Sunday, August 19, 2007

The Basics: Financial Statements and Accouting Terms

Hello everyone.
I hope that you all enjoyed your weekend. I will try to keep tonight's post relatively short, but I will cover something that's very crucial to your investing journey - accounting. Don't get me wrong, I'm not an accounting guru. Heck, I only took one accounting class in college and didn't take any economics courses. But recently, I've been reading "Accounting for Dummies" and would like to share some valuable insights that I've gleaned.

Every company that is publicly traded (that is, every company whose stock you can own) is required by the Securities and Exchange Commission to file something called a 10Q and a 10K. A 10Q is a report that is an overview of a company's financial performance for the past three months, or the last quarter. The 10Q is filed three times a year and is intended to provide visibility into a company's operations for the company's shareholders. A 10K, which is also inside the annual report, is a comprehensive report of the company's financial performance over the past year. This report is only filed once a year - typically at the end of the year, depending on the accounting/fiscal calendar that the company uses.

Within these reports - the 10Q and the 10K - there is a whole lot of valuable information about how much the company makes. But before I get into that, let me specify the types of statements you will find in these reports. The three statements are:

the income statement

the balance sheet, and

the statement of cash flows.

The income statement is a statement which talks about the company's revenues (how much it earns) and its expenses (how much it has to pay out over a certain period of time). A company can earn revenue from many things such as the things it sells, investments it holds, real estate that may appreciate in value, and interest from bonds it may hold. Similarly, a company's expenses include the price that it paid for raw materials for its product, the cost of research and development, salaries for the employees, rent, and the interest that it pays on its debt, if the company has any debt. When CEOs and stock market commentators talk about a company raising its top line, they are talking about increasing revenue.

The balance sheet is a statement that is akin to your annual banking statement. It states how much money you have (your assets), how much debt you owe (your liabilities), and another thing which is completely unrelated to an individual's financial position - owner's equity. Owner's equity is essentially the amount of capital the company received from investors in exchange for stock. It is also the difference between assets and liabilities, i.e. Assets - Liabilities = Owner's Equity. Or, Assets = Liabilities + Owner's Equity. A company's assets can be divided up into long-term assets and short-term assets. Long-term assets are things such as real estate and equipment/machinery. Generally, long-term assets cannot be easily converted into cash. Conversely, short-term assets are things like cash and marketable securities (stock) that will be used to pay for expenses in the next twelve months. When CEOs and financial commentators, talk about increasing a company's bottom line, they are talking about increasing the net profit a company earns - the last line on the balance sheet.

The statement of cash flows was/is for me the hardest statement to get my head around, since it involves so many adjustments. I will elaborate on it in my next post, in addition to giving some basic formulas to help you dig into accounting statements. But for now, I will just tell you that it is a statement that shows how efficiently a company uses cash. This statement adjusts for how much cash comes into the company, and how much goes out. Normally, statements like the income statement add the proceeds from a sale to their top line when a customer receives a product. But this does not necessarily mean that cash has been given to the company. Sometimes customers pay for an item a month later, and receive the product beforehand. When companies record this sale and add it to their revenue before cash/physical money has been received, this is called accrual based accounting. The statement of cash flows adjusts for sales on a cash-basis only. That is, the statement of cash flows shows how much cold hard cash the company received and how much it paid out. Nothing more, nothing less.

Thanks for reading and if you have any questions, please feel free to post them or email me. Until next time...


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