The world is shouting stock ideas back and forth, you don’t know who’s right who’s wrong – Bulls eye buy stock ‘x’ its cheap sell stock ‘y’ it’s expensive. Everyone is an ‘expert’ and has an opinion to offer. What to believe?
I have been there myself, I didn’t understand who was right and who had lot of hope built into his numbers. Well in reality no one is going to come and tell you where the best or bad deals are.
A stock picker should be able to think for himself, if you have the knowledge and are willing to put an effort into understanding what’s behind these numbers you can make the decision yourself. Because the numbers will tell the story about the business, the numbers themselves mean nothing we should be able to infer the reasons behind them– the jump or drop in profits, change in margins etc.
As Graham said “while buying a stock you are buying part ownership in a business” you will do well if the business does well. The three basics reports we need to understand to be able to make a ownership judgement are
- Balance sheet
- Income statement
- Cash flow statement
All the above three reports are connected to each other, the income statements usually report on progress between two balance sheet periods. For example Q1 2011 income statement will be generating income from assets reported as part of 2010 balance sheet and profits generated will be reported as part of 2011 balance sheet.
There is no magic metric or ratio which can help us understand the business, we need to look at it from multiple angles to be in a position to appraise it correctly.
Balance sheet : The simplest way to understand the balance sheet is to look at two parts - Source of funds (Liabilities) and Use of funds (Assets). Basically where the money comes from and where its applied.
- Assets : Are Current assets (short term like Cash, Inventory, Accounts receivables and others) and Fixed Assets (longer term like Net fixed assets,Investment, Intangibles etc). Usually all these assets are represented on 'cost value' not 'market value' although this is debatable.
- Liabilities : Are Current liabilities (short term Account payable,Short term loans and others),Long term liabilities (Long term loans like mortgages, debentures etc)
- Owners Funds :Share capital and Reserves&Surplus. Its interesting that the money that the owners funded( 'paid up share capital') to start the company is also part of liabilities because the company has a life independent of the owners now .
Balance sheet can help an investor understand the nature of business of the company, some companies are ‘more liquid’ (means they have less fixed assets but higher cash example retail but others like heavy engineering usually have more of fixed assets ). So look at a balance sheet as a listing financial value of assets (of various forms) , these assets are used to generate the profits which makes the company running. Keep looking at the sheet over the years and you will notice the story of how assets are changing and shareholder equity growing as a result.
The basis of balance sheet is the double entry book keeping system. It was designed many years ago to make sure accountant does not make a mistake, so for every transaction the accountant makes two entries and they balance (Assets = Owners Funds + Liability)
Income Statement (Profit and Loss) :It lists what the business has earned vs. spent over a period of time . It shows the ‘Net Profit or Loss’ as the case may be, the key thing to remember is that income from one period cannot be mixed up with next and must stick to the accounting standards.
‘Revenue’ gives importance of item being ‘sold’ does not always means that cash (receipts) has been received for example: If a consulting company performs a work it can report it as revenue even though the cash will be received later.Similarly ‘Expenses’ also give preference to being recognized than paid so its identified that cash is due but may be paid at a later date.
Besides the some accounting twists like above income statement is like you family budget of income minus expenses.
Cash Flow Statement : Unlike the income statement Cash flow statement shows the actual movement of cash. Its usually categorized into Operating activities cashflow, Investing activities cashflow and Financing activities cashflow.
Cashflow statement can tell us if the business requires heavy expenditure to generate returns or not. Some businesses will constantly need buckets of cash to generate earnings and may not be a good one to earn for this reason.
Cashflow statement also tells us how much actual cash is coming in and we need to compare it with revenues from the income statement to understand better.
We will take an approach of looking at the most important metrics first so that it can understand the financial framework and then delve into details. Until next time happy investing !
