The Balance Sheet
Now that you understand the purpose of fundamental analysis, the balance sheet is where it begins. This is the foundation for evaluating a company's financial position.
The Accounting Equation
- Assets = Liabilities + Shareholders' Equity
- This equation must always balance - every dollar of assets is funded by either debt (liabilities) or ownership (equity)
- Assets are listed in order of liquidity (most liquid first)
Think of it this way: The balance sheet is a snapshot of a company at a single moment in time. Everything the company owns (assets) was paid for with either borrowed money (liabilities) or owner investment (equity). If those two sides do not match, something is wrong with the books.
Key Balance Sheet Components
| Category | Items | Notes |
|---|---|---|
| Current assets | Cash, accounts receivable, inventory, marketable securities | Expected to convert to cash within 1 year |
| Fixed (long-term) assets | Property, plant, equipment (PP&E), land | Subject to depreciation (except land) |
| Intangible assets | Goodwill, patents, trademarks | Goodwill arises when an acquirer pays more than fair market value for a company |
| Current liabilities | Accounts payable, short-term debt, accrued expenses | Due within 1 year |
| Long-term liabilities | Bonds payable, long-term loans, deferred taxes | Due beyond 1 year |
| Shareholders' equity | Common stock (par value), paid-in capital, retained earnings | Also called net worth or book value |
- Current = within one year (both assets and liabilities)
- Total capitalization = Long-term debt + Preferred stock + Common equity
Depreciation and Depletion
- Depreciation: Systematic allocation of the cost of a tangible asset over its useful life
- Reduces the book value of assets on the balance sheet
- Two main methods:
| Method | How It Works | Effect |
|---|---|---|
| Straight-line | Equal amount each year | Steady, predictable expense |
| Accelerated (MACRS - Modified Accelerated Cost Recovery System) | Larger deductions in early years | Higher expense early, lower later |
-
Straight-line formula: (Cost - Salvage value) / Useful life
-
Depletion: Similar to depreciation but applies to natural resources (oil, timber, minerals)
- Reduces the book value of the natural resource as it is extracted
-
Key point: Neither depreciation nor depletion involves actual cash outflows; they are non-cash charges that reduce reported earnings
Exam Tip: Gotchas
- Depreciation is a non-cash expense. It reduces reported earnings but does NOT reduce cash flow. This is exactly why EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) adds back depreciation to measure operating performance independent of accounting methods.
- Land is NOT depreciated. It has an unlimited useful life, so it stays on the balance sheet at its original cost.
Inventory Valuation Methods
How a company values its inventory directly affects both the balance sheet and the income statement. The two main methods:
| Method | COGS (Cost of Goods Sold) Impact | Balance Sheet Inventory | Best Used When |
|---|---|---|---|
| FIFO (First In, First Out) | Older (lower) costs charged to COGS | Ending inventory reflects more recent (higher) prices | Prices rising - results in higher earnings and higher inventory values |
| LIFO (Last In, First Out) | Newer (higher) costs charged to COGS | Ending inventory reflects older (lower) prices | Prices rising - results in lower earnings but lower tax liability |
During Rising Prices (Inflation)
- FIFO: Lower COGS → higher net income → higher taxes → balance sheet shows higher inventory value
- LIFO: Higher COGS → lower net income → lower taxes → balance sheet shows lower inventory value
During Falling Prices
- The effects reverse - FIFO would show lower earnings than LIFO
Regulatory Note
- LIFO is permitted under U.S. GAAP but not under IFRS (International Financial Reporting Standards)
Exam Tip: Gotchas
- When prices are rising, FIFO makes the balance sheet look stronger (higher inventory value) and the income statement look more profitable (lower COGS). LIFO has the opposite effect but saves on taxes.
- The exam often presents a scenario with rising prices and asks which method produces higher earnings (answer: FIFO).
- LIFO is NOT allowed under IFRS - only under U.S. GAAP. If a question mentions international standards, LIFO is off the table.