In-Depth Notes on Financial Statements and Ratios

Overview of Financial Statements

• Assets

  • Current Assets:

  • Definition: Assets converted to cash or used within one year or one operating cycle.

  • Examples:

    • Cash
    • Trading Investments
    • Accounts Receivable
    • Inventory
    • Prepaid Expenses

  • Non-current Assets:

  • Definition: Assets not expected to be used or converted to cash within one year or one operating cycle.

  • Examples:

    • Long-term Investments
    • Property, Plant, and Equipment (PP&E)
    • Land
    • Buildings
    • Accumulated Depreciation
    • Intangible Assets
    • Goodwill

Balance Sheet Equation

• The fundamental accounting equation:
  • $ext{Assets} = ext{Liabilities} + ext{Equity}$
  • Alternate forms:
  • $ext{Assets} - ext{Liabilities} = ext{Equity}$
  • $ext{Assets} - ext{Equity} = ext{Liabilities}$

Current Assets

• Description: Assets expected to help generate revenue in the short term.
• Examples:
  • Cash
  • Accounts Receivable
  • Inventory
  • Prepaid Expenses
• Listed by liquidity: ease and speed of converting to cash.

Non-Current Assets

• Description: Assets used over a longer period.
• Categories:
  • Long-Term Investments:
  • Debt Securities: loans, notes, bonds.
  • Equity Securities: shares of other companies.
  • Property, Plant, and Equipment (PP&E):
  • Tangible assets with long useful lives, crucial for operations.
  • Examples:
    • Equipment
    • Vehicles

Depreciation and Amortization

• Depreciation:
  • Systematic distribution of an asset's cost over its useful life.
  • Applied to tangible assets (e.g., equipment).
• Amortization:
  • Allocation for intangible assets with definite lives (e.g., patents).
• Accumulated Depreciation:
  • Contra asset account reflecting total depreciation to date.
  • Carrying Amount (Net Book Value, NBV): Cost minus accumulated depreciation.

Intangible Assets

• Definition: Assets without physical substance that have significant value.
• Examples:
  • Patents
  • Trademarks
• Goodwill:
  • Represents unidentifiable advantages of a business post-acquisition.
  • Not amortized; reported separately from other intangible assets.

Liabilities

• Current Liabilities:
  • Obligations due within one year or one operating cycle.
  • Examples:
  • Accounts Payable
  • Accrued Wages
  • Current portion of long-term debt
• Non-Current Liabilities:
  • Obligations due beyond one year.
  • Examples:
  • Long-term notes payable
  • Bonds Payable

Shareholders' Equity

• Share Capital: Funds raised by issuing shares in a company.
• Retained Earnings:
  • Cumulative profits retained in the company, calculated as:
  • $ext{Revenues} - ext{Expenses} - ext{Dividends}$

Financial Ratios

• Used for evaluating performance and financial position, analyzed relative to:

  • Previous years
  • Industry averages
  • Competitors

• Key Ratios:

  • Liquidity Ratios: Measure short-term obligation meeting capacity.

  • Working Capital: $ext{Current Assets} - ext{Current Liabilities}$

  • Current Ratio: $rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

  • Solvency Ratios: Measure long-term obligation sustainability.

  • Debt to Total Assets: $rac{ ext{Total Liabilities}}{ ext{Total Assets}}$

  • Profitability Ratios: Assess income generation effectiveness.

  • Earnings per Share (EPS): $rac{ ext{Net Income} - ext{Preferred Dividends}}{ ext{Weighted Average Common Shares}}$

  • Price to Earnings Ratio: $rac{ ext{Market Price per Share}}{ ext{Earnings per Share}}$

Notes on Analysis Limitations

• Analysis quality heavily relies on data integrity and accounting choices.
• Common issues:
  • Ill-prepared estimates due to inflation.
  • Difficulty in industry comparisons for diversified companies.