MODULE 3: ANALYZING BALANCE SHEETS

Balance Sheet Frame

1. A balance sheet reports what a company owns, what it owes, and what belongs to owners at one specific date.
   What is owns: Assets controlled by the company.
   What is owes: Liabilities the company must settle.
   What is owners: Shareholders who have the residual claim after liabilities.
   Think of it like taking a photo of a room. You see what is inside the room on that date, but you do not automatically know how things moved during the year.
2. The basic equation is:

1. Analysts use the balance sheet to judge liquidity, solvency, and financial position. Liquidity asks whether the company can handle near-term bills. Solvency asks whether the company can survive its long-term obligations.
2. The tricky part is measurement. Some items sit at historical cost or amortized cost, some sit at fair value, and some valuable things are not recorded at all.
3. Apple may have massive brand loyalty, ecosystem power, and customer trust, but those internally built strengths are not recorded as separate assets. If Microsoft buys a company and pays extra for similar strengths, that extra payment can show up as goodwill.

Intangible Assets

1. An intangible asset is an identifiable non-monetary asset without physical substance.
   What is identifiable: It can be separated and sold, or it comes from a legal or contractual right.
   What is non-monetary: It is not cash and does not promise a fixed amount of cash.
   What is physical substance: You cannot touch it like a factory, truck, or inventory.
   A patent, license, trademark, copyright, franchise right, and customer list can be intangible assets.
2. Purchased identifiable intangibles are capitalized if future benefits are probable and cost can be measured reliably. If Reliance buys a telecom license for a clear price, that license can go on the balance sheet.
3. Internally created intangibles are harder. A company may build a brilliant brand, train employees, and create customer loyalty, but those usually do not appear as assets because the cost and control are hard to pin down.
4. Under International Financial Reporting Standards (IFRS), an internally generated project must be split between the research phase and the development phase. Research is expensed. Development can be capitalized only if the project meets strict criteria, including technical feasibility, ability to use or sell the asset, and ability to complete it.
5. Under United States generally accepted accounting principles (US GAAP), most internally developed intangible and research and development costs are expensed. Do not assume a software-like idea automatically becomes an asset.
6. The following are generally expensed under both IFRS and US GAAP: internally generated brands, mastheads, publishing titles, customer lists, start-up costs, training, admin overhead, advertising, relocation, reorganization, and termination costs.
7. Cost model means the intangible stays at cost minus accumulated amortization and impairment. If a patent is bought for Indian rupees 100 and amortized by Indian rupees 10 per year, the balance sheet does not care that someone now thinks the patent is worth Indian rupees 500.
8. Revaluation model is allowed under IFRS only when an active market exists for the intangible. That is rare for most intangibles because patents, brands, and customer lists are usually too unique.
9. US GAAP uses the cost model for intangibles. Revaluation upward is not allowed.
10. Finite-life intangibles are amortized over their useful lives, and the useful life and amortization method must be reviewed at least annually.
11. Indefinite-life intangibles are not amortized. Instead, the company must review whether the indefinite-life assumption still makes sense and test the asset for impairment at least annually.
12. Disclosures matter. Notes should tell you useful lives, amortization rates, amortization methods, and impairment losses or reversals.
13. Do not blindly delete all intangibles from analysis. The source says analysts often adjust, but an arbitrary zero value is not advisable. A drug patent and a vague brand label do not deserve the same treatment.

Goodwill

1. Accounting goodwill is the excess purchase price paid in an acquisition over the fair value of identifiable net assets acquired.
   What is purchase price: What the acquirer pays to buy the target company.
   What is fair value: The price that would be received to sell an asset or paid to transfer a liability in an orderly market.
   What is identifiable net assets: Identifiable assets minus liabilities.
   What is acquisition: One company buys another company.
   Goodwill is the accountant saying, "We paid extra because we expected extra value."
2. Goodwill appears only when there is a business acquisition. Internally generated goodwill is not recorded.
3. Economic goodwill and accounting goodwill are not the same. Economic goodwill comes from earning power, customer love, distribution strength, brand trust, and other business advantages. Accounting goodwill comes from past acquisitions.
4. Goodwill calculation:

1. If the fair value of identifiable net assets is greater than the purchase price, it is a bargain purchase. The gain is recognized in the income statement in the period it arises.
2. Goodwill is not amortized under IFRS or US GAAP. It is tested for impairment at least annually.
3. Goodwill impairment reduces net income and total assets. It is non-cash, but it tells you that an acquisition story did not work as expected.
4. A goodwill impairment can make future return on assets look better because assets are now lower. Do not mistake that later ratio improvement for better operating performance.
5. Acquisition accounting gives management room to shape future earnings. If more purchase price is allocated to goodwill and less to finite-life assets, future amortization expense is lower and income can look better.
6. Goodwill disclosures should explain the acquisition-date purchase price, the fair value assigned to major asset and liability classes, and the qualitative factors that created goodwill.
7. Safeway is the memory hook. It recorded a large goodwill impairment after earlier acquisitions looked less valuable in a weak economy. Goodwill was management saying "we paid extra for extra value"; the impairment was the market saying "that extra value did not show up."

Financial Instruments

1. A financial instrument is a contract that creates a financial asset for one entity and a financial liability or equity instrument for another entity.
   What is contract: A binding agreement between parties.
   What is financial asset: Cash, a right to receive cash, or an ownership investment.
   What is financial liability: An obligation to deliver cash or another financial asset.
   What is equity instrument: A residual ownership claim.
   A bond is easy: investor has a financial asset, issuer has a financial liability.
2. Derivatives can be financial assets or financial liabilities depending on the contract terms and current market conditions.
3. Financial instruments are generally measured after acquisition using either amortized cost or fair value.
4. Amortized cost means original recognized amount minus principal repayments, plus or minus amortized discount or premium, and minus impairment.
5. Fair value means the price to sell an asset or transfer a liability in an orderly market transaction.
6. Held-to-maturity debt securities are measured at amortized cost. Interest income goes to the income statement and then flows into retained earnings. Unrealized market value changes are ignored.
7. Available-for-sale debt securities are measured at fair value. Interest income goes to the income statement, while unrealized gains and losses go to other comprehensive income (OCI), not net income.
8. Trading securities are measured at fair value. Unrealized gains and losses go to the income statement, not OCI.
9. Equity investments are simpler under US GAAP and more flexible under IFRS. Under US GAAP, if Apple buys a small stake in another listed company and does not control or significantly influence it, changes in value usually go through the income statement. Under IFRS, the company may choose at the time of purchase to send those value changes to OCI instead, but that choice is locked in. Think of it like choosing the reporting lane on day one: US GAAP usually sends small equity stakes through earnings; IFRS may allow the OCI lane.
10. Realized gains and losses from selling a financial asset go to the income statement. The amortized-cost versus fair-value debate is mainly about unrealized gains and losses while the asset is still held.

Non-Current Liabilities

1. Non-current liabilities are obligations not classified as current. Common examples are long-term loans, notes payable, bonds payable, leases, post-employment obligations, non-current deferred revenue, and deferred tax liabilities.
2. Long-term financial liabilities are usually reported at amortized cost. If a company issues bonds at par, the carrying value starts at face value. If it issues at a discount or premium, that discount or premium is amortized so the carrying value moves toward face value by maturity.
3. Some liabilities are reported at fair value, including trading liabilities, derivative liabilities, and some hedged instruments.
4. Non-current deferred revenue means the company has collected or billed for goods or services expected to be delivered more than 12 months after the reporting date. Think of a software company paid upfront for a multi-year service contract.
5. Deferred tax liabilities arise from temporary timing differences when taxable income is lower than accounting income today, creating taxes payable in future periods.
6. A classic deferred tax liability comes from accelerated depreciation for tax and straight-line depreciation for financial reporting. The company pays less tax now, but the tax bill catches up later.

Common-Size Balance Sheets

1. A vertical common-size balance sheet expresses every balance sheet line item as a percentage of total assets.
   What is vertical: Looking down one statement for one period.
   What is line item: A reported account such as cash, inventory, debt, or equity.
   Why is percentage of total assets used: It lets you compare companies of different sizes.
   A bank and an airline may both be huge, but the bank owns loans and securities while the airline owns aircraft. Common-size analysis shows the shape of the business.
2. Formula:

1. Use common-size analysis over time to spot changes in liquidity, leverage, acquisition strategy, asset intensity, and working capital structure.
2. Use it across companies to compare business models. Apple can hold huge cash and marketable securities because the business throws off cash. An airline holds aircraft. A bank holds loans. Same word "asset," totally different risk.
3. Goodwill as a high percentage of total assets usually tells you the company has grown through acquisitions. Low goodwill usually points toward organic growth, but it does not prove the company lacks brand value.
4. Inventory, receivables, cash, and payables tell you how the operating machine works. A retailer with fast inventory turnover is not the same as a manufacturer with slow inventory and heavy plant.

Balance Sheet Ratios

1. Current ratio measures broad short-term liquidity:

1. Quick ratio removes inventory and prepaid-style softness:

1. Cash ratio is the strictest liquidity test:

1. Solvency ratios focus on long-term financial risk and leverage:

1. A higher current ratio, quick ratio, or cash ratio usually suggests lower liquidity risk. A higher debt-to-equity or financial leverage ratio usually suggests higher solvency risk.
2. Ratio analysis needs judgment. Accounting methods differ, diversified companies mix industries, and one year-end financing decision can temporarily flatter the current ratio.
3. The current ratio is only a rough point-in-time liquidity snapshot. Cash is ready now, marketable securities are close, receivables need collection, and inventory may take time or discounts to convert to cash.
4. Impairment write-down trap: if assets and equity fall but debt and revenue do not change, debt-to-equity increases and total asset turnover increases.