Welcome to the second part in the intermediate guide to investing! In the first part, we learnt about the importance of annual and quarterly earning reports. In those reports, there are financial statements that detail the company's financial state. In this part, we will teach you all about them!
If you haven't yet read our beginner's guide to investing, where we introduce things like why you should invest, how to start investing, risks, rewards and strategies, do check it out first!
Chapters in this guide:
Part 1 - Why Read Financial Statements?
Part 2 - How To Read Financial Statements
Part 3 - 10 Key Financial Ratios & Metrics
Part 4 - How To Analyze A Stock
Part 5 - Portfolio Management & Asset Allocation
Part 6 - Portfolio Rebalancing & Market Conditions
Resource - Stock Analysis Checklist
In this part, we will focus on the three main financial statements found in company reports - the income statement, balance sheet and statement of cash flows. We will also introduce key metrics within these financial statements to keep a lookout for.
In this guide, we will be using Microsoft's 2020 Q3 earnings report as an example. You can click the link and scroll down to the Income Statements section to follow along.
The income statement, as the name suggests, deals with the profit and loss of a company. It shows whether the company is making money or not.
The income statement records the following:
- Revenue (+)
How much money the company made through the sale of its products.
- Cost of revenue/Cost of goods sold (-)
How much money was spent to make that revenue. This mainly includes costs to create and maintain products such as ingredients, materials etc.
- Indirect costs (-)
Next, we have indirect costs which are costs of the company that are unrelated to the production of the product directly. This can include things like administration costs (accounting staff, HR), money spent on marketing etc.
Here, we end up with the number known as the operating income. This is the net income of a company to operate its production and sales directly, meaning that this income stems directly from the company's sale of its products minus any costs related to the production (directly or indirectly) of its products. Next, we have:
- Other income/costs (+/-)
Any other income not related to operating income (aka not related to the company's products) such as from investments, sale of property and equipment etc.
After this, we end up with the earnings before interest and taxes (EBIT). This is the amount of money the company made through all its operations before paying out any interests (on loans the company took) and income taxes.
Usually, we will also subtract depreciation and amortization from this amount, which is basically the loss of value of things over time for tangible assets (property, equipment) and intangible assets (patents, brand value) respectively.
We will then end up with earnings before interests, taxes, depreciation and amortization (EBITDA).
Next, we will deduct taxes and other expenses from these earnings:
- Income tax and interest expenses (-)
We deduct payment of interest on loans and income taxes from the government here. Note that income taxes can be zero (or even negative!) if a company made no profits or even have losses, thanks to tax rebates or benefits.
Thus, many companies purposely spend money on research, share repurchases or give out spare cash as dividends to avoid income taxes. This is actually the main reason for income taxes - to encourage companies to spend their income, which grows the economy instead of companies hoarding their profits.
Finally, we end up with the net income, which is the total remaining amount of money the company made or lost this financial period.
For publicly listed companies, such as in the case of Microsoft's quarterly income statement above, we also have earnings per share and outstanding shares.
- Outstanding shares
Outstanding shares refer to the number of common shares owned by the company's investors, including individuals and financial institutions etc. If the company buys back these shares, then they would become known as treasury shares, owned by the company.
The total number of outstanding shares and treasury shares make up the number of issued shares - the total number of shares that a company created as equity.
- Earnings per share
Earnings per share is simply the net income of a company dividend by the number of outstanding shares, and corresponds to the amount of profit that one share unit gave its investor that financial period.
Since the number of outstanding shares changes very rapidly as companies buy back outstanding shares and issue more shares, we often use the weighted average number of outstanding shares, which is simply a calculated average of the estimated number of outstanding shares to compute these figures.
The income statement is useful to see if a company is making money through its business or not. It can also help investors to see if a company is providing good growth value on its shares through the earnings per share metric.
Key metrics in the income statement
There are several key metrics to keep a lookout for in the income statement:
- Earnings per share
Arguably the most important metric in the income statement. If a company is not showing much growth in its earnings per share, the company may be stagnating.
A company with low earnings per share signifies that it is not providing much value (in terms of money growth) to investors, making it less attractive to investors. In turn, this results in less money being invested into the company, causing its growth to further decrease.
Generally, we want to look out for a high earnings per share. Of course, high is relative to the company's profits, but generally, we want to see good growth in earnings per share year over year.
- Net income
Similarly, the net income is another important metric since it tells you whether the company is making money or not. If a company has negative income, or near zero net income, you will want to look at the costs to see where they are spending that money.
If you see a lot of money going into research and development, the company could be trying to avoid taxes and fueling growth through new and innovative products. However, if you don't find a good reason, then the company might be bleeding cash due to poor sales, a dangerous sign.
- Shares outstanding
This is a good metric to keep track off since we can see how many shares a company is issuing. From the changes between one financial period to the next, we can also see if the company has repurchased or issued new shares.
If the outstanding shares in the previous period is less than the current period, we know that the company has repurchased shares. Repurchasing shares makes the remaining share value increase since there are less outstanding shares in the marketing so the earnings per share will be higher.
On the contrary, if the outstanding shares have increased, then the company has issued more shares. This dilutes the value of your existing shares since the earnings per share will decrease.
Next in the financial statements is the balance sheet. The balance sheet mainly deals with the company's assets, liabilities, and equity. In layman terms, this refers to what the company has, what the company owes and what shareholders will get from what the company has once the company pays off all that it owes respectively.
First up in the balance sheet are the assets. Assets can be thought of as the collective value of the company and anything that it owns, including cash, inventories, money it will receive and even the brand value it holds.
- Current assets (+)
Current assets give a glimpse into a company's liquidity, and are basically the company's cash as well as things that can be converted to cash in a short notice (typically within a year) such as short-term investments like bonds.
The total amount of current assets reveal a company's ability to stay resilient in a crisis, as it reflect the amount of cash that a company has on hand to continue paying its costs without collapsing or defaulting on its debts. A financially stable company will have positive current assets that can cover its liabilities.
- Account receivables (+)
This is basically the amount of money a company expects to receive, and is usually under current assets (although there may be some that are due in more than a year). This money can come from credit card payments for example, where a customer purchases a product using a credit card and promises to pay in the future.
- Doubtful accounts (-)
You will notice that there are doubtful accounts, which is the sum of money that a company subtracts from account receivables because they expect that they will NOT receive it. This could be from people defaulting on payments etc.
- Other assets (+/-)
Next, we have other assets like the property and equipment a company owns minus their respective depreciation as mentioned in the income statement. We also have equity investments (investments that the company made), including the value of shares this company holds in other companies.
We also have other intangible assets like goodwill (premium due to this company's brand value, connections etc.) and other things like brand recognition, all of which are estimates based on the company's worth.
Then, we have long term assets like property, equipment and land here which are hard to convert into cash within a year.
Finally, we end up with the total assets of the company, which is total estimated value of the company and everything that it has or is expected to have.
Next are the company's liabilities. This refers to the amount that the company owes other entities, including debts, interest payments and expenses.
- Accounts payable (+)
Refers to the expenses that a company is expected to pay in the short term. This could be payment transfers for materials or goods and services.
- Unearned revenue (+)
Refers to money paid to the company for goods and services that haven't been rendered yet. This is a liability since the company is expected to delivery those goods and services in the near future, but hasn't done so yet despite having received payment for it.
These liabilities and others are known as current liabilities, which are liabilities that the company has to fulfill within a year.
Next, we have the non-current liabilities, which extend beyond a year and could even be perpetual (recurring payments forever).
These may include long term debt, rent or other things. In total, these make up the liabilities of a company, which is the total value that a company is lawfully obligated to fulfill to others.
Last in the balance sheet we have the shareholder's equity. Shareholders own a stake in the company, and are entitled to receiving the company's assets should a company go bankrupt.
As such, you can think of shareholder's equity as being the value that the shareholders will receive should a company go bankrupt. It is the remaining value leftover from the company's assets after it has paid off all its liabilities.
Here, we see the value paid out to investors in terms of share value including dividends under common stock and shares.
We also see how many total shares the company has issued - in the case of Microsoft, 24,000, as well as how many are outstanding (owned by external investors). The difference is how many the company holds as treasury shares.
Retained earnings are the amount of value leftover after a company pays off its liabilities and shareholders, and represents the amount that a company plans to use to reinvest in its own growth.
As such, since a company can declare a dividend amount each time, they can control how much of their net income will be reinvested into the company, and how much goes into paying shareholders.
The ALOE formula
As mentioned, shareholder's equity is the amount leftover after a company uses all its assets (things it owns) and pays off all its liabilities (things it owes), representing the amount that shareholders in the company will own.
Therefore, it makes no surprise that adding the liabilities and shareholder's equity must equal to the company's assets. Shareholder's equity is also known as owner's equity.
Assets = Liabilities + Owner's Equity
This is known as the ALOE formula, or A = L + OE. They will always be equal, and the assets represent the entire value of the company as of that financial year. If you see a balance sheet where the above ALOE formula doesn't tally, it could be a sign of fraud or bad accounting.
Key metrics in the balance sheet
So, what key metrics are there in the balance sheet? Some things to look out for include:
- Current assets
As mentioned, this represents the value that a company can theoretically convert to cash quickly within a year. This represents the liquidity of a company and whether they have the means to pay off their obligations.
- Current liabilities
Similarly, we must take note of the current liabilities that the company is expected to fulfill or pay within a year. Since these are lawful obligations, the company must fulfill them or be sued and have to mortgage stuff to make up for it.
Therefore, we must make sure that the company's current assets must be able to cover their current liabilities to ensure financial stability. The ratio of current assets over current liabilities is known as the current ratio.
We want this ratio to be over 1 to ensure financial stability.
- Book value
We should also take note of the book value of the company, the value that a company's assets have as recorded by themselves in the balance sheet. This value can be obtained by taking the total assets and subtracting the intangible assets (like brand recognition etc).
This book value is the value of the company's tangible assets and is the intrinsic worth of the company based on the assets they own.
This is useful as we can use it to calculate the price to book ratio to see is a company is being overvalued or undervalued for its current share price. We will explore more useful ratios later on in this guide.
Statement of cash flows
The last in the trio of financial statements is the statement of cash flows. Unlike the income statement and balance sheet which deals with a lot of things such as expected value and money that is expected to come, the statement of cash flows demands tangibility.
The statement of cash flows only records the movement of cash in and out of the company. If any transaction does not include cash (physical or digital), then it is not recorded in the statement of cash flows.
This part of the statement of cash flows relates to cash involving the operations of the company, such as product sales and taxes.
- Net income
We start with the net income taken from the income statement. As mentioned, this is the total amount of value leftover from the company operations after deducting cost of goods sold, depreciation, amortization and taxes.
Remember when we said that the statement of cash flows only records actual cash and ignores the rest? We have a problem since the net income includes depreciation and amortization, which is the value we expect the company's assets to lose over time.
However, this is just an expected value, and doesn't involve any cash flows! Therefore, we must add them back into the net income to get back the amount of cash leftover from net income. This process is known as reconciliation.
We also reconcile other non-cash things like paying employees with stock instead of a salary (no cash involved), and add back any income tax benefits since we pay the tax first, and then get the rebate at a later date.
- Changes in operating assets and liabilities
In the income statement, we had the total receivables amount (value we expect to receive). In the statement of cash flows, since we record only cash transactions, we will record the receivables amount that we actually have received in cash, or ones that we have already paid.
Every company needs to raise money to fund its operations and to further expansion. It cannot simply rely on profits from sales to fund its operations as this is too slow.
To expedite growth, companies rely on other ways to get money quickly, such as selling shares of the company to investors and taking loans (debt).
In this part of the cash flows statement, we see how much the company paid out in cash as debt repayments. We also see how much the company made by selling its stock, how much cash it spent to repurchase stock, and how much dividends were paid out.
As you can see, financing doesn't necessarily have to be positive. Often, it can result in negatives due to dividend payments and stock repurchases.
Lastly, we have the investments that the company made. These investments can be other companies that the company buys and returns on investments made that have turned into cash profits/losses.
Here, we can see the cash that the company spent to acquire other companies and assets. We also see maturities of investments which are things like when a bond expires and you receive the principal amount back, as well as sales of investment products.
- Foreign exchange rate
If you look back at the other two financial statements, you might have noticed the effect of foreign exchange rates at the bottom. Not all investments, assets, liabilities and the like have the same currency as the one in the financial statements (in this case, USD).
Since a company may be multi-national, or its materials and goods come from and go to different countries, it is inevitable that different currencies are used within a company itself.
The conversion of all these different currencies to the primary currency used in the financial statement incurs currency risk - the loss/gain expected due to currency conversion rates.
Finally, we end up with the net cash and cash equivalents, the total amount of cash the company has as of this financial period.
Key metrics in the statement of cash flows
As mentioned, this can be negative, but this requires scrutiny. A company might sell stocks to raise money to cover its high debts. Generally, we don't like seeing too much financing from share sales as this suggests a desperate need for money for some reason or another.
- Cash and cash equivalents
Again, this measures the amount of cash the company has on hand. This number should remain positive for a company to be financially stable, as this means the company is able to pay off debts and its capital expenditure.
However, note that this doesn't tell the big picture. Remember that the cash flow statement only records cash movements, and doesn't take into account receivables and payables, which could be significant and affect the company's future.
Therefore, one should also make sure that the company is financial stable through other means like the current ratio (mentioned in the balance sheet).
That was long, but we've went through the basics of the financial statements! Hopefully now, you have gained an understanding of the income statement, balance sheet and statement of cash flows.
As mentioned, each of these three statements are just parts of a whole. Relying on one alone will NOT tell you the full picture, and could mislead you into believing a company is doing better than it actually is.
For example, relying on the statement of cash flows could show the company generating a lot of cash, but if you had looked at the balance sheet, you would see that the company is under a lot of debt and does not have enough assets to repay those debts.
As such, one must ultimately be careful in going through a company's finances, and this article will serve as a good base of understanding of financial statements.
In part 3 of our intermediate guide to investing, we will look at 10 key financial metrics and ratios of companies to simplify our decision making process.
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