How to read a balance sheet

Key takeaways

• Assets and liabilities are split into current (expected to be realized or settled within 12 months or the operating cycle) and non-current.
• Most assets sit at historical cost less depreciation, so book value is an accounting measure, not a market value.
• Goodwill is the excess of an acquisition price over the fair value of identifiable net assets; it is not amortized under IFRS or by US public companies but is tested for impairment.
• Equity combines contributed capital (common stock and APIC), retained earnings, accumulated other comprehensive income, and treasury stock as a deduction.
• Book value per share uses common equity attributable to the parent divided by shares outstanding; tangible book value also removes goodwill and intangibles.
• Deferred tax liabilities and assets arise when book and tax rules recognize the same item in different periods.

Structure: current and non-current

Every balance sheet is organized around the accounting equation: assets equal liabilities plus equity. Within assets and liabilities, the key division is between current and non-current. A current asset is cash, or an asset expected to be converted to cash, sold or consumed within 12 months of the balance sheet date or within the normal operating cycle if that is longer. A current liability is one expected to be settled within the same horizon. Everything else is non-current.

The split matters because it shows liquidity. Current assets less current liabilities is working capital, and comparing the two tells a lender whether short-term obligations are covered by short-term resources. A long-term loan that falls due within the next year moves into current liabilities as the current portion of long-term debt, which is why a balance sheet can look suddenly stretched the year before a maturity.

US companies usually list assets in order of liquidity, cash first, and liabilities before equity. Many IFRS reporters list non-current assets first and may show equity before liabilities. IAS 1 also allows a presentation based purely on liquidity, which banks and insurers typically use. The content is the same; only the order changes.

Current assets

Cash and cash equivalents are cash on hand, bank deposits and very short-term, highly liquid investments (typically with an original maturity of three months or less). Short-term investments are securities held for longer than that but expected to be realized within a year. Restricted cash, pledged to a lender or held in escrow, is disclosed separately and should not be counted as freely available.

Accounts receivable are amounts owed by customers for goods or services already delivered. They are shown net of an allowance for credit losses, management's estimate of amounts that will not be collected, measured under the expected credit loss models of ASC 326 (CECL) in the US and IFRS 9 elsewhere. A falling allowance while receivables grow is worth a question.

Inventory is goods held for sale, work in progress and raw materials, carried at the lower of cost and net realizable value. The cost formula matters: first-in, first-out (FIFO) and weighted average cost are allowed under both frameworks, while last-in, first-out (LIFO) is allowed under US GAAP but prohibited under IFRS. In a period of rising prices, LIFO produces a lower inventory balance and higher COGS. Prepaid expenses are payments made in advance for rent, insurance or services to be consumed within the year.

Non-current assets: PP&E, leases, goodwill and intangibles

Property, plant and equipment is shown net: original cost less accumulated depreciation and any impairment. Under US GAAP it must stay at historical cost. IFRS permits a revaluation model for a whole class of PP&E, though most companies use cost. Because land is not depreciated and old assets are carried at old prices, net PP&E can be far from replacement cost.

Since ASC 842 and IFRS 16, most leases appear on the balance sheet. The lessee records a right-of-use asset, its right to use the leased item, and a matching lease liability, the present value of remaining lease payments. Before these standards, operating leases were off balance sheet, so historical leverage ratios are not comparable with current ones.

Intangible assets are non-physical assets such as customer relationships, brands, patents and software. Internally generated intangibles such as a homegrown brand are generally not recognized. Most intangibles on a balance sheet came from acquisitions, where they are identified and measured at fair value. Those with a finite life are amortized; those with an indefinite life, such as some brands, are tested for impairment instead.

Goodwill is what remains of an acquisition price after every identifiable asset and liability has been recorded at fair value. It represents assembled workforce, synergies and going-concern value that cannot be separately recognized. Goodwill is not amortized under IFRS or by US public companies. It is tested for impairment at least annually, and a write-down flows through the income statement. US private companies may elect an accounting alternative that amortizes goodwill, generally over up to ten years.

Liabilities, including deferred taxes

Accounts payable are amounts owed to suppliers. Accrued liabilities are expenses incurred but not yet invoiced or paid, such as wages, bonuses, interest and taxes. Deferred revenue is cash received for goods or services not yet delivered. Debt is split between the current portion due within a year and long-term debt, and is usually carried at amortized cost, net of unamortized issuance costs, not at market value.

Deferred taxes arise because accounting profit and taxable profit often recognize the same item in different periods. The classic example is depreciation: tax rules frequently allow faster depreciation than the straight-line method used in the accounts. The company pays less tax now and more later, and the balance sheet records a deferred tax liability for that future tax. A deferred tax asset is the reverse, such as tax losses carried forward or expenses accrued in the books but deductible only when paid.

Deferred tax assets are recognized only to the extent future taxable profit is expected to be available to use them. Under US GAAP the asset is reduced by a valuation allowance where realization is not more likely than not, and under IFRS it is simply not recognized. On both frameworks all deferred tax balances are classified as non-current. Other non-current liabilities commonly include pension obligations, provisions for litigation or decommissioning, and long-term lease liabilities.

Shareholders' equity: stock, APIC, retained earnings, AOCI and treasury stock

Common stock and additional paid-in capital (APIC) together record what shareholders paid the company for its shares. In jurisdictions with par values, common stock holds the nominal par amount (often a fraction of a cent) and APIC holds everything paid above par. Ridgeway issued 100m shares with a $0.01 par value, so common stock is $1m and the rest of the $381m contributed sits in APIC. Share-based compensation expense also credits APIC. IFRS reporters often call this line share premium.

Retained earnings accumulate net income less dividends since inception. A company with a long history of losses shows an accumulated deficit, a negative figure. Accumulated other comprehensive income (AOCI) holds gains and losses that bypass net income: foreign currency translation of overseas subsidiaries, some unrealized gains and losses on securities, effective cash flow hedges and pension remeasurements. Under US GAAP most of these are reclassified into net income when realized. Under IFRS some, such as pension remeasurements, never are, and the balance is often labeled other reserves.

Treasury stock records shares the company has bought back and still holds. Under the cost method used by most US companies, it is shown at the price paid as a deduction from equity. No gain or loss is ever recognized on the income statement for buying or reissuing a company's own shares. Treasury shares are issued but not outstanding, so they carry no vote and receive no dividend, and they are excluded from EPS. Ridgeway has 100m shares issued and 8m in treasury, so 92m are outstanding.

Non-controlling interests, the equity in subsidiaries owned by outside shareholders, are shown within total equity but separately from the parent's equity. They belong to someone else, so ratios for the parent's shareholders exclude them.

Book value and tangible book value per share

Book value per share (BVPS) is common equity attributable to the parent divided by common shares outstanding. It is the accounting value of the equity behind each share. Price to book, the share price divided by BVPS, is a central valuation metric for banks, insurers and other balance-sheet businesses, and a reference point for asset-heavy industrials.

Tangible book value (TBV) removes goodwill and other intangible assets, on the view that they cannot be sold separately or used to repay creditors in a liquidation. It is the more conservative measure and is the standard metric for bank equity. If preferred stock exists, its liquidation value is deducted from equity before either calculation. Some analysts add back the deferred tax liability associated with acquired intangibles; state the convention whenever you quote the figure.

A share buyback changes book value per share in a way that surprises many readers. If the company repurchases shares at a price above BVPS, it removes more equity per share than the average share carries, and BVPS falls. If it repurchases below BVPS, BVPS rises. This is arithmetic, not a judgment on whether the buyback was a good use of cash.

What book value does not tell you

Book value is a record of historical transactions under accounting rules, not an estimate of what the company is worth. Land bought decades ago sits at its original cost. A software company's most valuable assets, its code, customer base and team, are mostly absent because they were built internally. A serial acquirer can carry large goodwill that reflects prices paid in a different market.

For a lender, the balance sheet question is recovery: what would the assets fetch, and who ranks ahead? That means looking past book values to the collateral, the seniority of each debt tranche and off-balance-sheet commitments disclosed in the notes, such as guarantees and purchase obligations. For an equity investor, the question is capital intensity: how much balance sheet does each dollar of profit require? Both questions start here but are not answered by the totals alone.