Getting back to the house example, if the house generates profits (via rental income), cash will go up and so will equity (via retained earnings).Even if youve never taken an accounting class, chances are, youll be asked questions that require rudimentary accounting knowledge.But what if you only have 30 minutes Thats what this quick lesson is for.
There is actually a 4 th statement, the Statement of Shareholders Equity, but questions about this statement are rare. It is critical that you take time to not only look at the four statements, but also read through the footnotes and MDA carefully to better understand the composition of these numbers. Liabilities represent the companys contractual obligations and include accounts payable, debt, accrued expenses, etc. The easiest way to intuitively understand this is to think of a house worth 500,000, financed with a 400,000 mortgage and a 100,000 down-payment. The asset in this case is the house, the liabilities are just the mortgage, and the residual is the value to the owners, the equity. One thing to note is that while both liabilities and equity represent sources of funding for the companys assets, liabilities (like debt) are contractual obligations that have priority over equity. Equity holders, on the other hand, are not promised contractual payments. That being said, if the company increases its overall value, the equity investors realize the gain while the debt investors only receive their constant payments. If the value of the business drastically falls then equity investors take the hit. As you can see, equity investors investments are more risky than that of debt investors. In a very broad sense, the income statement shows revenue less expenses equaling net income. It is recorded when earned (even though cash may not have been received at the time of transaction). There are several common expenses among companies including: cost of goods sold (COGS); selling, general, and administrative (SGA); interest expense; and taxes. COGS are costs directly associated with the production of the goods sold while SGA are costs indirectly associated with the production of the goods sold. Interest expense represents expense related to paying debt holders periodic payments while taxes is an expense related to paying the government. Depreciation expense, a non-cash expense accounting for the use of plant, property and equipment, is often either imbedded within COGS and SGA or shown separately. It is the profitability available to common shareholders after debt payments have been made (interest expense). Earnings per share (EPS) is the portion of a companys profit allocated to each outstanding share of common stock. The balance sheet is linked to the income statement through retained earnings in shareholders equity, specifically net income. This makes sense because net income is the profitability available to shareholders during a specific period and retained earnings is essentially undistributed profits. So, any profits not distributed to shareholders in the form of dividends should be accounted for in retained earnings.
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