Chapter 2: Assets and Liabilities - Financial Position Fundamentals PDF

Chapter 2 \| Assets and Liabilities: Statement of Financial Position Fundamentals ================================================================================= The basis of accounting is an equation. This fundamental accounting equation is necessary for accounting to do all the amazing things w...

Chapter 2 \| Assets and Liabilities: Statement of Financial Position Fundamentals ================================================================================= The basis of accounting is an equation. This fundamental accounting equation is necessary for accounting to do all the amazing things we discussed in the previous chapter. It ensures that our accounts balance, that errors are caught, and accounts are complete. Here's the equation: ***Assets = Liabilities + Equity*** Assets and liabilities are the main building blocks of accounting. We call them *elements of accounting*. Let's define each element in turn and then discuss how the elements relate to each other. [Assets] Assets are what you own: cash in the bank, your sneaker collection, a building, land, equipment, T-shirts in storage that you're planning on selling. There are many, many possibilities here because, like you or me, a company can own many things. The technical definition of an asset is: a resource controlled by an entity[^1^](#fn1){#fnref1.footnote-ref} as a result of past events and from which future economic benefits are expected to flow to the entity. It's a complicated definition, but we can break it down into small chunks. If we can say "yes, that makes sense for this resource" to all three parts, then the resource is an asset. Below is a flowchart. Consider a potential asset like cash in a bank account. Is it an asset? Answer the questions below and follow the arrows to find out. Flowchart: Classifying Assets 1. ***An asset is controlled by the entity***. This is important because if a company doesn't control something, it's not really theirs. So an asset might be a bank account *under the company's name*, or land where the *company holds the land title*, or a truck where the purchase invoice says *"sold to" the company*. Or maybe there's no paperwork but the company has physical control over the asset (i.e. can decide to sell it or use it). In any case, if an asset is controlled by the company we move to the next part of the definition. 2. ***An asset results from a past event***. The most common past event is that a company purchased a resource! Or maybe someone borrowed money from the company (i.e. receivable asset) -- this is a past event! 3. ***The asset will bring future economic benefits to the entity***. For example, investments get *interest*, we sell our T-shirts at for more than we bought them (*profit*), we use our warehouse to store T-shirts until we need them (the benefit is time -- having our goods ready for order). What did you find: is cash in a bank account an asset? Let's take a look: +-----------------------+-----------------------+-----------------------+ | Decision criteria | Discussion | Criteria met? | +=======================+=======================+=======================+ | 1. Is cash in the | Cash in a bank | Checkbox Checked with | | bank controlled | account is controlled | solid fill | | by the entity? | by the entity listed | | | | on the account, so if | | | | the bank account is | | | | in our name then we | | | | control it! | | +-----------------------+-----------------------+-----------------------+ | 2. Does cash in the | Yes, the cash got |  | +-----------------------+-----------------------+-----------------------+ | 3. Will cash in the | Surely the cash in | Checkbox Checked with | | bank bring future | the bank account will | solid fill | | economic benefits | bring economic | | | to the entity? | benefits. For | | | | example, the entity | | | | could buy inventory | | | | to sell, or they | | | | could invest the cash | | | | to make interest. | | +-----------------------+-----------------------+-----------------------+ Here's another example. Graphics Co. creates graphic designs on t-shirts using specialized printing press machinery. Is this machinery an asset? +-----------------------+-----------------------+-----------------------+ | Decision criteria | Discussion | Criteria met? | +=======================+=======================+=======================+ | 1. Is the machinery | Machinery is |  | | | like. They could use | | | | it for t-shirts or | | | | sell it. They could, | | | | foolishly, destroy | | | | it, if they like. | | +-----------------------+-----------------------+-----------------------+ | 2. Does the | Yes. Graphics Co. | Checkbox Checked with | | machinery result | came into possession | solid fill | | from a past | of the machinery | | | event? | somehow. Probably | | | | they purchased it | | | | from a printing press | | | | supplier. | | +-----------------------+-----------------------+-----------------------+ | 3. Will the | Yes. Graphics Co |  | | entity? | their t-shirts. The | | | | graphic designs | | | | printed by the | | | | machinery increase | | | | the value of Graphic | | | | Co.'s t-shirt | | | | inventory. | | +-----------------------+-----------------------+-----------------------+ [Liabilities] If we go back to the simple definition -- an asset is what you own -- then a liability is just the opposite: a liability is what you owe. A company may owe money in the form of borrowings (e.g., for T-shirts you picked up but haven't paid for yet, or a mortgage on a building). Or a company may owe money to employees for time worked (accrued wages). Or maybe a company owes customers custom T-shirts because a customer has paid a deposit (unearned revenue). There are many possibilities, because a company can be obligated for many different reasons. The technical definition of a liability is: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow of the entity's resources. Below is a flowchart for liabilities. Consider a potential liability like a credit card balance owing. Is it a liability? Answer the questions below and follow the arrows to find out. Flowchart: Classifying liabilities 1. ***A liability is a present obligation***. The company owes something now -- even though the company isn't going to pay until later. 2. ***A liability arises from past events***. For example, the company may have signed a mortgage, or taken goods with a promise to pay for the goods later, or employees may have worked (and not been paid yet). There are many possible past events that lead to a present obligation. 3. ***A liability is expected to result in an outflow of the entity's resources***. Usually (but not always) this means the company will pay out cash. Think about mortgage payments, or salary payments to employees, or payments to suppliers for goods. These are all paid with cash from the company's bank account. What did you find? Is a credit card balance a liability? Let's take a look: +-----------------------+-----------------------+-----------------------+ | Decision criteria | Discussion | Criteria met? | +=======================+=======================+=======================+ | 1. Is a credit card | A credit card balance | Checkbox Checked with | | balance a present | will have to be paid | solid fill | | obligation? | back. It is therefore | | | | a present obligation. | | | | We owe the credit | | | | card company now, | | | | even if we don't pay | | | | off our credit card | | | | immediately. | | +-----------------------+-----------------------+-----------------------+ | 2. Does a credit | The credit card |  | | | used the credit card | | | | to pay for them. | | +-----------------------+-----------------------+-----------------------+ | 3. Will a credit | The credit card | Checkbox Checked with | | card balance | company will require | solid fill | | result in an | a payment from the | | | outflow of the | entity. The entity | | | entity's | will pay in cash, a | | | resources? | resource. | | +-----------------------+-----------------------+-----------------------+ Here's another example. Graphics Co. creates graphic designs on t-shirts. They took out a bank loan to purchase machinery. Is this loan a liability? +-----------------------+-----------------------+-----------------------+ | Decision criteria | Discussion | Criteria met? | +=======================+=======================+=======================+ | 1. Is the loan a | The loan balance will |  | | | but will pay the loan | | | | back in regular | | | | instalments. | | +-----------------------+-----------------------+-----------------------+ | 2. Does the loan | Graphics Co. borrowed | Checkbox Checked with | | result from a | money from the bank | solid fill | | past event? | -- a past event. | | +-----------------------+-----------------------+-----------------------+ | 3. Will the loan | Graphics Co will pay |  | | resources? | cash which is a | | | | resource belonging to | | | | Graphics Co. | | +-----------------------+-----------------------+-----------------------+ So now you know that assets are what a company owns and a liability is what a company owes. You have been given 3-part decision criteria (in the form of definitions) for assets and liabilities. Now let's practice identifying items as assets and liabilities. Example: You are the owner of a vintage bookstore. You purchase vintage books and resell them for more than you bought them for (i.e. at a profit). A friend of yours is taking Introductory Accounting at university and has asked you to list several of the bookstore's assets and liabilities and explain why each item is an asset or liability. Some have been done for you -- fill in the blanks. a. Bookshelves b. Books c. Amount that customers owe the company: collectors pick up large quantities of books and pay the bookstore later d. Building e. Mortgage on the building f. Amounts the bookstore owes to people who have dropped off books g. Salaries owing to the bookstore staff (they've worked for a week, but their paycheque goes out next week) h. Cash register i. Deposits received from customers for books not yet shipped j. Interest owed from customers on unpaid accounts k. Invoice amount from the bookstore's accountant (unpaid) l. Income taxes owing amount from the bookstore's tax return Well done! The answers are on the next page -- but don't look at them until you've finished your work. Accounting is not a spectator sport -- the only way to learn this is to practice! **SOLUTION:** d. Building *Asset. The bookstore controls the building (can use it to display books, store inventory, etc.) as a result of past event (purchased the building) and expect future economic benefits (building used to store inventory until needed to sell in future).* e. Mortgage on Building f. Amounts the bookstore owes to people who have dropped off books g. Salaries owing to the bookstore staff (they've worked for a week, but their paycheque goes out next week) h. Cash register *Asset. The bookstore controls the cash register (will use it to hold cash and facilitate sales) as a result of past event (purchased the cash register) and expect future economic benefits (expect to generate future sales using the cash register).* i. Deposits received from customers for books not yet shipped *Liability. The bookstore has a present obligation (currently owes books to customers), as a result of past event (deposits were received), and there is expected outflow of the bookstore's resources (books shipped to customers).* j. Interest owed from customers on unpaid accounts *Asset. The bookstore controls the interest to be received (interest will be received by the bookstore) as a result of past event (customers did not pay off their accounts) and expect future economic benefits (expect to receive interest cash payments when customers pay off accounts).* k. Invoice amount from the bookstore's accountant (unpaid) *Liability. The bookstore has a present obligation (currently owes money to accountant), as a result of past event (received invoice from accountant), and there is expected outflow of the bookstore's resources (cash will be paid to accountant).* l. Income taxes owing amount from the bookstore's tax return *Liability. The bookstore has a present obligation (currently owes money for income taxes), as a result of past event (bookstore filed tax return), and there is expected outflow of the bookstore's resources (cash will be paid for income tax owing amount).* [Statement of Financial Position] Now you know how to categorize assets and liabilities, but how is this categorization useful? Assets and liabilities are the foundation of the Statement of Financial Position[^2^](#fn2){#fnref2.footnote-ref}. The Statement of Financial Position is one of the four financial statements that are prepared every year by every company. Each financial statement provides different information on the company. Let's start with the Statement of Financial Position. It is presented in three sections: Assets, Liabilities, and Equity. The good news here is that you know two of the three sections already! The three sections relate to each other through the basic accounting equation (this is REALLY important): Assets = Liabilities + Equity Like any equation, we can move the terms around. Another helpful way the accounting equation is presented is: Assets -- Liabilities = Equity Now you're likely wondering, "what's Equity?" Good question. Equity is defined as the residual interest in the assets of an entity after deducting all of its liabilities. It is literally defined using the equation above: Equity = Assets -- Liabilities. That's it! But who owns this residual interest? Equity holders (or shareholders) own the residual interest. That means that, if the company stopped operating and all the assets were sold for cash and the liabilities were paid off with that cash, all the residual interest (the cash left in the company) would be split between the equity holders. That's what residual interest means: what's left over. But who are these equity holders; the individuals who own the company? The equity holders may be the people who started the company (and likely currently manage it). We call this a privately held company. But maybe it's easier to understand if we compare *privately held* with *publicly held*. If the company is public, shares are issued and traded on an exchange like the Toronto Stock Exchange (TSX) -- this means that the company is owned by lots of different people/companies all over the world. If you buy a share, you get a proportional ownership interest in the company (usually quite a small proportion because the company likely has thousands of shares outstanding). And these shareholders can buy and sell shares of the company -- exchange with other investors -- without affecting the company's accounting. The company only controls is the number of shares they issue to the exchange. The important thing to understand here is that private companies usually have very few shareholders (often just one), and public companies have many, many shareholders who are constantly changing as shares are traded. But regardless, these shareholders (or equity holders -- we can use these interchangeably) get the residual interest in the company: Assets -- Liabilities. Now we know what assets, liabilities, and equity are, and their relation to each other. Let's talk about the Statement of Financial Position. Draw a line lengthwise down a sheet of paper. You will list all the assets on the left-hand side; liabilities and equity on the right hand side. When you add all your assets on the left side, and you add all your liabilities and equity together on the right, the two sides of the paper should equal. After all, Assets = Liabilities + Equity. Let's try it. Below is a list of assets, liabilities, and equity. This is called a post-closing trial balance. Assets are labeled with an A; Liabilities (L); and Equity (E). Notice that the balance for assets is listed in the *debit* column and liabilities and equity are *credit* -- it's an important distinction that we'll come back to in a later chapter. Tryme Ltd Post-closing Trial Balance December 31, 20X1 **Account** **Debit (DR)** **Credit (CR)** ------------------------------------- ---------------- ----------------- Cash (A) \$ 23,500 Accounts payable (L) \$ 8,000 Accounts receivable (A) 5,000 Inventory (A) 36,000 Accrued salaries (L) 2,300 Investment in Apple Ltd. Shares (A) 14,000 Building, net (A) 522,000 Mortgage payable (L) 225,000 Equipment, net (A) 75,000 Common shares (E) 200,000 Land (A) 125,000 Retained Earnings (E) 365,200 Total \$ 800,500 \$ 800,500 Write the assets on the left-hand side of the worksheet, liabilities and equity on the right, then add up each side -- they should equal the same amount. Tryme Ltd Statement of Financial Position As at December 31, 20X1 Assets Liabilities Equity Total Assets \$\_\_\_\_\_\_\_\_\_\_ Total Liabilities & Equity \$\_\_\_\_\_\_\_\_\_ **SOLUTION:** Tryme Ltd Statement of Financial Position As at December 31, 20X1 Assets Liabilities Cash \$ 23,500 Accounts payable \$ 8,000 Accounts receivable \$ 5,000 Accrued salaries \$ 2,300 Inventory \$ 36,000 Mortgage payable \$225,000 Investment in Apple Ltd. Shares \$ 14,000 Building, net \$522,000 Equity Equipment, net \$ 75,000 Common shares \$200,000 Land [\$125,000] Retained earnings [\$365,200] Total Assets \$800,500 Total Liabilities and Equity \$800,500 Try another one! Here is a post-closing trial balance for KWH Ltd. KWH Ltd Post-closing Trial Balance December 31, 20X1 **Account** **Debit (DR)** **Credit (CR)** ----------------------------- ---------------- ----------------- Cash (A) \$ 88,400 Investment in RBC bonds (A) 75,000 Accounts receivable (A) 5,000 Inventory (A) 36,000 Accrued salaries (L) \$7,400 Accounts payable (L) 66,000 Furniture, net (A) 454,000 Loan payable (L) 305,000 Common shares (E) 110,000 Prepaid Insurance (A) 42,000 Retained Earnings (E) 212,000 Total \$ 700,400 \$ 700,400 KWH Ltd Statement of Financial Position As at December 31, 20X1 Assets Liabilities Equity Total Assets \$\_\_\_\_\_\_\_\_\_ Total Liabilities & Equity \$\_\_\_\_\_\_\_\_\_ Solutions are on the next page. **SOLUTION:** KWH Ltd Statement of Financial Position As at December 31, 20X1 Assets Liabilities Cash \$ 88,400 Accrued salaries \$7,400 Accounts receivable \$ 5,000 Accounts payable \$66,000 Inventory \$ 36,000 Loan payable \$305,000 Investment in RBC Bonds \$ 75,000 Furniture, net \$454,000 Equity Prepaid Insurance [\$ 42,000] Common shares \$110,000 Retained earnings [\$212,000] Total Assets \$700,400 Total Liabilities and Equity \$700,400 We're almost there! You have the broad classifications for the Statement of Financial Position! Within the broad categories of Asset and Liability, it is helpful to identify whether accounts are going to convert to cash during the year. Examples of current assets include: - Accounts Receivable (A/R) is amounts owed by customers. A/R increases when a customer buys a product of service but doesn't pay until later. Because cash will likely be collected within the year (typically within a month), it is classified as a current asset. - Inventory. Product available to be sold, like T-shirts or cars, will likely be sold within one year. On the liability side, current liabilities include: - Accounts Payable (A/P) is amounts we owe to suppliers. A/P increases when we buy a product or service but don't pay until later. - Sales tax payable to the government. GST and PST are collected from customers on behalf of the federal and provincial governments. The government will expect to be paid regularly (monthly, quarterly or annually depending on the amount of tax collected). - Employee salaries payable are due within the year. Employees will expect to get paid shortly after submitting their timecard. Usually employees are paid biweekly or monthly. As a general rule, if an account will be settled (usually in cash received or paid) during the fiscal year, we classify the account as 'current'. Here's a quick reference for current assets and liabilities. If you see these accounts, your instinct should be to classify as current: **Current Assets** **Current Liabilities** ------------------------ --------------------------------------------- Cash Bank Overdraft (i.e. negative cash balance) Short-term investments Accounts Payable (A/P) Accounts Receivable Sales Tax Payable Inventory CPP Payable Prepaid expenses EI Payable Employee Income Taxes Payable Interest Payable Income Taxes Payable Current Portion of Long-Term Debt Accounts that aren't classified as *current* are *non-current*. Non-current assets are used by the company over a long period of time to create value. Example assets include Property, Plant, and Equipment (PPE) including land, buildings, equipment, and furniture; investments that mature in more than one year; and intangible assets like patents and copyrights. Notice that all these assets are typically held for at least one year, and in many cases multiple years. Non-current liabilities are amounts owed by the company that won't be paid within one year. Debt is a non-current liability. Sometimes you'll see debt expressed as *mortgage*, or *bonds payable*. When you see these accounts, you should immediately think *non-current*: **Non-Current Assets** **Non-Current Liabilities** ------------------------------- ----------------------------- Long-term investments Mortgage payable Property, Plant and Equipment Bonds payable Land Debt Building Equipment Furniture and Fixtures Machinery Intangible Assets Goodwill Patent Copyright One last thing about non-current assets: these assets are grouped. All PP&E (land, buildings, and equipment) are grouped together and given a subtotal. Same with investments and intangible assets: they are grouped and totalled. Groupings aren't necessary with non-current liabilities: they are just listed one-by-one. This makes sense because there aren't as many non-current liability accounts as there are non-current asset accounts. Here's an example of a Statement of Financial Position in good form. You'll be expected to produce similar Statement of Financial Positions. Note the title, which is important. It starts with the company name, then the type of statement (Statement of Financial Position), then *as at* and the current date. These two words, *as at* are really important. They signal that the Statement of Financial Position represents a snapshot in time of the company's financial position: what they own and owe *as at* the fiscal year end date. Here's a sample Statement of Financial Position that you can use as a reference for your work: Teeter's Totters Inc. Statement of Financial Position As at December 31, 2020 Assets Liabilities and Equity --------------------------- -- ----------------------------------- -- Current Assets Liabilities Cash and cash equivalents Current liabilities Short-term investments Accounts payable Accounts receivable Sales tax payable Inventory Interest payable Total Current Assets Other accrued liabilities Current portion of long-term debt Non-current Assets Total Current Liabilities Long-term investments Non-current liabilities PP&E Long-term debt Land Mortgage Payable Buildings (net) Total Liabilities Equipment (net) Furniture (net) Equity PP&E total Common shares Preferred shares Intangible assets Contributed surplus Patents AOCI Copyrights Retained Earnings Goodwill Total Equity Total intangible assets Total non-current assets Total Assets Total Liabilities and Equity Don't worry if you don't understand what all these accounts mean. I want to be somewhat thorough at this point so you can use this Statement of Financial Position as a reference, but we haven't discussed every account. You may be wondering: what is this Equity section? That's a great question. The Equity section is what shareholders own in the company. It is what's leftover after a company uses its assets to pay liabilities. Remember that assets -- liabilities = equity. There are only three possible classifications, so anything that's not an asset or a liability is classified as equity. On the Statement of Financial Position, you will see common shares and retained earnings in the equity section. *Common shares* is cash paid into the company by shareholders. *Retained earnings* are earnings on the contributed capital. Shareholders invest money in the company as common shares, then that investment grows as the company earns profit. We call that growth *retained earnings.* Equity is so important that it gets its own statement: the Statement of Changes in Equity, but we'll get to that later. Right now, let's move on to the next section. We will discuss how a financial statement user might use assets and liabilities to evaluate a company's condition. This is important because users like employees, investors, and suppliers rely on these evaluations to make decisions. [Ratios: Measuring liquidity and solvency] Now that we are familiar with the basic building blocks of accounting: assets and liabilities, let's look at how we can use these elements to evaluate companies. We may want to answer the question *has the company improved over last year* or *how is the company doing compared to its competitors*. Financial statement ratios help us answer those questions. Because the Statement of Financial Position tells us what the company owns and what they owe, we can evaluate whether the company is in a good position to pay back its liabilities as they come due. Let's look at some ratios that use assets and liabilities to evaluate companies. **Liquidity** describes a company's ability to pay its short-term obligations as they come due.. A good rule of thumb is that a liquidity ratio should be around 2, but this depends on a company's industry and life stage. We'll work on two liquidity ratios: *current* and *quick.* \ [\$\$Current\\ Ratio = \\frac{\\text{Curent\\ Assets}}{\\text{Current\\ Liabilities}}\$\$]{.math.display}\ *The current ratio tells us how easily a company can repay its current liabilities as they come due. A company with a greater current ratio has an easier time paying its obligations. For example, if a company has \$100,000 in current assets and owes \$50,000 in current liabilities, this company has a current ratio of 2:1. Its current assets are twice as high as its current liabilities.* *The current ratio is a good start and is the most common liquidity ratio used in practice. But can we pay off our current liabilities with inventory? The bank and suppliers typically want cash, not inventory. To get cash from our inventory, we must sell the inventory and then collect from our customers. This could take months!! The quick ratio solves this problem by only including the most liquid current assets.* \ [\$\$Quick\\ Ratio = \\frac{Current\\ Assets - Inventory - Prepaid\\ expenses}{\\text{Current\\ Liabilities}}\$\$]{.math.display}\ *Again,* inventory has to be sold in order to make payments, so it isn't very liquid. Another current asset that can't be directly used to pay current liabilities is prepaid expenses. For example, rent paid for in advance will be settled in goods or services, not cash. We can't pay our liabilities with prepaid rent! For both current and quick ratios, a higher ratio signals greater liquidity. Which liquidity ratio should you choose? Each ratio gives us a glimpse into how efficiently the company uses current liabilities, and its liquidity risk. Think of ratio analysis as investigation. The more proof we can gather, the better. So, using two ratios gives us more insight to build a case for either (1) how a company's liquidity has changed over time or (2) how one company's liquidity compares to its competitors. **Solvency** is a similar concept, but describes the company's ability to repay its total liabilities. Debt to total assets is a solvency ratio. Notice that, contrary to the liquidity ratios, liabilities is in the numerator. So a low solvency ratio means a company is able to easily pay off its total assets as they come due. As a rule of thumb, a ratio around 0.5 or 1:2 is preferable. As with the current ratio, this rule of thumb means that assets are twice as high as liabilities. \ [\$\$Debt\\ to\\ Total\\ Assets = \\frac{\\text{Total\\ Liabilities}}{\\text{Total\\ Assets}}\$\$]{.math.display}\ Again, solvency improves as assets increase in proportion to liabilities, therefore a lower ratio indicates greater ability to pay back debt (i.e., greater solvency). When we analyse ratios, we can compare two companies or compare one company year-over-year. Let's see how we can calculate liquidity and solvency to determine (a) which company is in a better position to repay its current and total liabilities; or (b) whether a company has improved their position over the previous year. Below are two questions. I'll perform ratio analysis for the first one, and you'll get a chance to do the second. First, my turn!! The following two companies, Gubba's Grub (GG) and Kenny's Kitchen (KK) have worked hard to each create their Statement of Financial Position for 20X2: Gubba's Grub Statement of Financial Position As at December 31, 20X2 Assets Liabilities and Equity --------------------------- ----------------------- ----------------------------------- ----------------------- Current Assets Liabilities Cash and cash equivalents 10,000 Current liabilities Short-term investments 22,000 Accounts payable 7,000 Accounts receivable 18,000 Sales tax payable 1,000 Inventory [15,000] Other accrued liabilities 15,000 Total Current Assets 65,000 Current portion of long-term debt [25,000] Total Current Liabilities 48,000 Non-current Assets PP&E Non-current liabilities Equipment (net) 50,000 Long-term debt [50,000] Buildings (net) [200,000] Total Liabilities 98,000 PP&E total 250,000 Equity Intangible assets Common shares 100,000 Patents 8,000 Preferred shares 10,000 Copyrights [11,000] Contributed surplus 6,000 Total intangible assets [19,000] Retained Earnings [120,000] Total non-current assets [269,000] Total Equity [236,000] Total Assets 334,000 Total Liabilities and Equity 334,000 Kenny's Kitchen Statement of Financial Position As at December 31, 20X2 Assets Liabilities and Equity --------------------------- ----------------------- ----------------------------------- ---------------------- Current Assets Liabilities Cash and cash equivalents 15,000 Current liabilities Short-term investments 35,000 Accounts payable 5,000 Accounts receivable 20,000 Sales tax payable 1,000 Inventory [23,000] Other accrued liabilities 10,000 Total Current Assets 93,000 Current portion of long-term debt [20,000] Total Current Liabilities 36,000 Non-current Assets PP&E Non-current liabilities Equipment (net) 125,000 Long-term debt [40,000] Buildings (net) [200,000] Total Liabilities 76,000 PP&E total 325,000 Equity Intangible assets Common shares 130,000 Patents 5,000 Preferred shares 20,000 Copyrights [13,000] Contributed surplus [10,000] Total intangible assets 18,000 Retained Earnings 200,000 Total non-current assets [343,000] Total Equity 355,000 Total Assets 436,000 Total Liabilities and Equity 436,000 We can analyze the two companies using the ratios we learned above starting with Gubba's Grub: +-----------------------------------------------------------------------+ | \ | | [\$\$\\text{GG}\^{\'}s\\ Current\\ Ratio\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ = \\frac{\\text{Curent\\ Assets}}{\\text{Current\\ Liabilities}}\\ | | \$\$]{.math.display}\ | | | | \ | | [\$\$\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ = \\frac{\\\$ 65,000}{\\\$ 48,000}\$\$]{.math | |.display}\ | | | | \ | | [                                                  = 1.35]{.math | |.display}\ | | | | \ | | [\$\$\\text{GG}\^{\'}s\\ Quick\\ Ratio\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{Cash + Accounts\\ Receivable + Short\\ | | term\\ investments}{\\text{Current\\ Liabilities}}\$\$]{.math | |.display}\ | | | | \ | | [\$\$\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{\\\$ 10,000 + \\\$ 18,000 + \\\$ | | 22,000}{\\\$ 48,000}\$\$]{.math.display}\ | | | | \ | | [  = 1.04]{.math.display}\ | | | | \ | | [\$\$\\text{GG}\^{\'}s\\ Debt\\ to\\ Total\\ Assets = | | \\frac{\\text{Total\\ Liabilities}}{\\text{Total\\ | | Assets}}\$\$]{.math.display}\ | | | | \ | | [\$\$\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{\\\$ 98,000}{\\\$ 334,00}\$\$]{.math | |.display}\ | | | | \ | | [                                                   = 0.29]{.math | |.display}\ | +-----------------------------------------------------------------------+ And then calculate for Kenny's Kitchen: +-----------------------------------------------------------------------+ | \ | | [\$\$\\text{KK}\^{\'}s\\ Current\\ Ratio\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ = \\frac{\\text{Curent\\ Assets}}{\\text{Current\\ | | Liabilities}}\$\$]{.math.display}\ | | | | \ | | [\$\$\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{\\\$ 93,000}{\\\$ 36,000}\$\$]{.math | |.display}\ | | | | \ | | [                                                   = 2.58]{.math | |.display}\ | | | | \ | | [\$\$\\text{KK}\^{\'}s\\ Quick\\ Ratio\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{Cash + Accounts\\ Receivable + Short\\ | | term\\ investments}{\\text{Current\\ Liabilities}}\$\$]{.math | |.display}\ | | | | \ | | [\$\$\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{\\\$ 15,000 + \\\$ 20,000 + \\\$ | | 35,000}{\\\$ 36,000}\$\$]{.math.display}\ | | | | \ | | [                                                   = 1.94]{.math | |.display}\ | | | | \ | | [\$\$\\text{KK}\^{\'}s\\ Debt\\ to\\ Total\\ Assets = | | \\frac{\\text{Total\\ Liabilities}}{\\text{Total\\ | | Assets}}\$\$]{.math.display}\ | | | | \ | | [\$\$\\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ = \\frac{\\\$ 76,000}{\\\$ 436,000}\$\$]{.math | |.display}\ | | | | \ | | [                                                   = 0.17]{.math | |.display}\ | +-----------------------------------------------------------------------+ Summary: [Ratio] [Gubba's Grub] [Kenny's Kitchen] ---------------------- ---------------------------- ------------------------------- Current Ratio 1.35 2.58 Quick Ratio 1.04 1.94 Debt to Total Assets 0.29 0.17 Analysis: We can see that Kenny's Kitchen is in a much more favourable position than Gubba's Grub. Remembering for the Current and Quick Ratio, a higher ratio is favourable due to the assets being in the numerator. Conversely, for the Debt to Total Assets Ratio, a lower ratio is favourable due to the liabilities being in the numerator Your turn!! Ted's Twinkies has created the following Statement of Financial Position for 20X2: Ted's Twinkies Statement of Financial Position As at December 31, **20X2** Assets Liabilities and Equity --------------------------- ----------------------- ----------------------------------- ---------------------- Current Assets Liabilities Cash and cash equivalents 17,000 Current liabilities Short-term investments 22,000 Accounts payable 20,000 Accounts receivable 14,000 Sales tax payable 5,000 Inventory [20,000] Other accrued liabilities 30,000 Total Current Assets 73,000 Current portion of long-term debt [25,000] Total Current Liabilities 80,000 Non-current Assets PP&E Non-current liabilities Equipment (net) 25,000 Long-term debt [75,000] Buildings (net) [75,000] Total Liabilities 155,000 PP&E total 100,000 Equity Intangible assets Common shares 10,000 Patents 30,000 Preferred shares 5,000 Total intangible assets 30,000 Retained Earnings [33,000] Total non-current assets [130,000] Total Equity [48,000] Total Assets 203,000 Total Liabilities and Equity 203,000 A year has passed and Ted's Twinkies reports this Statement of Financial Position at December 31, 20X3: Ted's Twinkies Statement of Financial Position As at December 31, **20X3** Assets Liabilities and Equity --------------------------- ----------------------- ----------------------------------- ----------------------- Current Assets Liabilities Cash and cash equivalents 30,000 Current liabilities Short-term investments 37,000 Accounts payable 15,000 Accounts receivable 16,000 Sales tax payable 3,000 Inventory [25,000] Other accrued liabilities 12,000 Total Current Assets 108,000 Current portion of long-term debt [20,000] Total Current Liabilities 50,000 Non-current Assets PP&E Non-current liabilities Equipment (net) 20,000 Long-term debt [50,000] Buildings (net) [70,000] Total Liabilities 100,000 PP&E total 90,000 Equity Intangible assets Common shares 20,000 Patents 20,000 Preferred shares 5,000 Total intangible assets [20,000] Retained Earnings [93,000] Total non-current assets [110,000] Total Equity [118,000] Total Assets 218,000 Total Liabilities and Equity 218,000 Required: Calculate the three ratios and comment on Ted's Twinkies' liquidity and solvency. Here's some room for your work. Give it a try for 20X2: +-----------------------------------------------------------------------+ | \ | | [\$\$20X2\\ Current\\ Ratio\\ = \\frac{\\text{Curent\\ | | Assets}}{\\text{Current\\ Liabilities}}\\ \$\$]{.math.display}\ | | | | \ | | [\$\$20X2\\ Quick\\ Ratio\\ = \\frac{Cash + A/R + Short\\ term\\ | | investments}{\\text{Current\\ Liabilities}}\$\$]{.math.display}\ | | | | \ | | [\$\$20X2\\ Debt\\ to\\ Total\\ Assets = \\frac{\\text{Total\\ | | Liabilities}}{\\text{Total\\ Assets}}\\text{\\ \\ \\ \\ \\ \\ \\ \\ | | \\ \\ \\ \\ \\ \\ }\$\$]{.math.display}\ | +-----------------------------------------------------------------------+ Now for 20X3: +-----------------------------------------------------------------------+ | \ | | [\$\$20X3\\ Current\\ Ratio\\ = \\frac{\\text{Curent\\ | | Assets}}{\\text{Current\\ Liabilities}}\\ \$\$]{.math.display}\ | | | | \ | | [\$\$20X3\\ Quick\\ Ratio\\ = \\frac{Cash + A/R + Short\\ term\\ | | investments}{\\text{Current\\ Liabilities}}\$\$]{.math.display}\ | | | | \ | | [\$\$20X3\\ Debt\\ to\\ Total\\ Assets = \\frac{\\text{Total\\ | | Liabilities}}{\\text{Total\\ Assets}}\\text{\\ \\ }\$\$]{.math | |.display}\ | +-----------------------------------------------------------------------+ Summary: Ratio 20X2 20X3 ---------------------- ------ ------ Current Ratio Quick Ratio Debt to Total Assets Next you can analyze if Ted's Twinkies is in a better or worse position in 20X3 compared to 20X2 and explain why (solution on the next page, but don't look until you've given it a try): Analysis: \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ **\ ** **SOLUTION:** Ratio 20X2 20X3 ---------------------- ------ ------ Current Ratio 0.91 2.16 Quick Ratio 0.66 1.66 Debt to Total Assets 0.76 0.46 Analysis: We can see that Ted's Twinkies is in a much better position at the end of 20X3 compared to 20X2. The Current and Quick Ratio both increased whereas the Debt to Total Assets Ratio decreased. Both of these occurrences signify a stronger position for Ted's Twinkies in 20X3. Great work. Thanks for working through basic accounting equation concepts and completing the activities as you go. Feel free to revisit these concepts as you move through the textbook, and to re-do any of the activities. You're now in a good position to look at transactions: events that make assets, liabilities and/or equity balances change. Such transactions might be selling to a customer, buying inventory, paying employees, or taking on debt. Let's move to the next chapter and take a look. ::: {.section.footnotes} ------------------------------------------------------------------------ 1. ::: {#fn1} An entity may be a company, group of companies, unincorporated business (i.e. sole proprietor or partnership), or other circumscribed area of business activities of interest to capital providers. We'll talk about companies, but the discussion is equally relevant to unincorporated business.[↩](#fnref1){.footnote-back} ::: 2. ::: {#fn2} Also called the Statement of Financial Position -- you can use these terms interchangeably.[↩](#fnref2){.footnote-back} ::: :::