The foundational accounting equation (Assets = Liabilities + Equity) provides the framework for understanding a company's financial position. However, to effectively analyze financial statements, we must expand our understanding of Equity. Equity is comprised of contributed capital, retained earnings, and other comprehensive income (OCI). Retained earnings represent the accumulated profits (less dividends) of the company over time. OCI includes unrealized gains and losses that aren't yet recognized on the income statement. Understanding these components is critical for tracing the impact of various transactions. For example, a stock repurchase reduces both assets (cash) and equity (treasury stock), affecting the balance sheet. Similarly, foreign currency translation adjustments will affect OCI.

Example: Consider a company with beginning Retained Earnings of $1,000,000. During the year, it earns a net profit of $200,000, declares dividends of $50,000, and experiences a loss on available-for-sale securities (to be recognized in OCI) of $10,000. What is the ending Retained Earnings? The calculation is: Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings. Therefore, $1,000,000 + $200,000 - $50,000 = $1,150,000. The OCI loss would not directly affect retained earnings, only indirectly via the comprehensive income reported in the Statement of Changes in Equity, which also contains Retained Earnings.

The three core financial statements are inextricably linked. The Income Statement reports a company's financial performance over a period of time, leading to changes in Retained Earnings (and therefore, Equity on the Balance Sheet). The Statement of Cash Flows categorizes cash inflows and outflows, affecting the cash balance on the Balance Sheet. The Balance Sheet, a snapshot at a specific point in time, reflects the cumulative impact of transactions recorded on the Income Statement and the Statement of Cash Flows.

Example: A company sells goods on credit (revenue recognized on the Income Statement). This increases Accounts Receivable (an asset on the Balance Sheet) and potentially impacts the Statement of Cash Flows (when the cash is collected). Accruing interest expense increases expenses on the Income Statement, reduces retained earnings, and increases liabilities on the balance sheet. A large write-off of an asset may decrease its book value, an impairment expense in the Income Statement, and, through retained earnings, decrease equity on the balance sheet. Depreciation expense (non-cash) decreases income and Retained Earnings on the balance sheet, but does not affect cash flows.

Financial ratios are powerful tools for evaluating a company's performance, profitability, solvency, and efficiency. Common ratios include: Profitability Ratios (Gross Profit Margin, Net Profit Margin), Liquidity Ratios (Current Ratio, Quick Ratio), Solvency Ratios (Debt-to-Equity, Interest Coverage Ratio), and Efficiency Ratios (Inventory Turnover, Receivables Turnover). It is crucial to use these ratios with a critical eye, considering their limitations. Ratios are based on accounting data, which can be influenced by accounting policies and management's discretion. Moreover, ratios are backward-looking and may not accurately predict future performance. Industry comparisons are important, as is a thorough understanding of the company's business model and economic environment.

Example: A declining Gross Profit Margin may signal issues with pricing, cost of goods sold, or both. An increase in the Debt-to-Equity ratio may suggest increased financial risk, while a higher current ratio may indicate strong liquidity but potentially inefficient use of working capital. A high Inventory Turnover may indicate strong sales, but could also indicate potential issues with stockouts.

The choice of accounting methods can significantly impact the financial statements. The most relevant example is the accounting for inventory (LIFO, FIFO, Weighted Average). In a period of rising prices, FIFO generally results in higher reported profits (lower COGS) and a higher ending inventory valuation than LIFO. LIFO results in lower net income and lower tax payments in inflationary environments, which can be beneficial to the company. The specific inventory method used can affect key financial ratios and analysis, specifically profitability ratios. Similarly, depreciation methods (Straight-line, Accelerated) impact expense recognition and asset valuation.

Example: If a company uses FIFO and the cost of inventory is increasing, the cost of goods sold reported on the income statement will be lower than if LIFO was used. The reported net income and, consequently, retained earnings, will be higher. The balance sheet will show a higher value of ending inventory. The choice of which method is appropriate often depends on the tax law and regulatory standards of a company's operating jurisdiction.