Tuesday, May 14, 2013, AM | 2 Comments
Are you making good money? Are you saving some of it? If yes, the next question is “Are you investing it?” Instead of just putting it in saving and checking account collecting dust in the form of measly interest, you’d better be investing it. However, in order to invest in a company, you should understand and be familiar with the various financial statements of the company to know where it stands.
The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.
Like Cuba Gooding Jr. once said “Show me the money” in one of his movies, you must ask the company the same question and be satisfied with the answer before you pour your hard-earned money into it.
There are four major financial statements that you should know about:
A company’s assets (what it owns), liabilities (what it owes) and shareholders’ equity (what is owned by shareholders.) A balance sheet puts them together in the form of a formula:
Assets = Liabilities + Shareholders’ Equity
The accountants and financial gurus must balance them out.
The company has revenues and expenses. An income statement puts them together in the form of a formula:
Net worth = Revenue – Expenses
Revenue is frequently known as top line and net worth as bottom line. If net worth is negative – expenses are more than revenue – then the company is in the red, meaning it loses money. To be in the black, its expenses must be less than its revenue.
The important thing to remember about an income statement is that it represents a period of time. This contrasts with the balance sheet, which represents a single moment in time.
Cash flow statement
The cash can travel in two directions – cash coming in and cash going out. There is a third direction called black hole where cash disappears. There are also non-cash transactions on this statement, for example, depreciation or write-offs on bad debts.
Statements of shareholders’ equity
Shareholders’ equity is the investment and usually comes from two sources:
- External investments in the company.
- Internal retained earnings through its operations.
You should also consider…
There are two important ratios you must consider before investing in a company. For example,
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity
Debt is good as long as it’s manageable even if it is more than the shareholder’s equity.
price-to-earnings ratio (P/E)
A higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.
Read The Footnotes…
Financial statements have footnotes. Please read them carefully. They usually consist of the following:
Accounting policies & practices
A public company is required to provide accounting policies and practices.
The company publishes its retirement programs – may that be pension fund, 401(k) or other programs and the resulting cost to the company.
Here the company publishes stock options given to officers and employees.
The company must publish its income taxes – federal, state, local and/or foreign. This includes current as well as deferred taxes.
In a Nutshell
So before you talk to your financial adviser, educate yourself, understand as much as you can about a company before investing in it.