Understanding Financial Statements

Three main statements are crucial: the balance sheet, income statement, and cash flow statement.

• Balance Sheet: A snapshot of a company’s assets (what it owns), liabilities (what it owes), and equity (ownership stake) at a specific point in time. The fundamental equation is Assets = Liabilities + Equity. Key metrics include current assets, current liabilities, and total debt.
• Income Statement: Shows a company’s financial performance over a period. It starts with revenue, subtracts expenses to arrive at net income (profit). Important terms: gross profit, operating income, and earnings before interest and taxes (EBIT).
• Cash Flow Statement: Tracks the movement of cash both into and out of a company. It’s divided into three sections: operating activities (from core business), investing activities (purchase/sale of long-term assets), and financing activities (debt, equity). Positive cash flow indicates a company is generating more cash than it’s using.

Core Financial Ratios

Ratios help analyze a company’s performance and financial health.

• Profitability Ratios: Measure how effectively a company generates profits. Examples include gross profit margin (gross profit/revenue) and net profit margin (net income/revenue). Higher margins generally indicate better performance.
• Liquidity Ratios: Assess a company’s ability to meet its short-term obligations. The current ratio (current assets/current liabilities) and quick ratio (excluding inventory from current assets) are key. A ratio of 1 or higher is generally desired.
• Solvency Ratios: Indicate a company’s ability to meet its long-term obligations. The debt-to-equity ratio (total debt/total equity) is a common measure. A high ratio might suggest higher risk.
• Efficiency Ratios: Measure how efficiently a company uses its assets. Examples include inventory turnover (cost of goods sold/average inventory) and accounts receivable turnover (revenue/average accounts receivable). Higher turnover generally indicates greater efficiency.

Time Value of Money

The concept that money available today is worth more than the same amount in the future due to its potential earning capacity.

• Present Value (PV): The current value of a future sum of money or stream of cash flows, given a specified rate of return.
• Future Value (FV): The value of an asset at a specified date in the future, based on an assumed rate of growth.
• Discount Rate: The rate used to calculate the present value of future cash flows.
• Understanding these concepts is crucial for investment decisions, capital budgeting, and loan calculations.

Investment Basics

Key terms and concepts related to investing.

• Risk and Return: Generally, higher potential returns come with higher risk.
• Diversification: Spreading investments across different asset classes to reduce risk.
• Asset Allocation: Dividing investments among different asset classes (stocks, bonds, real estate, etc.) based on risk tolerance and investment goals.
• Compounding: Earning returns on both the principal and accumulated interest.