How are a company's financial statements connected?
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When you do research on different companies by looking at their annual reports, you will typically come across two separate financial statements: the balance sheet and the income statement (also known as the statement of profit and loss). These two statements are very significant for companies as they can be used to describe the company's health and effectiveness of management.
Balance Sheet - B/S
The balance sheet gives investors a general overview of a company's financial situation. That is, it tells investors exactly what a company owns (assets) and who it owes (liabilities).
Assets and liabilities are listed in order of liquidity (relative ease of convertibility to cash), from most liquid to least liquid. Assets appear on the left hand side of the balance sheet and liabilities on the right hand side. For simplicity's sake, think of a B/S as an indicator of net worth: that is, how much a company is worth "on the books."
Income Statement – I/S
The income statement tells investors about the company's profits and losses for a specific time period. Expenses are subtracted from income to determine a firm's profit or loss. Unlike the B/S, the I/S doesn't look at the company's financial health (total net worth). Instead, it looks at how much revenue a company is able to create. If you were to think of the B/S as an indicator of net worth, you can think of the I/S as a company's profitability: that is, how much it can make in a given time frame.
These two statements are intertwined and should be looked at by all people who are considering investing their hard earned money in a particular company. You should look at a company's B/S to see exactly how much it is worth (remember, this is a book value representation rather than market capitalization), and look at the I/S to see how profitable the company is. Obviously, if it has a negative net worth (its liabilities are greater than its assets) or if it has a negative income, then the company might not be the best place to invest your money.
http://www.investopedia.com/ask/answers/03/061603.asp
Showing posts with label income statement value. Show all posts
Showing posts with label income statement value. Show all posts
Saturday, 5 December 2009
Tuesday, 7 July 2009
Bottom lines and other lines
Revenue
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income
The bottom line, refers to the net earnings or income after all expenses, taxes, and extraordinary items are factored in. The bottom line is the final "net" measure of all business activity.
----
Gross profit:
This is simply the sales less the direct cost of producing the company's product or service.
Direct cost includes:
Gross profit, often called gross margin, is the purest indicator of business productivity, because each cost dollar is directly generated by production and sale of the product.
Value investors closely watch gross margin trends as an indicator of market dominance, price control, and future profitability.
----
Operating Income:
This term refers to gross profit less period expenses, such as overhead or marketing costs not directly attributable to product production.
Selling, general, and administrative expenses (SG&A) usually cover all headquarters functions, information technology, marketing, and other indirect costs.
It generally includes financing costs, such as interest, and taxes.
Amortization is usually included, because cost recovery for property, plant and equipment is part of operating expense.
Items deemed extraordinary are not included.
Operating profit gives a more complete picture of how the business is performing on a day-to-day basis.
It sometimes appears as operating income, earnings from operations, or something similar.
----
Net Income:
This represents the net result of all revenues, expenses, interest, and taxes.
----
There are other supplemental earnings measures, such as free cash flow and "EBITDA."
The point is that there are many ways to measure income.
Each reveals an important layer of business performance, both for determining intrinsic value and also for comparing companies.
less COGS
-----------
Gross Profit
less Operating Expenses
-SGA
-R&D
-Depreciation & Amortization
-Impairment, Investments & Write Downs
-Goodwill amortization
-----------
less or add interest
-----------
PBT
less tax
-----------
Operating Income or Income from continuing operations
less or add extraordinaries
-----------
Net Income
The bottom line, refers to the net earnings or income after all expenses, taxes, and extraordinary items are factored in. The bottom line is the final "net" measure of all business activity.
----
Gross profit:
This is simply the sales less the direct cost of producing the company's product or service.
Direct cost includes:
- labor,
- material, and
- expenses directly attributable to producing it.
Gross profit, often called gross margin, is the purest indicator of business productivity, because each cost dollar is directly generated by production and sale of the product.
Value investors closely watch gross margin trends as an indicator of market dominance, price control, and future profitability.
----
Operating Income:
This term refers to gross profit less period expenses, such as overhead or marketing costs not directly attributable to product production.
Selling, general, and administrative expenses (SG&A) usually cover all headquarters functions, information technology, marketing, and other indirect costs.
It generally includes financing costs, such as interest, and taxes.
Amortization is usually included, because cost recovery for property, plant and equipment is part of operating expense.
Items deemed extraordinary are not included.
Operating profit gives a more complete picture of how the business is performing on a day-to-day basis.
It sometimes appears as operating income, earnings from operations, or something similar.
----
Net Income:
This represents the net result of all revenues, expenses, interest, and taxes.
----
There are other supplemental earnings measures, such as free cash flow and "EBITDA."
The point is that there are many ways to measure income.
Each reveals an important layer of business performance, both for determining intrinsic value and also for comparing companies.
Tuesday, 19 May 2009
Reading a Profit and Loss Account
Reading a Profit and Loss Account
A profit and loss (P&L) account is a statement of the income and expenditure of a business over the period stated, drawn up in order to ascertain how much profit the business made. 'Income" and "expenditure' here mean only those amounts directly attributable to earning the profit and thus would exclude capital expenditure, for example.
Importantly, the figures are adjusted to match the income and expenses to the time period in which they were incurred - not necessarily the same as that in which the cash changed hands.
What is a profit and loss account?
A profit and loss account is an accountant's view of the figures that show how much profit or loss a business has made over a period. To arrive at this, it is necessary to allocate the various elements of income and expenditure to the time period concerned, not on the basis of when cash was received or spent, but on when the income was earned or the liability to pay a supplier or employees was incurred. While capital expenditures are excluded, depreciation of property and equipment is included as a non-cash expense.
Thus if you sell goods on credit, you will be paid later but the sale takes place upon the contract to sell them. Equally if you buy goods and services on credit, the purchase takes palce when you contract to buy them, not when you actually settle the invoice.
What does a profit and loss account not show?
Most importantly, a P&L account is not an explanation of the cash coming into and going out of a business.
MAKING IT HAPPEN
The presence of stock and purchases indicates that the business is trading or manufacturing goods of some kind, rather than selling services.
Where a business holds stock, the purchases figure has to be adjusted for the opening and closing values in order to reach the right income and expenditure amounts for that period only. Goods for resale bought in the period may not have been used purely for that period but may be lying in stock at the end of it, ready for sale in the next. Similarly, goods used for resale in this period will consist parly of items already held in stock at the beginning of it. So take the amounts purchased, add the opening stock, and deduct the closing stock. The resulting adjusted purchase figure is known as 'cost of sales'.
In some businesses there may be other direct costs apart from purchases included in cost of sales. For example, a manufacturer may include some wages if they are of a direct nature (wages of employees directly involved in the manufacturing process, as distinct from office staff, say). Or a building contractor would include plant hire in direct costs, as well as purchses of materials.
How to interpret the figures
A lot of accounting analysis is valid only when comparing the figures, usually with similar figures for earlier periods, projected future figures, or other companies in the same business.
On its own, a P&L account tells you only a limited story, though there are some standalone facts that can be derived from it.
However, it is in comparisons that such figures start to have real meaning.
If you then looked at similar margin figures for the preceding accounting period, you would learn something about this business.
Say the gross margin was 45% last year compared with 46% this year - there has been some improvement in the profit made before deducting overheads. But then suppose that the net profit margin of 8.8% this year was 9.8% last year. This would tell you that, despite improvement in profit at the gross level, the overheads have increased disproportionately. You could then check on the ratio of each item of the overheeads to sales to see where this arose and find out why. Advertising spending could have shot up, for example, or perhaps the company moved to new premises, incurring a higher rent. Maybe something could be tightened up.
Another commonly-used ratio
Another ratio often used in business analysis is return on capital employed. Here we combine the profit and loss account with the balance sheet by dividing the net profit (either before or after tax as required) by shareholders' funds. This tells you how much the company is making proportionate to money invested in it by the shareholders - a similar idea to how much you might get in interest on a bank deposit account. It's a useful way of comparing different companies in a particular industry, where the more efficient ones are likely to derive a higher return on capital employed.
COMMON MISTAKES
Assuming that the bottom line represents cash profit from trading
It does not! There are a few examples where this is the case: a simple cash trader might buy something for one price, then sell it for more; his profit then equals the increase in cash. But a business that buys and sells on credit, spends money on items that are held for the longer term, such as property or machinery, has tax to pay at a later date, and so on, will make a profit that is not represented by a mere increase in cash balances held. Indeed, the cash balance could quite easily decrease druing a period when a profit was made.
Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)
A profit and loss (P&L) account is a statement of the income and expenditure of a business over the period stated, drawn up in order to ascertain how much profit the business made. 'Income" and "expenditure' here mean only those amounts directly attributable to earning the profit and thus would exclude capital expenditure, for example.
Importantly, the figures are adjusted to match the income and expenses to the time period in which they were incurred - not necessarily the same as that in which the cash changed hands.
What is a profit and loss account?
A profit and loss account is an accountant's view of the figures that show how much profit or loss a business has made over a period. To arrive at this, it is necessary to allocate the various elements of income and expenditure to the time period concerned, not on the basis of when cash was received or spent, but on when the income was earned or the liability to pay a supplier or employees was incurred. While capital expenditures are excluded, depreciation of property and equipment is included as a non-cash expense.
Thus if you sell goods on credit, you will be paid later but the sale takes place upon the contract to sell them. Equally if you buy goods and services on credit, the purchase takes palce when you contract to buy them, not when you actually settle the invoice.
What does a profit and loss account not show?
Most importantly, a P&L account is not an explanation of the cash coming into and going out of a business.
MAKING IT HAPPEN
The presence of stock and purchases indicates that the business is trading or manufacturing goods of some kind, rather than selling services.
Where a business holds stock, the purchases figure has to be adjusted for the opening and closing values in order to reach the right income and expenditure amounts for that period only. Goods for resale bought in the period may not have been used purely for that period but may be lying in stock at the end of it, ready for sale in the next. Similarly, goods used for resale in this period will consist parly of items already held in stock at the beginning of it. So take the amounts purchased, add the opening stock, and deduct the closing stock. The resulting adjusted purchase figure is known as 'cost of sales'.
In some businesses there may be other direct costs apart from purchases included in cost of sales. For example, a manufacturer may include some wages if they are of a direct nature (wages of employees directly involved in the manufacturing process, as distinct from office staff, say). Or a building contractor would include plant hire in direct costs, as well as purchses of materials.
How to interpret the figures
A lot of accounting analysis is valid only when comparing the figures, usually with similar figures for earlier periods, projected future figures, or other companies in the same business.
On its own, a P&L account tells you only a limited story, though there are some standalone facts that can be derived from it.
- Was this business successful in the period concerned?
- Was it able to make a profit, and not a loss?
- Was it able to pay dividends to shareholders out of that profit?
However, it is in comparisons that such figures start to have real meaning.
- The gross profit margin of X% was an important statistic in measuring business performance.
- The net profit margin before tax was Y%.
- You can calculate the net profit after tax (the bottom line).
- You could take the margin idea further and calculate the net profit after tax ratio to sales.
- Or you could calculate the ratio of any expense to sales. E.g. the wages to sales ratio.
If you then looked at similar margin figures for the preceding accounting period, you would learn something about this business.
Say the gross margin was 45% last year compared with 46% this year - there has been some improvement in the profit made before deducting overheads. But then suppose that the net profit margin of 8.8% this year was 9.8% last year. This would tell you that, despite improvement in profit at the gross level, the overheads have increased disproportionately. You could then check on the ratio of each item of the overheeads to sales to see where this arose and find out why. Advertising spending could have shot up, for example, or perhaps the company moved to new premises, incurring a higher rent. Maybe something could be tightened up.
Another commonly-used ratio
Another ratio often used in business analysis is return on capital employed. Here we combine the profit and loss account with the balance sheet by dividing the net profit (either before or after tax as required) by shareholders' funds. This tells you how much the company is making proportionate to money invested in it by the shareholders - a similar idea to how much you might get in interest on a bank deposit account. It's a useful way of comparing different companies in a particular industry, where the more efficient ones are likely to derive a higher return on capital employed.
COMMON MISTAKES
Assuming that the bottom line represents cash profit from trading
It does not! There are a few examples where this is the case: a simple cash trader might buy something for one price, then sell it for more; his profit then equals the increase in cash. But a business that buys and sells on credit, spends money on items that are held for the longer term, such as property or machinery, has tax to pay at a later date, and so on, will make a profit that is not represented by a mere increase in cash balances held. Indeed, the cash balance could quite easily decrease druing a period when a profit was made.
Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)
Sunday, 10 May 2009
Introduction to financial statements
Learn about stocks
Stocks 107: Introduction to financial statements
You don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: The income statement, the balance sheet, and the statement of cash flows.
[Related content: stocks, stock market, investments, investing strategy, bonds]
By Morningstar.com
Although the words "financial statements" and "accounting" send cold shivers down many people's backs, this is the language of business, a language investors need to know before buying stocks. The beauty is you don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: the income statement, the balance sheet, and the statement of cash flows. All three of these statements are found in a firm's annual report, 10-K, and 10-Q filings.
The financial statements are windows into a company's performance and health. We'll provide a very basic overview of each financial statement in this lesson and go into much greater detail in Lessons 301-303.
Morningstar.com's Investing Classroom
The income statement
The income statement tells you how much money a company has brought in (its revenues), how much it has spent (its expenses), and the difference between the two (its profit or loss). It shows a company's revenues and expenses over a specific time frame such as three months or a year. This statement contains the information you'll most often see mentioned in the press or in financial reports -- figures such as total revenue, net income or earnings per share.
The income statement answers the question, "How well is the company's business performing?" Or in simpler terms, "Is it making money?" A company must be able to bring in more money than it spends or it won't be in business for very long. Companies with low expenses relative to revenues -- and thus, high profits relative to revenues -- are particularly desirable for investment because a bigger piece of each dollar the company brings in directly benefits you as a shareholder.
Each of the three main elements of the income statement is described below.
Revenues. The revenue section is typically the simplest part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenues in ways that provide more information (for instance, segregated by geographic location or business segment). Revenues are also commonly known as sales.
More from MSN Money and Morningstar
Stocks 108: Learn the lingo – basic ratios
Stocks 101: Stocks versus other investments
Stocks 102: The magic of compounding
Stocks 103: Investing for the long run
MSN Money's New Investor Center
Expenses. Although there are many types of expenses, the two most common are the cost of sales and SG&A (selling, general and administrative) expenses. Cost of sales, which is also called cost of goods sold, is the expense most directly involved in creating revenue. For example, Gap (GPS, news, msgs) may pay $10 to make a shirt, which it sells for $15. When it is sold, the cost of sales for that shirt would be $10 -- what it cost Gap to produce the shirt for sale. Selling, general, and administrative expenses are also commonly known as operating expenses. This category includes most other costs in running a business, including marketing, management salaries, and technology expenses.
Profits. In its simplest form, profit is equal to total revenues minus total expenses. However, there are several commonly used profit subcategories investors should be aware of. Gross profit is calculated as revenues minus cost of sales. It basically shows how much money is left over to pay for operating expenses (and hopefully provide profit to stockholders) after a sale is made.
Using our example of the Gap shirt before, the gross profit from the sale of the shirt would have been $5 ($15 sales price - $10 cost of sales = $5 gross profit). Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings."
The balance sheet
The balance sheet, also known as the statement of financial condition, basically tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets," "stockholders' equity," or "net worth."
More investing courses from Morningstar
The balance sheet provides investors with a snapshot of a company's health as of the date provided on the financial statement. Generally, if a company has lots of assets relative to liabilities, it's in good shape. Conversely, just as you would be cautious loaning money to a friend who is burdened with large debts, a company with a large amount of liabilities relative to assets should be scrutinized more carefully.
Each of the three primary elements of the balance sheet is described below.
Assets. There are two main types of assets: current assets and noncurrent assets. Within these two categories, there are numerous subcategories, many of which will be explained in Lesson 302. Current assets are likely to be used up or converted into cash within one business cycle -- usually defined as one year. For example, the groceries at your local supermarket would be classified as current assets because apples and bananas should be sold within the next year. Noncurrent assets are defined by our left-brained accountant friends as, you guessed it, anything not classified as a current asset. For example, the refrigerators at your supermarket would be classified as noncurrent assets because it's unlikely they will be "used up" or converted to cash within a year.
Liabilities. Similar to assets, there are two main categories of liabilities: current liabilities and noncurrent liabilities. Current liabilities are obligations the company must pay within a year. For example, your supermarket may have bought and received $1,000 worth of eggs from a local farm but won't pay for them until next month. Noncurrent liabilities are the flip side of noncurrent assets. These liabilities represent money the company owes one year or more in the future. For example, the grocer may borrow $1 million from a bank for a new store, which it must pay back in five years.
Equity. Equity represents the part of the company that is owned by shareholders; thus, it's commonly referred to as shareholders' equity. As described above, equity is equal to total assets minus total liabilities. Although there are several categories within equity, the two biggest are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares. Retained earnings represent the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated deficit."
The statement of cash flows
The statement of cash flows tells you how much cash went into and out of a company during a specific time frame such as a quarter or a year. You may wonder why there's a need for such a statement because it sounds very similar to the income statement, which shows how much revenue came in and how many expenses went out.
The difference lies in a complex concept called accrual accounting. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. While that explanation seems simple enough, it's a big mess in practice, and the statement of cash flows helps investors sort it out.
More from MSN Money and Morningstar
Stocks 108: Learn the lingo – basic ratios
Stocks 101: Stocks versus other investments
Stocks 102: The magic of compounding
Stocks 103: Investing for the long run
MSN Money's New Investor Center
The statement of cash flows is very important to investors because it shows how much actual cash a company has generated. The income statement, on the other hand, often includes noncash revenues or expenses, which the statement of cash flows excludes.
One of the most important traits you should seek in a potential investment is the company's ability to generate cash. Many companies have shown profits on the income statement but stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies may have warned investors that rocky times were ahead.
Because companies can generate and use cash in several different ways, the statement of cash flows is separated into three sections: cash flows from operating activities, from investing activities and from financing activities.
The cash flows from operating activities section shows how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. Investors should look closely at how much cash a company generates from its operating activities because it paints the best picture of how well the business is producing cash that will ultimately benefit shareholders.
The cash flows from investing activities section shows the amount of cash firms spent on investments. Investments are usually classified as either capital expenditures -- money spent on items such as new equipment or anything else needed to keep the business running -- or monetary investments such as the purchase or sale of money market funds.
The cash flows from financing activities section includes any activities involved in transactions with the company's owners or debtors. For example, cash proceeds from new debt, or dividends paid to investors would be found in this section.
Free cash flow is a term you will become very familiar with over the course of these lessons. In simple terms, it represents the amount of excess cash a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations; thus, it's considered "free." Although there are many methods of determining free cash flow, the most common method is taking the net cash flows provided by operating activities and subtracting capital expenditures (as found in the "cash flows from investing activities" section).
Cash from Operations - Capital Expenditures = Free Cash Flow
The bottom line
Phew!!!
You made it through an entire lesson about financial statements. While we're the first to acknowledge that there are far more exciting aspects of investing in stocks than learning about accounting and financial statements, it's essential for investors to know the language of business. We also recommend you sharpen your newfound language skills by taking a good look at the more-detailed discussion on financial statements in Lessons 301-303.
Stocks 107: Introduction to financial statements
You don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: The income statement, the balance sheet, and the statement of cash flows.
[Related content: stocks, stock market, investments, investing strategy, bonds]
By Morningstar.com
Although the words "financial statements" and "accounting" send cold shivers down many people's backs, this is the language of business, a language investors need to know before buying stocks. The beauty is you don't need to be a CPA to understand the basics of the three most fundamental and important financial statements: the income statement, the balance sheet, and the statement of cash flows. All three of these statements are found in a firm's annual report, 10-K, and 10-Q filings.
The financial statements are windows into a company's performance and health. We'll provide a very basic overview of each financial statement in this lesson and go into much greater detail in Lessons 301-303.
Morningstar.com's Investing Classroom
The income statement
The income statement tells you how much money a company has brought in (its revenues), how much it has spent (its expenses), and the difference between the two (its profit or loss). It shows a company's revenues and expenses over a specific time frame such as three months or a year. This statement contains the information you'll most often see mentioned in the press or in financial reports -- figures such as total revenue, net income or earnings per share.
The income statement answers the question, "How well is the company's business performing?" Or in simpler terms, "Is it making money?" A company must be able to bring in more money than it spends or it won't be in business for very long. Companies with low expenses relative to revenues -- and thus, high profits relative to revenues -- are particularly desirable for investment because a bigger piece of each dollar the company brings in directly benefits you as a shareholder.
Each of the three main elements of the income statement is described below.
Revenues. The revenue section is typically the simplest part of the income statement. Often, there is just a single number that represents all the money a company brought in during a specific time period, although big companies sometimes break down revenues in ways that provide more information (for instance, segregated by geographic location or business segment). Revenues are also commonly known as sales.
More from MSN Money and Morningstar
Stocks 108: Learn the lingo – basic ratios
Stocks 101: Stocks versus other investments
Stocks 102: The magic of compounding
Stocks 103: Investing for the long run
MSN Money's New Investor Center
Expenses. Although there are many types of expenses, the two most common are the cost of sales and SG&A (selling, general and administrative) expenses. Cost of sales, which is also called cost of goods sold, is the expense most directly involved in creating revenue. For example, Gap (GPS, news, msgs) may pay $10 to make a shirt, which it sells for $15. When it is sold, the cost of sales for that shirt would be $10 -- what it cost Gap to produce the shirt for sale. Selling, general, and administrative expenses are also commonly known as operating expenses. This category includes most other costs in running a business, including marketing, management salaries, and technology expenses.
Profits. In its simplest form, profit is equal to total revenues minus total expenses. However, there are several commonly used profit subcategories investors should be aware of. Gross profit is calculated as revenues minus cost of sales. It basically shows how much money is left over to pay for operating expenses (and hopefully provide profit to stockholders) after a sale is made.
Using our example of the Gap shirt before, the gross profit from the sale of the shirt would have been $5 ($15 sales price - $10 cost of sales = $5 gross profit). Operating profit is equal to revenues minus the cost of sales and SG&A. This number represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. Net income generally represents the company's profit after all expenses, including financial expenses, have been paid. This number is often called the "bottom line" and is generally the figure people refer to when they use the word "profit" or "earnings."
The balance sheet
The balance sheet, also known as the statement of financial condition, basically tells you how much a company owns (its assets), and how much it owes (its liabilities). The difference between what it owns and what it owes is its equity, also commonly called "net assets," "stockholders' equity," or "net worth."
More investing courses from Morningstar
The balance sheet provides investors with a snapshot of a company's health as of the date provided on the financial statement. Generally, if a company has lots of assets relative to liabilities, it's in good shape. Conversely, just as you would be cautious loaning money to a friend who is burdened with large debts, a company with a large amount of liabilities relative to assets should be scrutinized more carefully.
Each of the three primary elements of the balance sheet is described below.
Assets. There are two main types of assets: current assets and noncurrent assets. Within these two categories, there are numerous subcategories, many of which will be explained in Lesson 302. Current assets are likely to be used up or converted into cash within one business cycle -- usually defined as one year. For example, the groceries at your local supermarket would be classified as current assets because apples and bananas should be sold within the next year. Noncurrent assets are defined by our left-brained accountant friends as, you guessed it, anything not classified as a current asset. For example, the refrigerators at your supermarket would be classified as noncurrent assets because it's unlikely they will be "used up" or converted to cash within a year.
Liabilities. Similar to assets, there are two main categories of liabilities: current liabilities and noncurrent liabilities. Current liabilities are obligations the company must pay within a year. For example, your supermarket may have bought and received $1,000 worth of eggs from a local farm but won't pay for them until next month. Noncurrent liabilities are the flip side of noncurrent assets. These liabilities represent money the company owes one year or more in the future. For example, the grocer may borrow $1 million from a bank for a new store, which it must pay back in five years.
Equity. Equity represents the part of the company that is owned by shareholders; thus, it's commonly referred to as shareholders' equity. As described above, equity is equal to total assets minus total liabilities. Although there are several categories within equity, the two biggest are paid-in capital and retained earnings. Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares. Retained earnings represent the total profits the company has earned since it began, minus whatever has been paid to shareholders as dividends. Because this is a cumulative number, if a company has lost money over time, retained earnings can be negative and would be renamed "accumulated deficit."
The statement of cash flows
The statement of cash flows tells you how much cash went into and out of a company during a specific time frame such as a quarter or a year. You may wonder why there's a need for such a statement because it sounds very similar to the income statement, which shows how much revenue came in and how many expenses went out.
The difference lies in a complex concept called accrual accounting. Accrual accounting requires companies to record revenues and expenses when transactions occur, not when cash is exchanged. While that explanation seems simple enough, it's a big mess in practice, and the statement of cash flows helps investors sort it out.
More from MSN Money and Morningstar
Stocks 108: Learn the lingo – basic ratios
Stocks 101: Stocks versus other investments
Stocks 102: The magic of compounding
Stocks 103: Investing for the long run
MSN Money's New Investor Center
The statement of cash flows is very important to investors because it shows how much actual cash a company has generated. The income statement, on the other hand, often includes noncash revenues or expenses, which the statement of cash flows excludes.
One of the most important traits you should seek in a potential investment is the company's ability to generate cash. Many companies have shown profits on the income statement but stumbled later because of insufficient cash flows. A good look at the statement of cash flows for those companies may have warned investors that rocky times were ahead.
Because companies can generate and use cash in several different ways, the statement of cash flows is separated into three sections: cash flows from operating activities, from investing activities and from financing activities.
The cash flows from operating activities section shows how much cash the company generated from its core business, as opposed to peripheral activities such as investing or borrowing. Investors should look closely at how much cash a company generates from its operating activities because it paints the best picture of how well the business is producing cash that will ultimately benefit shareholders.
The cash flows from investing activities section shows the amount of cash firms spent on investments. Investments are usually classified as either capital expenditures -- money spent on items such as new equipment or anything else needed to keep the business running -- or monetary investments such as the purchase or sale of money market funds.
The cash flows from financing activities section includes any activities involved in transactions with the company's owners or debtors. For example, cash proceeds from new debt, or dividends paid to investors would be found in this section.
Free cash flow is a term you will become very familiar with over the course of these lessons. In simple terms, it represents the amount of excess cash a company generated, which can be used to enrich shareholders or invest in new opportunities for the business without hurting the existing operations; thus, it's considered "free." Although there are many methods of determining free cash flow, the most common method is taking the net cash flows provided by operating activities and subtracting capital expenditures (as found in the "cash flows from investing activities" section).
Cash from Operations - Capital Expenditures = Free Cash Flow
The bottom line
Phew!!!
You made it through an entire lesson about financial statements. While we're the first to acknowledge that there are far more exciting aspects of investing in stocks than learning about accounting and financial statements, it's essential for investors to know the language of business. We also recommend you sharpen your newfound language skills by taking a good look at the more-detailed discussion on financial statements in Lessons 301-303.
Tuesday, 13 January 2009
Monday, 12 January 2009
Income Statement Value: The Earnings Payoff
Income Statement Value: The Earnings Payoff
Successful asset leveraging shows up in the income statement.
The income statement reports revenues less expenses and depicts an important measure of business performance. This is not a picture of cash flows because GAAP uses accrual, not a cash method of reporting.
In accrual accounting, economic activity is recorded according to the relationship between revenue and expense, rather than the timing of cash inflows or outflows. This is not an idiosyncrasy of accounting tradition, but a reflection of accounting’s goal of measuring and allocating business events that reflect economic reality. Those accruals capturing noncash costs of doing business reflect that cash will be absorbed in the future.
Pure value investors (Graham and Dodd) believe that current earnings (adjusted) are the most reliable indicator of a company’s sustainable long-term cash flows.
Adding a further constraint, pure value investors believe that the most reliable way to use current earnings as a valuation metric is to assume they will be constant in the future at current rates – not grow according to estimates.
The math is easy.
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
That is,
V = E/k.
E = Earnings are earnings.
k = The cost of capital. (This is the company’s weighted average cost of debt and cost of equity. The former can be calculated simply; the latter still requires some estimating).
Successful asset leveraging shows up in the income statement.
The income statement reports revenues less expenses and depicts an important measure of business performance. This is not a picture of cash flows because GAAP uses accrual, not a cash method of reporting.
In accrual accounting, economic activity is recorded according to the relationship between revenue and expense, rather than the timing of cash inflows or outflows. This is not an idiosyncrasy of accounting tradition, but a reflection of accounting’s goal of measuring and allocating business events that reflect economic reality. Those accruals capturing noncash costs of doing business reflect that cash will be absorbed in the future.
Pure value investors (Graham and Dodd) believe that current earnings (adjusted) are the most reliable indicator of a company’s sustainable long-term cash flows.
Adding a further constraint, pure value investors believe that the most reliable way to use current earnings as a valuation metric is to assume they will be constant in the future at current rates – not grow according to estimates.
The math is easy.
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
That is,
V = E/k.
E = Earnings are earnings.
k = The cost of capital. (This is the company’s weighted average cost of debt and cost of equity. The former can be calculated simply; the latter still requires some estimating).
The virtues of this approach are simplicity and reliability:
- Characteristic of simplicity is that investors need not bother with growth rates because no growth is assumed.
- Both data points are known or can be reliably estimated.
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