So September 20’s post was a fun, no-pressure introduction to the three major types of financial statements and how they work. The results?
a) No one commented, and
b) No one pointed out that we promised to follow up on the details in the next post and didn’t.
Conclusion: reading financial statements is boring. Explaining how to read financial statements is boring. Even poking fun at how boring it is to read financial statements is apparently boring.
What do you want from us? No one said deciphering financial statements was interesting, except Warren Buffett, and do you want to take lifestyle advice from a polygamist who still lives in a house assessed at $700,000 despite having $36 billion to his name?
Let’s do this as pithily as possible and see where it leads:
If you’re looking to invest in a particular company, you can’t just go by word of mouth or general feeling. Worse yet, you don’t want to concern yourself with how pretty a graph the company’s stock price has been plotting recently (this is called technical analysis, and it’s the financial equivalent of phrenology.) Stupidest of all is the investment strategy that equates being a customer with being a shareholder.
You need to research, at least a little. Are you willing to spend a couple of hours to potentially earn yourself hundreds or thousands (or just as importantly, not cost yourself that much)? You should be, assuming you enjoy money and how easy it can make your life.
There are only 3 types of financial statements you need to know about. Any other ones you come across aren’t that important, at least not at this stage of the game. You find them at sec.gov/edgar/searchedgar/companysearch.html.
Enter the company name, scroll down to the first appearance of “10-K” in the left column, click on “Interactive Data”. Among other things, you’ll find the critical financial statements:
Income statements. Balance sheets. Cash flow statements. That’s it. Describing what’s in each one in sufficient detail could give us a year’s worth of blog posts, but let’s do this in digestible chunks.
What an income statement tells you, you can hopefully deduce from its title. Income is the difference between the revenue the company generated and the expenses it incurred, over a fixed period (usually a year, occasionally a quarter.)
Income statement (actual size)
Peruse the categories if you want, but the most important number at this point is the difference between gross income and expenses: net income, or in common parlance, profit.
But you can’t just rank companies by net income and say whichever one makes the most money is thus the best investment. You have to look at the relative sizes of the companies. Everything else being equal, a company that makes $100 million on revenues of $500 million is more impressive than one that makes $110 million on revenues of $1 billion.
A balance sheet tells you how much in assets the company has on hand, and how much it has in outstanding liabilities. The difference between them is called shareholders’ equity, which is one traditionally accepted measure of the company’s value.
Columns of numbers!
Over how long a period? A year?
You don’t listen, do you?
It’s the amount of assets and liabilities the company has (present tense), not the amount it acquired (past tense). That means it counts every dollar the company has ever taken in and hasn’t yet spent, minus every obligation it’s ever had and hasn’t yet settled. So in theory, a company could have a different balance sheet every millisecond. While an income statement refers to a particular period, a balance sheet refers to One Moment In Time, just like your prom did. Only without the awkward makeout sessions and vomiting.
Since shareholders’ equity, the value of the company, is assets minus liabilities by definition, you can understand why we keep hammering you to buy assets and sell liabilities. Divide net earnings (from the income statement) into shareholders’ equity and you get return on shareholders’ equity, a number that gives you an idea of how long it takes an investment in the company to pay for itself.
Finally, a cash flow statement tells you if the company’s bringing in more than it’s spending, and how much. That sounds straightforward, but it can occasionally be complicated (a rare repudiation of the oracular pronouncements in our book, Control Your Cash: Making Money Make Sense. Here’s the only other one.) There are 3 ways a company can generate revenue: via operations, investments, and financing.
Sorry, ran out of jokes. Alright, maybe this stuff is a little tedious
Operations is hopefully pretty clear. For Caterpillar, it’s making and selling lift trucks. For Anheuser-Busch, it’s brewing and selling beer. For General Motors, it’s collecting undeserved money from you and tens of millions of other taxpayers.
Unless the company in question is a financial firm, Investments is probably going to be a negative number, because it includes buying expensive things that help keep the company growing – factories and stuff. The category also includes buying and selling securities that have little or nothing to do with the company’s core business. For instance, if they have cash on hand, putting it in securities (Treasury bills, currency, other companies’ stocks or bonds) on behalf of the shareholders.
Financing includes issuing and buying back the company’s own stock and bonds. That means bringing new investors on board (usually healthy, if the company isn’t growing just for the sake of growing) and borrowing money (bad if it’s done for reasons other than covering new capital expenditures, paying it back with interest, and not risking default.)
Next time, or whenever we get around to it depending on the quality and quantity of this week’s comments, we’ll explain what desirable financial statements look like.
**This post is featured in the Carnival of Wealth #7-Entrepreneurship Edition**
