes:
- Understand the role of the finance and accounting functions in an organisation.
- Identify the terminology and concepts that underlie the preparation of general-purpose financial reports.
- Prepare and summarise financial statements to support business decision making.
- Apply mathematics of finance to determine risk, return, evaluation of investment, financing, working capital and distribution decisions.
- Develop analytical skills drawing from key finance theories, concepts and techniques.
Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these prior to attending your scheduled seminar with your lecturer.
Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.
Read Chapter 13 (pp.393-396), 14 and 16 of Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
Read the following journal articles:
- Wolf, I & López del Río, LC 2021, 'Sustainability of funded pension schemes: A financial position perspective using options', Investment Management and Financial Innovations, 18(4):111-119.
- Melse, E 2004, 'What color is your balance sheet? The relevance and explanatory power of wealth accounts', Balance Sheet, 12(4):17-32.
Identify the key takeouts and add these to your reflective journal. You can access the reflective journal by clicking on ‘Journal’ in the navigation bar for this subject. If you are unsure of any concepts, reach out to your lecturer.
Read the following web articles:
- Accounting Simplified n.d., 'Financial statement analysis: balance sheet analysis'.
- Mohammed 2021, 'Balance sheet analysis with examples' - Brightflow.ai
Identify the key takeouts and add these to your reflective journal. If you are unsure of any concepts, reach out to your lecturer.
Read the case study, 14.1: Financial Statement Analysis, on pp. 423-426 of the prescribed text.
Then, consider Discussion question 1 on p. 426. Make note of your answers in your reflective journal and be ready to share your reflections with the class during the scheduled seminar.
What kind of ratio analysis is more valuable to an analyst:
- Time series
- Cross sectional
- Industry averages?
Explain your choice.
This topic has a discussion forum activity, which will enhance your knowledge and give you the opportunity to interact with your peers. You can access the activity by clicking on the following link. You can also navigate to the forum by clicking on 'FIN100 Subject Forum' in the navigation bar for this subject.
Read and watch the following content.
The balance sheet
The balance sheet is one (1) of the final statements prepared to show the financial position of a business at a specific point in time. It balances the total company assets (owned) against total company liabilities (owed) and identifies the difference between the owned and owed as owners’ equity.
A balance sheet helps a business to make two (2) major types of decisions:
- Operating decisions
- Capital budgeting decisions.
Operating decisions
Operating decisions are the decisions needed to manage an uninterrupted business process. Many of these decisions need to occur multiple times within a financial year. Examples of operating decisions include the decisions involved with:
- Buying raw materials
- Customer service inquiries
- Pricing
- Promotions
- Sales discounts.
Operating decisions are typically based around and have an effect on the current assets and current liabilities of a balance sheet, which will either be received or paid back within the next 365 days.
Capital budgeting decisions
Capital budgeting decisions are the decisions needed to make towards the growth of a business. When expanding a business, capital is necessary. Capital can be acquired either through owners’ equity (ordinary shares) or as debt financing (such as bank loans and bonds). Either way, this money ultimately ends up in long term assets, which provide the business with long term benefits and generate new income streams.
The basic accounting equation
Having discussed revenue and expenses in the previous topic; we will now look into the basic accounting equation and formula.
The following equation provides a mathematical overview of the total assets owned by a company and its expenses in relation to the total of its owners' equity, debt holders and revenue. The basic accounting equation is the basis of the double entry accounting system used for financial accounting and reporting.
$$\boldsymbol{\mathsf{Assets}}+\mathsf{expenses}=\boldsymbol{\mathsf{liabilities}}+\boldsymbol{\mathsf{equity}}+\mathsf{revenue}$$
Assets
An asset is a present economic resource controlled by an entity as a result of past events. An economic resource is a right that has the potential to produce economic benefitsOtun 2018
Asset recognition criteria
There must be an established likelihood of future economic benefits that can be accurately and reliably measured.
Asset presentation
In the balance sheet, assets are typically listed according to their liquidity rank, which is the rate that an asset can be converted into cash. The most liquid assets will be at the top of the list, while the least liquid will be found at the bottom. Therefore, “cash and cash equivalents/cash at bank” always appears on the top of a balance sheet and “buildings/property plant and equipment” stays at the bottom.
Liabilities
A liability is a present obligation of the entity to transfer an economic resource as a result of past events. An obligation is a duty or responsibility that the entity has no practical ability to avoidOtun 2018
Liability recognition criteria
There must be an established likelihood of an outflow that can be accurately and reliably measured.
Liability presentation
In a similar manner to assets, liabilities are listed according to their liquidity. Current liabilities that need to be settled at the earliest date are on top of the liability section, while long-term liabilities are at the bottom. Current assets and liabilities are generally subject to realise within the next financial year or within the next 365 days of business operations. While non-current asset and liabilities are subject to realise beyond the next financial year.
The following video provides more detail about the differences between current and non-current assets and liabilities.
Every business needs assets to generate revenue in order to achieve profits. Cash is the most liquid of all assets. Investing cash into business operations will expand exiting and help create more revenue streams.
For example, a production company using its cash surplus to purchase new machinery will increase the machinery asset while decreasing the cash asset of the company. On the other hand, a business could also purchase the same machinery on credit. In this situation, the machinery asset increases by the purchase price and its liabilities will also increase the same amount.
You may have already noticed that both situations, in the previous example, balanced the accounting equation. Purchasing machinery using cash will both increase and decrease the assets by the same amount on the left side of the equation. Whereas, in the second scenario, purchasing machinery on credit will increase the assets on the left of the equation while increasing the liability of the amount owed on the right side of the equation. Hence balancing the equation.
The following video further explains the differences between assets and liabilities.
Equity
Equity is the residual interest in the assets of the entity after deducting all its liabilities. Equity is easily calculated using the following formula:
$$\mathsf{Equity}=\mathsf{assets}-\mathsf{liabilities}$$
Equity increases as a result of profitable operations. Equity is also influenced by the measurement system adopted for assets and liabilities and the concepts of capital and capital maintenance.
Equity represents the owner’s money invested in a business. Traditionally, a business owner will start up their business with their own money, equipment, land or property, and so on. As a result, in the beginning, the total business assets are equal to the equity put up by the owner. As the business grows to the point where the business is able to take care of its own investments, businesses tend to borrow money from external investors, which represents the liability.
According to the accounting equation discussed previously, total assets will now be equal to the sum of owner’s equity and liabilities.
Balance sheet ratios
The following ratios show the strength of a company and its financial position in the industry. Read through the table for the following:
- Names of ratios
- Formulas to calculate them
- Brief description of the purpose of each.
| Types of balance sheet ratios | |||
|---|---|---|---|
| No. | Ratio | Formula | Description |
| 1. | Current ratio |
$$\frac{\mathsf{current\;assets}}{\mathsf{current\;liabilities}}$$ |
Analyses the company’s liquidity by using its current assets to pay the current liability. |
| 2. | Quick ratio |
$$\frac{(\mathsf{current\;assets}\,-\,\mathsf{inventory})}{\mathsf{current\;liabilities}}$$ |
Analyses the company’s liquidity by using its current assets, which excludes inventory to pay the current liability. This is due to the inventory that may take some time to convert to cash. |
| 3. | Cash ratio |
$$\frac{\mathsf{cash\;and\;cash\;equivalents}}{\mathsf{current\;liabilities}} $$ |
Analyses the company’s ability to pay its short-term liability in a stressful situation where its inventory will not sell and its receivables will not be able to be collected in a short period of time. |
| 4. | Receivables turnover |
$$\frac{\mathsf{net\;credit\;sales}}{\mathsf{average\;receivables}}$$ |
Measures how fast the company can collect payment from its receivables. |
| 5. | Days sales outstanding |
$$\frac{\mathsf{receivables}}{\mathsf{credit\;sales}}\times365$$ |
Measures how long the company takes in days to collect payment from its receivables after the sales have been made. |
| 6. | Doubtful account |
$$\frac{\mathsf{allowance\;for\;doubtful\;accounts}}{\mathsf{receivables}}$$ |
Analyses the quality of the company’s receivables. Auditors usually use it in the examination of receivables. |
| 7. | Inventory turnover |
$$\frac{\mathsf{cost\;of\;goods\;sold}}{\mathsf{inventory}}$$ |
Measures how many times the company sold and replaced its inventory during the period. |
| 8. | Days inventory outstanding |
$$\frac{\mathsf{inventory}}{\mathsf{cost\;of\;goods\;sold}}\times365$$ |
Measures how long the company takes, in days, to sell its inventory. |
| 9. | Payables turnover |
$$\frac{\mathsf{purchases}}{\mathsf{average\;payables}}$$ |
Measures how many times the company pays its payables during the period. |
| 10. | Days payable outstanding |
$$\frac{\mathsf{payables}}{\mathsf{cost\;of\;goods\;sold}}\times365$$ |
Measures how long the company takes, in days, to pay back its payables. |
| 11. | Debt-to-equity ratio |
$$\frac{\mathsf{liabilities}}{\mathsf{equity}}$$ |
Analyses the company’s financial leverage, which indicates how much debt the company uses compared to its equity, in running the business. |
| 12. | Debt-to-asset ratio |
$$\frac{\mathsf{liabilities}}{\mathsf{assets}}$$ |
Analyses the company’s financial leverage, which indicates how much debt the company uses compared to its total assets. |
In summary, the balance sheet is one of the most important documents to measure a business’s financial position and its market value. Higher company value increases the shareholders wealth. Therefore, it is vital for whoever may be interested in investing in a company to be able to analyse the numbers of a balance sheet and to correctly interpret its meaning.
Key takeouts
Congratulations, we made it to the end of the ninth topic! Some key takeouts from Topic 9:
- Operating decisions are the day-to-day business decisions that relate to current assets and current liabilities.
- Capital budgeting decisions are made to finance the fixed assets of a company to generate revenue streams.
- Definitions and recognition criteria of assets, liabilities and equity are important to identify the business transactions and their effects on the business.
- Balance sheet ratios are vital to interpret business’s financial situation at a point in time.
Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your seminar.
The following learning tasks will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
In-seminar learning tasks
The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.
Watch the following two (2) videos about the balance sheet and financial ratio analysis.
- Accounting Stuff 2021, The BALANCE SHEET for BEGINNERS (Full Example), streaming video, YouTube
- Finbox Acadamy 2020, Balance Sheet Analysis: 10 Ratios You Should Use, streaming video, YouTube
Working in a breakout room team assigned by your lecturer during the scheduled seminar, discuss the following questions with your teammates. Your lecturer will request that you present the findings back to the class.
- What is the normal statistical figure expected on the following two (2) ratios?
- Quick ratio
- Current ratio.
- Explain why those values are expected.
- Working in the same breakout room as previously, visit the Harvey Norman Holdings website.
- Access its Annual Report to shareholder.
- The, calculate the following ratios for the FY 2020/2021
- Quick ratio
- Current ratio
- Debt-to-equity ratio
- Debt-to-asset ratio
- Days payable outstanding.
- Share the calculations with your teammates. Describe the trends and discuss how can they improve.
Welcome to your post-seminar learning tasks for this week. Please ensure you complete these after attending your scheduled seminar with your lecturer. Your lecturer will advise you if any of these are to be completed during your consultation session. Click on each of the following headings to read more about the requirements for each of your post-seminar learning tasks.
This learning task can be completed during the consultation session.
Knowledge check
Complete the following three (3) tasks. The following questions have been adapted from p. 428 of Melicher, RW & Norton, EA 2017, Introduction to finance: Markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
Click the arrows to navigate between the tasks.
Complete the Topic 9 Worksheet and save it to your journal. This learning task can be completed during the consultation session.
Start preparing a balance sheet for the client in Assessment 3. You can access the instructions by clicking “Assessment 3” in the navigation bar for this subject.
Each week you will have a consultation session, which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your consultation session.
Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
- Mcclure, B 2020, How to analyze a company’s financial position, Investopedia
- Myšková, R & Hájek, P 2017, ‘Comprehensive assessment of firm financial performance using financial ratios and linguistic analysis of annual reports’, Journal of International Studies, 10(4):96–108.
References
- Accountinguide n.d., Balance sheet ratios formula and example, https://accountinguide.com/balance-sheet-ratios/#:~:text=%2012%20Types%20of%20Balance%20Sheet%20Ratios%20,in%20the...%206%20Inventory%20Turnover.%20%20More%20
- Accounting Simplified 2015., Financial statement analysis: balance sheet analysis, https://business-accounting-guides.com/balance-sheet-analysis/
- Accounting Stuff 2021, The BALANCE SHEET for BEGINNERS (Full Example), streaming video, YouTube, https://www.youtube.com/watch?v=CMv1zlZhb4Q
- The Finance Storyteller 2019, Assets vs Liabilities, streaming video, YouTube, https://www.youtube.com/watch?v=f4hIGyWByNA
- Finbox Academy 2020, Balance Sheet Analysis: 10 ratios you should use, streaming video, YouTube, https://www.youtube.com/watch?v=DOpMgyRhdQU
- Melicher, RW & Norton, EA 2017, Introduction to finance: markets, investments, and financial management, 16th edn., John Wiley & Sons, Inc.
- Melse, E 2004, 'What color is your balance sheet? The relevance and explanatory power of wealth accounts', Balance Sheet, 12(4):17-32.
- Mohammed 2021, Balance Sheet Analysis with Examples - Brightflow ai, https://brightflow.ai/blog/balance-sheet-analysis/
- Otun, A 2018, Revised Conceptual Framework, IFRS is easy, https://www.adedamolaotun.com/2018/11/revised-conceptual-framework.html
- Tetracarbon (Phillip Wong) 2017, The difference between current and non-current assets?, streaming video, YouTube, https://www.youtube.com/watch?v=pG8D53USUBE
- Wolf, I & López del Río, LC 2021, 'Sustainability of funded pension schemes: A financial position perspective using options', Investment Management and Financial Innovations, 18(4):111-119.
