Understanding The Financial Statements
Cash Flow Statement, Balance Sheet, and Income Statement
I hope everyone has had a good week so far!
When you invest in a company, one of the most important things that you can do is get a good understanding of the financial statements. If you do not understand a companies financials, you will never know if you are overpaying or finding a great deal.
In this newsletter, I will go over how the three financial statements are linked. I will do this by breaking them down in a simple to understand way. Keep in mind this is a simple overview.
The three financial statements are the cash flow statement, balance sheet, and income statement.
All publicly traded companies are required to report their financial statements on a quarterly basis (Form 10-Q), within 45 days of each quarter-end.
They are also required to report their financial statements within 90 days after each year-end (Form 10-K). Both of these reports are filed with the U.S. Securities and Exchange Commission (SEC).
Accounting is the language of investing, and it is key that you understand these before putting your hard earned money to work.
1. Cash Flow Statement
The cash flow statement shows how much cash is incoming and outgoing of the business.
Cash is divided into 3 sections:
Cash from operating activities
Cash from investing activities
Cash from financing activities
Cash flows from operating activities explains the cash flows within the business for its normal operations over a particular period.
This will show whether a company is capable of generating positive cash flow to maintain and grow its operations.
The most important thing when looking at operating activities is to make sure the number is positive.
If the number is positive this means it is generating more money than it’s spending for the normal operations.
If the number is negative this means the company could be in major long term trouble. They will most likely have to take on debt to fund their company.
If a company is taking on debt to fund their operations, they will not survive.
Cash flows from investing activities comes from the profit and losses from investments that the company has made.
Any long-term physical or intangible asset that the company expects to deliver value in the future will be included.
Common line items in this section include: Purchase of Property, Plant and Equipment (PP&E), Proceeds from disposal of PPE and Proceeds from sell of stocks and acquisitions.
Cash Flow from financing activities explains the cash flows used to fund the company’s operations and payback their shareholders along with creditors.
Common line items include:
Borrowing of long-term debt, Repayment of Long-term debt, Repayment of short-term debt, Proceeds from stock options, Proceeds from stock offering, Repurchases of Common Stock, and Dividends Paid
Free Cash Flow
The most important numbers you can gather from the cash flow statement is free cash flow.
Free Cash Flow tells investors and analysts how much cash a business generates after growing and maintaining it’s business.
This cash can be paid to shareholders as a dividend, be used to pay down debt, buyback shares or to just keep as cash on balance sheet.
This is a very important metric to gauge when valuing a stock.
You should look for a company with FCF of 10%+.
2. Income Statement
The purpose of an income statement is to show how a company performs over a period of time via their revenue and expenses. Another name is the profit and loss statement.
Companies share their income statement in their 10-Q (Quarterly Report) and 10-K (Annual Report.)
The primary job of every company in the stock market is to make as much profit possible to maximize their value for shareholders. Therefore, the income statement is crucial to read and analyze to understand the profits being made by a business.
The income statement formula in its simplest form is shown below:
The brief summary of what is in an income statement can be seen below:
Revenue (aka Net/Gross Sales or Income): The top-line figure that shows the income earned by a business for any products/services sold.
Costs of Goods Sold (COGS) (aka Cost of Sales): Direct costs associated with the production of the goods sold by a business.
Gross Profit (aka Gross Income): Total revenue less COGS.
Operating Expenses (OPEX): Costs associated with normal operations of a business. Often includes selling, general, and administrative expense (SG&A) and depreciation (when assets lose value over time).
Operating Income (aka Operating Profit or Recurring Profit): Gross profit less operating expenses. Very similar to EBIT.
EBITDA: Earnings (income) before interest, depreciation, taxes, and amortization.
EBIT: Earnings (income) before interest and taxes.
Non-Operating Expense: Costs associated with activities unrelated to the core operations of a business. Includes interest payments.
EBT: Earnings (income) before taxes. Equal to operating income less non-operating expenses.
Net Income (NI) (aka Net Profit, Net Sales, or Net Earnings): The bottom-line number left after subtracting all expenses, taxes, and costs from revenue. Equal to EBT less taxes.
Earnings per Share (EPS): Net income divided by the total number of outstanding shares. Indicator of a company's profitability.
Income statements should be used when comparing similar time periods. This will allow an investor to determine if the company is growing or shrinking.
For example, study Apple yearly earnings over the last 5 years.
3. Balance Sheet
The balance sheet shows how much a company is worth at that point of time.
The balance sheet balances the amount of assets that a company has against its liabilities and stockholders' equity.
Assets = Liabilities + Shareholders' equity
Assets: Any resource with economic value that a company owns. Ideally, a company's assets will provide future benefit to the company's stakeholders.
Liabilities: Obligations or claims to a company's assets.
Shareholders' equity (aka book value of a business): The residual claims on a company's assets once all liabilities have been paid down.
The balance sheet reports a company's assets, liabilities, and shareholders' equity at a specific point in time. Assets on the balance sheet refer to what the company owns, liabilities refer to what the company owes, and shareholders' equity represents the net worth of a company. Assets will always be equal to the sum of liabilities and shareholders' equity.
You want the cash and equivalents to be more than the short term debt, and you want a low number of accounts receivable.
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Stay Hungry, Stay Long,