Financial statements are the backbone of a company's financial reporting. They provide a snapshot of a business's financial health, showing income, equity changes, and overall financial position. These statements work together to give a comprehensive view of a company's financial activities and status.

Liquidity ratios are crucial tools for assessing a company's short-term financial health. By analyzing current assets and liabilities, these ratios help determine if a business can meet its immediate financial obligations. Understanding these metrics is key for investors, creditors, and managers to gauge a company's financial stability.

Financial Statements

Construction of financial statements

• Income Statement
  • Reports revenues, expenses, and net income generated by a business over a specific period of time (month, quarter, year)
  • Formatted as: Revenues - Expenses = Net Income
  • Revenues represent inflows of assets earned from providing goods or services to customers (sales, fees)
  • Expenses are outflows of assets or incurrences of liabilities necessary to generate revenues (salaries, rent, utilities)
    • Depreciation is an expense that allocates the cost of long-term assets over their useful life
  • Net Income represents the profits earned by the business after subtracting expenses from revenues
• Statement of Owner's Equity
  • Reports changes in the owner's equity of a business over a period of time
  • Formatted as: Beginning Equity + Net Income + Owner Investments - Owner Withdrawals = Ending Equity
  • Beginning Equity is the owner's equity balance at the start of the period
  • Net Income from the income statement increases owner's equity
  • Owner Investments represent additional capital contributions made by the owner during the period
  • Owner Withdrawals are funds taken out of the business by the owner for personal use, reducing owner's equity
  • Ending Equity is the owner's equity balance at the end of the period
• Balance Sheet
  • Reports the assets, liabilities, and owner's equity of a business at a specific point in time (end of month, quarter, year)
  • Follows the fundamental accounting equation: Assets = Liabilities + Owner's Equity
  • Assets are economic resources owned by the business that are expected to provide future benefits (cash, inventory, equipment)
    • Current Assets are cash and other resources expected to be converted to cash or used up within one year (accounts receivable, prepaid expenses)
    • Long-term Assets are resources expected to provide benefits to the business beyond one year (land, buildings, machinery)
  • Liabilities represent debts or obligations owed by the business to creditors (accounts payable, loans)
    • Current Liabilities are debts that are due to be paid within one year (wages payable, interest payable)
    • Long-term Liabilities are debts that are due to be paid beyond one year (mortgage payable, bonds payable)
  • Owner's Equity represents the owner's residual claim on the assets of the business after subtracting liabilities
    • Retained earnings, which are accumulated profits not distributed to owners, are included in owner's equity

Interrelation of financial statements

• Net Income from the income statement directly impacts the statement of owner's equity
  • If the business generates a net income, it increases owner's equity for the period
  • If the business incurs a net loss, it decreases owner's equity for the period
• Ending Equity from the statement of owner's equity carries forward to the balance sheet
  • The ending equity balance becomes part of the owner's equity section on the balance sheet
• The balance sheet provides a snapshot of a company's financial position by summarizing the cumulative effect of all transactions since the business began operations
  • Asset, liability, and owner's equity balances from the end of the previous period are carried forward as beginning balances
  • Current period changes, such as net income from the income statement and owner investments/withdrawals, are added to the carried forward balances
  • The ending balances in the balance sheet assets, liabilities, and owner's equity reflect the company's financial position at that point in time

Accounting Principles and Financial Reporting

• Financial statements are prepared using either accrual basis accounting or cash basis accounting
• Generally Accepted Accounting Principles (GAAP) provide guidelines for financial reporting to ensure consistency and comparability among companies
• Financial reporting involves presenting financial information to stakeholders through various means, including financial statements, annual reports, and regulatory filings

Liquidity Ratios

Liquidity ratios from balance sheet

• Liquidity ratios assess a company's ability to meet its short-term financial obligations using data from the balance sheet
• Working Capital measures the company's ability to pay off current liabilities with current assets
  • Formula: $Current Assets - Current Liabilities$
  • Represents the excess of current assets over current liabilities
  • A positive working capital indicates the company has sufficient current assets to cover its current liabilities (adequate liquidity)
  • A negative working capital suggests the company may struggle to pay off current liabilities as they come due (potential liquidity issues)
• Current Ratio expresses the proportion of current assets available to cover each dollar of current liabilities
  • Formula: $\frac{Current Assets}{Current Liabilities}$
  • A ratio greater than 1 indicates the company has more than $1 of current assets for each $1 of current liabilities (good liquidity)
  • A ratio less than 1 indicates the company has less than $1 of current assets for each $1 of current liabilities (liquidity risk)
  • A ratio equal to 1 means current assets exactly equal current liabilities
• Interpreting liquidity ratios provides insights into a company's short-term financial health
  • Higher liquidity ratios generally indicate a stronger ability to meet short-term obligations (less risk of default)
  • Ratios significantly above industry averages may suggest the company is not efficiently utilizing its current assets (excess cash, slow-moving inventory)
  • Ratios should be analyzed over multiple periods to identify trends and compared to similar companies to assess relative liquidity