This article is the first in a series to help those who are interested in the necessary financial knowledge to start investing in stocks. As previously mentioned, we always recommend that you seek the help of a financial advisor, but our aim is to also help those who are already, or want to start, investing on their own. In this article, we will begin to cover the fundamentals that all financial analysts use on a daily basis and that you should apply as you consider buying stocks.
As you learn about investing in stocks, it is important to first understand the backbone of communication used between companies and their investors or lenders. A company is required to communicate its financial performance to others through financial statements. Financial statements record a company’s performance in detail through a specific period of time and are made available to the general public via the S.E.C. (Securities and Exchange Commission).
Yes, any individual has access to these records. The S.E.C., which regulates the security industry and enforces securities laws, makes these filings mandatory and accessible to the public. Try it out: you can go to the S.E.C’s EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system online and retrieve the filings of any public company. You can search by either company name or ticker symbol. Type Apple Computer or APPL and see what comes up.
There are four types of financial statements that are commonly prepared: an income statement, a statement of cash flows, a balance sheet, and a statement of changes in equity. Although there are four types of financial statements, there are only three which are widely analyzed when looking at a company’s financial performance. Below we tell you about each:
The Income Statement
The income statement, also known as the profit and loss statement, records the profitability of a business. It shows a company’s sales for a specific period of time, usually a quarter or a year, and deducts all expenses associated with operating the business for the same time period. To think about it in another way, the income statement simply shows sales minus costs resulting in profit or “bottom line”.
Why is the bottom line important? Because it will determine the viability of a business. If a business is not profitable it simply cannot operate for long before running out of cash and being forced to close. If Bob’s Donuts has $10,000 of cash, and they lose $2,000 per month, they will only have runway to operate for five months; $10,000/$2,000. In addition, investors buy and sell stock based on their beliefs about the future performance of a company. If you believe that Bob’s Donuts is going to be successful and increase their profits in the future, you might consider buying their stock.
Statement of Cash Flows
Equally important, the statement of cash flows provides financial information about the cash receipts and payments of a company for a specific period of time. When compared to the income statement, a statement of cash flows focuses only on the items that represent a movement in the cash balance of a company. It does not list sales like the income statement but shows items that help you understand how cash moves through the business. How much cash does a company have, did it change from the last reporting period, where did it come from, and where did they spend it? For example, if Bob’s Donuts bought flour to make their donuts, cash must have gone down but their inventories must have gone up. This change would be reflected in the cash flow statement.
It is very important for a company, investors, lenders, and other involved parties, to know where the business stands from a cash perspective. If Bob’s Donuts is running a loss and cash is running tight, it will be extremely important for the company to keep laser-focused on its cash balance and the use and source of it. If the company fails to focus on its cash and is losing money, it could suffer a liquidity crisis: running out of money and ceasing to operate. Without cash, a business cannot operate for long; with it, a company can embark on growth projects or even return it back to its shareholders.
The job of a balance sheet is to report all assets, liabilities (financial obligations), and claims of a business. While a statement of cash flows focuses on the movement of cash in a business, the balance sheet gives you a snapshot of the company’s cash and other assets and claims to those assets at the end of a reporting period. Assets are simply any resources that the company owns; physical like furniture or intangible like a brand name.
A balance sheet can be thought of in this way: assets = liabilities + stockholders’ equity. Stockholders’ equity are claims that owners of the business have to the company’s net assets. In other words (and without going into its components), it denotes the ownership of the company’s shareholders.
A balance sheet is important because it allows you to see Bob’s Donuts financial position: the amount of cash and other assets they have as well as the amount of debt or other liabilities.
If Bob’s Donuts is making a profit but is heavily burdened with debt, you would make sure to be aware of that. A high debt burden could put a significant amount of financial pressure on Bob’s Donuts. The company might not be able to pay the interest due every month and eventually go bankrupt. On the other hand, if Bob’s Donuts has very little debt and a strong cash balance, it would be a good indicator for you as a stock investor. At that point, you could decide if you would like to investigate the company further and determine if it’s the right investment opportunity for you.
So Why Is This All Really Important?
If you are interested in investing in single company stocks, understanding financial statements is an absolute requirement. Without understanding financial statements you simply would not be able to analyze a company’s financial data. If you are not doing financial analysis as you invest, you will just be speculating or gambling with your hard-earned money. I would also argue that understanding financial statements is not only important as you invest in single company stocks, but also as you look at structures like ETFs or mutual funds. Even those types of investments, while less risky at times, need some financial analysis.
In future articles we will explore financial statements more in depth. We will use certain line items from each statement to create ratios and other measures to properly measure the value of a stock and the financial performance of a company. In the meantime, take at look at the examples below of the three main statements, and become familiar with them. If you are eager to understand more, I challenge you to replicate them in Excel or Google Docs to study and better understand how they flow.