Liabilities
A liability is an obligation to give up assets or provide services in the future because of a past transaction.
- Current liabilities are due within one year (or one operating cycle): accounts payable, wages payable, unearned revenue, the current part of long-term debt.
- Long-term liabilities are due later: bank loans and bonds.
The current ratio = current assets ÷ current liabilities. It measures short-term liquidity. A company with $90,000 of current assets and $60,000 of current liabilities has a ratio of 1.5.
Corporate equity
For a corporation, equity (stockholders' equity) has two main sources:
- Contributed capital: money from issuing stock. Issuing shares for cash raises both cash (asset) and equity.
- Retained earnings: accumulated profits kept in the business.
Retained earnings roll forward each year:
Ending retained earnings = Beginning + Net income − Dividends
Dividends are distributions to shareholders. They reduce retained earnings; they are not an expense and do not appear on the income statement.
Statement of cash flows
Profit is not cash. The cash flow statement explains the change in cash during the period using three sections:
- Operating activities: cash from the day-to-day business: collections from customers, payments to suppliers and employees, interest and taxes.
- Investing activities: buying and selling long-term assets, such as equipment, or investments.
- Financing activities: raising and repaying money: borrowing, repaying loans, issuing stock, paying dividends.
The indirect method begins with net income and adjusts it. It adds back non-cash expenses such as depreciation (which reduced income but not cash), and adjusts for changes in working capital: an increase in receivables means income was earned but not collected, so it is subtracted; an increase in payables is added.
Worked example
Company data for the year:
- Net income: $40,000. Depreciation: $8,000. Receivables rose by $5,000.
- Bought equipment for $20,000 cash.
- Borrowed $15,000; paid dividends of $6,000.
- Beginning retained earnings: $100,000.
Operating: 40,000 + 8,000 − 5,000 = $43,000.
Investing: buying equipment is −$20,000.
Financing: +15,000 − 6,000 = +$9,000.
Net change in cash = 43,000 − 20,000 + 9,000 = +$32,000.
Ending retained earnings = 100,000 + 40,000 − 6,000 = $134,000.
Common mistakes
- Treating dividends as an expense.
- Putting interest paid or dividends in the wrong section.
- Forgetting that increases in receivables reduce operating cash flow.