- Since we're going to be using the financial statements
to do our analysis,
let's quickly review the primary financial statements.
There are three.
The balance sheet, the income statement
and the statement of cash flows.
Let's briefly review what's contained in each one
of these three primary financial statements
and we'll start with the mother of all financial statements,
the balance sheet.
The balance sheet is a listing of a company's assets,
it's resources, it's valuable things, it's cash,
it's land, it's inventory, the thing that it sells.
Those are it's assets.
The other part of the balance sheet is a listing
of where the company got the money to buy those assets,
the liabilities, and the equities.
The balance sheet embodies the accounting equation,
one of the greatest inventions of the human mind
invented in Italy over 500 years ago.
Now we're going to use a hypothetical example
to do some financial ratio analysis.
So let's make up this example now.
We'll call the company, very cleverly, Uncertain Company.
And we are not sure how Uncertain Company is doing.
So here are the assets
for this hypothetical Uncertain Company.
Cash $700.
Accounts receivable, that's money owed by other people
to this company, to Uncertain, of $4000.
Inventory, the things that Uncertain Company holds
to sell to other people, $1800.
And finally, property, plant and equipment,
that's land, machines, buildings, of $8000
for total assets of $14,500.
Since the balance sheet has to balance, hence the name,
then Uncertain must now detail where the resources came from
to purchase those $14,500 in assets.
What are those sources?
Well one possible source, liabilities.
Liabilities are obligations to repay money
or to provide a service in the future.
Consider Walmart for example.
Where does Walmart get most of it's inventory?
That's the things that Walmart has on it's shelves
to sell to you and me.
Well suppliers finance it.
Suppliers say, "You can pay us later."
We call those accounts payable.
Other liabilities?
Well Disney's borrowed money on a long-term basis,
sometimes very long-term.
That money has to be repaid.
Delta Airlines has a very interesting liability.
When you and I fly on Delta, we pay first and fly later.
In the interim, Delta Airlines owes us a ride
on an airplane, that's an obligation, that's a liability.
That's listed on Delta's balance sheet.
Now the liabilities for our Uncertain Company are two,
accounts payable of $2500 and long-term debt of $4500
for total liabilities of $7000.
Meaning of those $14,500 in assets
that Uncertain Company has, $7000 of those dollars came
from borrowing in these two different forms.
Now the second source of financing to buy assets
is owner's equity.
This is money provided to the company by the owners.
Now owners can do this in two general ways.
One is that the owners can take money
out of their personal savings and put it into the company.
They've been working for years saving $1000 here
and $1000 there.
Now they put it in the company.
We call that paid-in capital.
That's one way that owners invest in the company.
They put capital into the business.
Now a second way that owners invest in a company
is by keeping the profits of the company in the business.
We call this retained earnings.
The profits of a business belong to the owners.
The owners can take those profits out
in the form of dividends and do with them what they'd like.
Or the owners can say let's put those profits back
into the business.
We call those earnings retained earnings.
Paid-in capital and retained earnings are the amount
of money that are provided to the company
by the owners to then buy assets.
The equity of Uncertain Company is paid-in capital of $1500
and retained earnings of $6000.
So let's see if this all adds up.
The assets of Uncertain Company are $14,500.
Where did Uncertain get the money to buy those assets?
Well $7000 was borrowed and $7500 was invested
either directly or indirectly by the owners.
It's perfect.
The accounting equation always works.
You've got assets and you've got to get the money
to buy those assets from somewhere.
Those relationships, which assets and which mix,
and where did we get the money to buy those assets,
those tell us very important things
about a business, it's strengths, it's weaknesses,
and it's risks.
Now we're going to use the balance sheet
in financial ratio analysis.
The balance sheet,
that's the mother of all financial statements.