Level 1 CFA® Exam:
Balance Sheet Components, Format & Presentation
Balance Sheet – Basics for Level 1 CFA Candidatesstar content check off when done
Welcome to the first lesson on the balance sheet. In this lesson, you’ll find:
- an overview of the balance sheet, its components, and limitations,
- alternative balance sheet presentation formats.
Balance Sheet – Definitions
- asset – a resource controlled by the company as a result of past events if it is expected to bring future economic benefits to the company
- liability – a present obligation of the company arising from past events, the settlement of which is expected to result in an outflow from the company of resources embodying economic benefits
- owners’ equity (also called shareholders’ equity) – owners’ residual interest in the assets of the company; it represents the excess of the company’s assets over liabilities
- liquidity – the company’s ability to settle its obligations in the short term
- current asset – an asset held mainly for the purpose of trading activity; the company expects to sell the asset, use it up, or convert into cash within one year (or one operating cycle)
- non-current asset – an asset that the company does not expect to sell, use up, or convert into cash within one year (or one operating cycle); very often such assets are called long-term or long-lived assets
- operating cycle – the average amount of time that the company can transform the purchased inventory into cash sales to customers
- liquidity – the company’s ability to meet its financial obligations with the liquid assets available to them; the ability to pay off debts as they come due
- solvency – the company’s ability to meet its long-term debts and financial obligations
CFA Exam: Overview of the Balance Sheet, Its Components, and Limitationsstar content check off when done
The balance sheet, together with the income statement, is the key element of each financial report and it allows an analyst to gain a better understanding of the company’s position and its ability to finance its operation, settle debts, plus it provides information on the company’s value. Depending on the accounting regime, it might be called differently. The most common naming conventions include Balance Sheet, Statement of Financial Position, or Statement of Financial Condition.
The balance sheet includes information on assets, liabilities, and equity. The relationship between those components is characterized by the following equation:
assets = liabilities + owners’ equity
The equation above can be also interpreted in a more intuitive, business-oriented meaning, namely the assets are the things that the company owns and that have been financed by both the liabilities (e.g., loans provided by banks) and equity (i.e., funding capital provided by the owners to start the company).
While it might be intuitive to treat equity as the company’s value, we should not assume that this value will be equal to the market or intrinsic value of the firm. This is due to certain limitations of the balance sheet as an analytical tool:
Firstly, accounting rules allow different valuation methods of both assets and liabilities. So, different types of assets and liabilities are very often measured using different valuation techniques, e.g., some are measured using historical cost, while others are valued at their fair value.
Secondly, values reported in the balance sheet result from the measurement at the reporting date and they might change between the reporting date and the moment when the financial statements are published (e.g., inventory value changes under an inflationary economic environment).
Finally, the current standing of the company presented in the balance sheet is not always representative of the company’s true potential. Thus, the reported value of equity may fail to account for the company’s true value and specifically for the cash flows that it can generate in the future (BTW, potential cash flows are the key elements that drive valuation).
Balance Sheet Components
Current vs Non-Current Assets/Liabilitiesstar content check off when done
As presented above, the key idea behind the split between assets and liabilities is to differentiate them into:
- current assets and liabilities,
- non-current assets and liabilities.
The differentiation between current and non-current assets and liabilities lies in the intent that the company has towards their use and the expectation around the timelines when the assets are going to be used or the liabilities settled. If the asset or liability that arises due to trading activity within one operating cycle is going to be used or settled within one year, we classify it as a current asset/liability. All *other assets and liabilities are treated as non-current. Non-current assets are the ones that allow the company to operate and usually represent the multi-year investment into the company’s infrastructure.
While it is relatively easy to identify current assets and then appropriately recognize them in the balance sheet, to classify a liability as current certain criteria are required to be met:
- the company can reasonably expect that the liability will be settled within one year or one operating cycle,
- the company entered into the liability for trading purposes,
- there are no additional rights connected to the liability that would allow the company to prolong the settlement date above 1 year from the balance sheet reporting date.
Certain accounting regimes such as IFRS may introduce more detailed guidance on the classification of liabilities into current and non-current. IFRS, for example, require that the liabilities that are part of the working capital are classified as current even if they are to be settled after 1-year post the balance sheet reporting date.
Working Capitalstar content check off when done
Let’s now explain what working capital is.
Working capital – a difference between the company’s current assets and current liabilities.
CFA Exam: Alternative Balance Sheet Presentationstar content check off when done
If the company thinks that the classified balance sheet presentation form does not faithfully and accurately represent its financial position, it is allowed to choose a liquidity-based format. This format is usually chosen by banks and other financial industry firms where the liquidity of assets and liabilities is vital for a better understanding of how those firms operate and perform.
The idea behind a liquidity-based presentation is simple – the assets and liabilities are presented starting from the most liquid to the least liquid. Below, we illustrate a balance sheet that is ordered using a liquidity-based presentation:
Balance sheet (liquidity-based format):
ABC company liquidity-based balance sheet (as of Dec 31, 2021)
|Assets||millions of USD||Liabilities||millions of USD|
|Cash and Cash equivalents||876||Accounts payable||6,570|
|Financial assets||65||Short-term financial liabilities||2,978|
|Accounts receivable||7,632||Accrued liabilities||2,340|
|Inventory||5,908||Long-term financial liabilities||5,246|
|Property, plant, and equipment||3,870||Deferred tax liabilities||967|
|Intangible assets||179||Total liabilities||18,101|
|Other non-current assets||1,353||Retained earnings||979|
|Total Assets||20,130||Total liabilities and equity||20,130|
Level 1 CFA Exam Takeaways for Balance Sheet Components & Presentationstar content check off when done
- The balance sheet is one of the key elements of the company’s financial statements and it includes information about the assets that the company owns, the liabilities that the company owes to others, and the equity which is the residual value belonging to the owners of the company.
- The relationship between assets (A), liabilities (L), and equity (E) is described by a simple equation: A-L=E or A=L+E.
- Assets and liabilities are divided into current assets and liabilities and non-current assets and liabilities.
- Current assets and liabilities are the ones that arise due to trading activity within one operating cycle and the ones that the company is going to use or settle within one year.
- All other assets and liabilities that are not classified as current assets or liabilities are classified as non-current.
- A typical balance sheet presentation shows assets and liabilities split into current and non-current. However, some entities use a liquidity-based presentation, which is a viable alternative that presents assets and liabilities based on their liquidity (from the most liquid to the least liquid).