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If you are just beginning to invest, it might be a good idea for you to set some time aside to learn how to read a financial statement. Financial statements are one of the best tools you can use to understand your investments. There is a misconception that you have to be an accounting wizard just to learn how to read a financial statement.
This myth stems from the idea that learning how to read a financial statement is too difficult for an ordinary person. That could not be further from the truth; the reality is that anyone can learn how to read one.
However, just because everyone is capable of reading them does not mean they will. Some people just find financial stuff boring and refuse to learn.
If you take the time to learn, reading financial statements will give you tons of valuable insights into how a company is performing. No more surprises if your stock does not do well, the proof is in the pudding.
Financial statements give you access to information regarding how much money a company has made, is currently making, and will make in the future. All of these will help you pick better stocks and eventually become a more polished investor.
How Much Accounting Do You Need to Know?
You do not need any formal education in accounting to read a financial statement. Basic knowledge of the subject can help, but it is not necessary. Once you start understanding the terms and what they mean, they will start making sense.
Plus, accounting is not that complicated of a subject anyway. Now, if your goal is to become a CPA, it is not going to be easy. Though, you can rest assured that you will never need to go that far. The most you will need to know are some basic accounting principals.
Why You Must Learn How To Read a Company Financial Statement
If, for some reason, you still do not see the value in learning how to read a financial statement, look at Warren Buffet. He and his partner, Charlie Munger, blow through thousands of financial statements when they value companies.
One of the reasons why these two men are so successful is because they read so much. They read and analyze so much information that they know the financial ins and outs of all their investments.
Try to picture the information in a financial statement as the roots of a tree.
The roots sprout into trees (being shares) and grow. Yet, if the roots are rotten then the tree won’t sprout properly. It’s the same thing with stocks. Yes indeed, investor speculation does affect stock prices; and yes it’s also true that the value of shares changes every day. However, stock prices are set by how much money a company is making and will eventually make.
How do investors figure this out? By analyzing the financial statements. That is how people like Warren Buffet learn so much about their investments. Of course, other things do need to be considered when investing in a company besides its financials.
However, if a business is not making any money, or if it has too much debt and expenses, then it is probably best to avoid it.
Now without further ado, let us get started.
Understanding Financial Statements
Financial statements are just records of a person, entity, or business. They are used to measure how good or bad someone is at organizing their money. Financial statements are kind of similar to your personal background history.
Think about how the FBI does background checks on people. They can search for their history to see if they broke the law in the past.
When it comes to your financial statements, the IRS can dig up your history during an audit. From this information, they can see how much money you have made, spent, and lost each year. If your spending is more than your income, the IRS can investigate you for tax evasion
A financial statement is sort of the same thing, except the information is open to the public.
Publically traded companies are required to share their financial records with investors. In a way, you, as the investor, take on the role of the IRS. Would you trust somebody with a loan and a ton of credit card debt? Likewise, would you trust a company that has a ton of debt but barely any income?
Your answer should be no to both of those questions. Companies that have too much debt will have less cash flow and less money going into the business. You should also be hesitant to lend money to someone with a lot of debt.
Learning how to read a financial statement can help prevent you from investing in bad companies. You will gain the ability to weed out those bad apples and start investing in companies worth your money.
There are three main types of financial statements:
How To Read a Financial Statement: #1 The Balance Sheet
The first financial statement out of the three is known as the balance sheet. The balance sheet is responsible for recording the company’s assets, liabilities, and shareholder’s equity.
For simplicity’s sake, we’ll be referring to Apple Inc as an example.
Apple is a large company with many assets underneath its belt. Think of all of the buildings, land, and equipment they use daily. On a balance sheet, the assets are as follow:
- Cash and cash equivalents
- Marketable securities
- Accounts Receivable
- Prepaid Expenses
Cash and equivalents
Cash and equivalents are pretty self-explanatory: they’re the most liquid assets available to a company, hard currency.
In Apple’s case, the company is sitting on loads of cash. That is a good sign since it shields the business from any unexpected financial problems.
Marketable Securities are similar in that they are liquid as well. In other words, these are more like liquid assets that can quickly turn into cash. Think of stocks and bonds that can be bought and sold daily.
If you’ve ever taken a remedial accounting class before, then you’ve probably heard of this term. Accounts receivable is any money owed by customers to a company.
A business like Apple has other debtors that owe them money as well. That all gets paired up with accounts receivable on the balance sheet.
Inventory is any goods that a company has, which can sell below market value. Think of any raw material used to make a product. When a baker makes bread, he needs things like eggs, milk, and flower; these would be considered raw materials.
Lastly, we have Prepaid Expenses, which are expenses already paid. Yes, even a company like Apple has these. They can be anything from insurance costs to advertising, marketing, or event rent.
Other things to consider: GoodWill
If you look towards the bottom of assets, you’ll see something called Goodwill. Goodwill isn’t a tangible asset like cash or stocks.
Goodwill is an intangible asset that has no physical nature. For example, think of customer loyalty and brand recognition. We all know how much of a loyal fan base Apple has. Their customers keep coming back every year to buy their products no matter what.
It’s the same for brand recognition. When you see the Apple logo, you can instantly recognize it. These two things put Apple at a competitive advantage. Apple’s valuable Goodwill has a lot to do with why Warren Buffet eventually decided to invest in the company.
If a company were to purchase a fixed asset, it would be for the long-term. One of the most common fixed assets owned by companies is real estate.
An example of this is McDonald’s, which on the surface, seems like they only make money by selling hamburgers. However, the reality is that McDonald’s is a real estate business disguised as a fast-food company. Over 50% of their total revenues comes from rent, royalties, and initial fees of their franchises.
That is insane because you’d think that McDonald’s, being a fast-food restaurant, should make most of its money from big macs, but that isn’t the case.
Liabilities are any money that a business owes to another person or entity. Businesses use liabilities to pay for their assets. For example, a restaurant can’t operate without having suppliers and paying rent.
Suppliers and rent cost a lot so those two big liabilities will eat away at a business’s profit. Debt is also a liability, we’ll discuss good debt vs bad debt in a little bit.
There are two different kinds of liabilities on a balance sheet, current and long term. Long term liabilities are liabilities that are due after a year, while short term liabilities are within a year.
Any kind of dividend, wages, rent, or accounts payable are all considered current liabilities. Long-term liabilities are things like long term debt or even employee pension funds such as 401ks.
Accounts payable is money owed by a business to its suppliers. Next time you blame your local restaurant for charging you too much for a meal, take a look at how much they owe on their accounts payable and you might understand.
Rising costs from suppliers will cause a company to raise its prices. Similarly, accrued expenses will severely affect a business’s prices. Accrued expenses are expenses that have not yet been paid but expected to be in the future.
These include things like employee wages, salaries, and benefits. When a business is struggling financially, the first method they’ll use to reduce costs is to layoff employees.
Start paying more attention to minimum wage increases. The price of your morning coffee is likely going to increase along with it.
Red Flag: Good Debt vs Bad Debt
Debt is one of those misunderstood liabilities. It’s true that some debt isn’t bad and can actually be healthy for a business if utilized well. Companies take on debt all the time; it helps them raise capital so that they can expand.
One company that has a lot of corporate debt as of 2020 is Apple. Their total debt is about $118 billion. To put that into perspective, McDonald’s’ has a total market cap of $138 billion. Apple almost has enough of it to be worth the same as the entirety of McDonald’s; I know it’s crazy.
But is that bad? How can a business have so much debt yet still be so successful? Well, Apple does indeed have a ton of debt, but let’s look at their other numbers.
Their total market cap surpasses $1 trillion, making it one of the most valuable companies in the world. Yet, their annual net income is around $50 billion, which is about $50 billion shy from their total debt.
If you know anything about personal finance, you must understand the dangers of having debt that exceeds your income.
However, the key here for Apple is the amount of cash they have. Apple sits on about $200 billion worth of cash, around $100 billion more than its total debt.
Realistically, this gives them leverage since they can pretty much pay off all their debt and still have $100 billion cash left over. That is a perfect example of why context matters when analyzing a company.
The Corporate Debt Problem
America has a BIG problem with corporate debt. Ever since the great recession in 2007-2008, interest rates have been at record low levels. This has allowed companies to borrow free money, resulting in a large corporate debt bubble.
A Forbes article from 2018 states that U.S. corporate debt levels have reached a dangerous 45% of GDP. These levels are worse than that of the Dot-com crash during the early 2000s.
With the coronavirus hurting the economy, the debt that these companies have is starting to catch up to them. Not every business is a successful juggernaut like Apple. Not every company can survive a huge debt load and an economic crisis at the same time.
The current crisis makes it clear that good debt can turn into bad debt very quickly.
Finally, the last slice that makes up the balance sheet pie is called shareholders’ equity. Money that a publically traded company receives from its investors is considered shareholder’s equity
Pay attention to the retained earnings of a company. Retained earnings (RE) is money that a business reinvests into itself. That is important because the more money a company has left over after paying expenses, the more likely it is to be financially stable.
When companies finish paying off their debt and start reinvesting into themselves, they can use these leftover earnings to pay dividends to their investors. It’s imperative since a company that pays dividends and increases those dividends over time is financially healthy.
Remember to keep an eye out for companies that pay more in dividends to their investors over time.
Another thing to keep in mind when looking at shareholders’ equity is treasury stocks. You can see it listed here at the bottom.
Treasury stocks are also known as stock buybacks, which is basically when a company uses its funds to reacquire its own shares.
Are Stock Buybacks Good or Bad?
Companies will buy back their stock for a few reasons. For starters, stock buybacks will reduce the number of outstanding shares that a business has on the market. If a company feels that the market has discounted its shares too much, they will buy back some stock and increase its shareholder value.
In a way, stock buybacks are one of the best methods for a company to reinvest in itself. The market can indeed be harsh on some stocks, especially during a bear market.
However, this is not always the case. There have been instances where companies will buyback stocks to make their shareholders happy. Most of the time, the largest shareholders of a company are its executives and founders.
Do some companies use buybacks to raise their share values so they can cash out? Sure, but these are the sort of companies you might want to avoid.
For example, just recently, airline companies that had spent billions of dollars on stock buybacks were asking the government for financial aid during the pandemic.
Many will make the argument that these companies should have just used those funds towards their employees or other operations rather than their shareholders. Of course, companies are free to do whatever they want with their money.
Yet, with more and more businesses relying on corporate debt and tax cuts to stay afloat, how these companies spend their money becomes more vital.
How To Read a Financial Statement: #2 The Income Statement
The second most important financial statement is the income statement. The income statement records the expenses and revenues of a given company. It’s a good indicator of how much money a company is making or losing at a given point in time.
Income statements can provide valuable clues as to how well the company manages itself.
Income statements start off recording the sales (or revenue) of a business, then ends with the total net income.
The income statement starts with the sales of the company. This is whatever money the business makes before factoring in the costs. Next, we have the cost of goods sold; again, another popular term used in accounting courses.
The cost of goods sold or COGS is the cost it takes to produce the product sold. By subtracting the cost of goods sold from revenue, you will get the gross profit.
Every business will have some kind of expense. However, operating expenses are what a business directly spends money on for their daily operations. For example, companies will spend money on advertising to get people’s attention to their product or service.
Companies might reduce spending on ads during certain economic cycles. However, this is one expense that never goes away, no matter how bad the economy gets.
Administrative expenses are similar in a way that they never disappear. These are the salaries that companies pay their senior executives. Likewise, companies might reduce the pay of their executives during a recession.
But, businesses will still have to pay these people for them to operate: plus executives tend to have very high salaries.
Operating Income=Gross Profit−Operating Expenses
You can calculate operating income by subtracting total operating expenses by the gross profit
Non-Operating or Other
Non-operating expenses and revenues have nothing to do with the principal operations of a business.
An example of non-operating income is the gains from investments. If a company decided to invest money in the stock market and makes a return, that money would get listed under non-operating income.
Now for non-operating expenses, think of something like legal fees. Those costs get grouped with non-operating expenses.
So if you don’t know, Google was just recently sued for tracking its users on incognito tabs. That technically breaches user privacy, so Google faced a lawsuit for it. Those expenses get recorded under Google’s non-operating expenses.
How To Read a Financial Statement: #3 The Cash Flow Statement
Finally, we have the last of the three financial statements, the cash flow statement. This statement is mainly to understand where a business’s money is going, coming from, and how much cash they have. Investors need to be aware of these things so they can know whether or not a business is in good financial standing.
The amount of cash is crucial since it allows a business to pay off debt and operating expenses when they need to. We talked about this previously when we used Apple as an example on the balance sheet.
This cash flow statement can be a little confusing so, we will go through it step by step. Three main segments make up a cash flow statement. They are cash flow from operations, cash flow from investing, and cash flow from financing.
The daily operations of a business are what makeup cash flow from operations. Investments made by a company that gained or lost cash would be under cash flow from investing. Cash flow from financing is just money gained or lost from how the business finances its operations.
Let’s say company X’s net earnings are $100,000
The cash flow statement above shows all of the money added to net earnings. Remember that accounts receivable is money owed by customers to a business. When customers pay off their debts, accounts receivable will decrease, and that money goes toward net earnings.
Accounts payable are bills not yet paid by a business. This money is added to net earnings since it is cash that the company has not relinquished.
Company X’s net earnings are now $152,000
The red numbers, increase in inventory and equipment, show the amount of money subtracted from net earnings. Equipment and inventory are both expenses that cost a large amount of cash. A note payable is a loan that the business has received from another party, so we can count that toward net earnings.
That is pretty much it for cash flow. For company X, the number of expenses that the company took on was under control. If a business has expenses that exceed its revenue, it will result in negative cash flow.
It is super important that you read the cash flow statement because it’s a good indication of how much money the company is losing or making. But even though it is such a great tool, that does not mean you should rely on it blindly. You still have to consider the context of the situation.
If a business is heavily expanding, it may have a negative cash flow for a while. Is that a bad thing? No, since we are aware that expansion is a sign that a business is successful.
The point is that sometimes financial data doesn’t tell the whole story, so you need to do that extra bit of research on every company.
The Bottom Line
Learning how to read a financial statement doesn’t have to be difficult. Accounting is just memorization and basic math. After reading this post you should understand financial statements better. You can use this understanding to invest in better companies. If you want to go into more detail, I suggest you read How To Read a Financial Report by John A. Tracy and Tage C. Tracy. This is hands down the best book on this topic and it’s super easy to understand.
It even helps you learn how to manage your own business. When you know what makes a business look good on paper, you’ll try to achieve the same thing for your own. Just remember to study the balance sheet, income statement, and cash flow statements separately.
Every business has a unique situation, so try to consider that when you do your research. With a little bit of time and effort, reading a financial statement can become second nature to you.