The language of business is accounting. Therefore, it is important that you understand well accounting if you want to be a successful investor. The following is an accounting crash course for beginners, mainly inspired by the excellent “The five rules for successful stock investing“, by Pat Dorsey.
As an investor, you’re mainly going to be interested in the balance sheet, the income statement, and the statement of cash flows of a company. These three tables are your windows into corporate performance, and they’re the place to start when you are analysing a company.
All three of these statements can be found in the three major types of financial filings: an annual report, a 10-K filing, and a 10-Q filing. You’re probably familiar with annual reports – those glossy booklets with smiling employees that firms mail out every year – but to really understand a firm, you’ll need to look up 10-Ks and 10-Qs. These are dense, detailed sets of financial information that companies files with the Securities and Exchange Commission (SEC) every year (the 10-K) or every quarter (the 10-Q).
Think of the three statements like this: The balance sheet is like a company’s credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. It tells you how strong the framework and foundation of the business is.
The Income statement, meanwhile, tells how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses over a set period, such as a fiscal year.
Finally, there’s the statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out. The statement of cash flows ties the income statement and the balance sheet together.
Right now, you are probably wondering why we need an income statement and a cash-flow statement – after all, if a company makes money, it makes money, right? The difference lies in a confusing concept called accrual accounting. Here’s how it works. Companies record sales (or revenue) when a service or a good is provided to the buyer, regardless of when the buyer pays. As long as the company is reasonably certain that the buyer will eventually pay the bill, the company can post the sale to its income statement.
The cash flow statement, on the other hand, is concerned only with when cash is received and when it goes out the door. I’ll go over the cash flow statement in detail later in this chapter, but here’s a quick example.
Let’s say that Colgate sells a few cases of toothpaste to Joe’s Corner Store for $1,000 on February 15 but gives Joe 60 days to pay because he’s a regular customer and has a good track record of paying his bills on time. March 31 rolls around, joe hasn’t paid yet, and Colgate closes its books for the quarter. Colgate shows $1,000 in sales on its income statement because it shipped the toothpaste to Joe -according to the income statement, the sale is complete, regardless of whether Colgate received payment. But because Joe hasn’t ponied up the grand yet, Colgate will post an entry on its balance sheet to show that joe owes Colgate $1,000. (The entry goes into the accounts receivable line – more on this later in the chapter.)
As you can see, a company can show rip-roaring sales growth without receiving a cent of cash. In fact, if Colgate produces and sells toothpaste faster than its customers pay for the toothpaste, sales growth would look fantastic even though cash is flowing out of the door – which is why we need a statement of cash flows.
Where the money goes
Figure 4.1 illustrates how money moves from investors, through the company, to consumers, and back to the company. This isn’t nearly as bad as it looks. Let’s follow some money through the company to show you what I mean.
A group of investors and bondholders (1) provide capital to a firm, either by buying shares in the company (stockholders) or by buying the company’s bonds (bondholders). The company takes the money and buys fixed assets (2) such as machinery and buildings – and uses those assets to produce inventory (3). Some of the inventory is sold for cash (4), and some is sold on credit (5).
The credit sales are posted to “accounts receivable” – a fancy name for IOU -until the customer pays the firm (6). Once the firm has cash in hand, it can spend it in all sorts of ways. Some of it goes back into production (7), which means buying replacement raw materials to create more inventory, and some of it goes into investment (8), which means buying more machinery or building another factory. (In accounting lingo, you’ll usually see any investment that purchases a tangible long-term asset such as a building or factory called “capital expenditure”, or simply “capex”).
Another chunk of cash goes to Uncle Sam as taxes (9), and some may flow out as dividends to stockholders if the firm pays a dividend or as interest to bondholders (10) if the firm has debt.
That’s really all there is to it. Cash flow in, and (you hope) cash flows out. Let’s walk through a simplified company – Mike’s Hot Dog Stand – to illustrate how all of this comes together. We’ll use Mike’s to introduce many of the specific line items in financial statements that tell us how well a company is doing its core job, which is investing shareholder’s money to generate a solid return.
Practical financials – The statements in use
It’s the fourth of July, and Mike thinks he can make a few bucks by setting up a hot dog stand near the parade route. Mike has $100 to start his hot dog-selling operation, with the money provided by the first National Bank of Mom.
|TABLE 1 – Borrows $100 from First National Bank of Mom|
Mike spends $70 for lumber, nails, and paint to assemble the stand as well as tongs for turning the dogs on the grill (He’s borrowing Dad’s grill to cook the dogs.) Then he buys $20 worth of hot dogs, buns, ketchup, and mustard, and some charcoal and lighter fluid for the grill. He keeps the remaining $10 for making change and such.
|TABLE 2 – Buys Property, Plant, and Equipment (PP&E) and Inventory|
He’s spent $90 ($70 for the stand and $20 for ingredients), but that money hasn’t disappeared – it’s turned into assets and inventory. As shown in the chart, the $70 he spent on the hot dog stand and the tongs is “Property, plant and equipment”, while the $20 in buns and such has become “inventory”, and the $10 in cash is just that. Look at the simplified balance sheet below to see how this would look if Mike had to file an annual report (Don’t worry if you see an unfamiliar line item – we’ll cover it later in the chapter).
|TABLE 3- Simple Balance Sheet for Mike’s hot dog stand|
|+ Accounts receivable||0|
|+ Net PP&E||70|
|= Total Assets||100|
|Total Liabilities & Equity||100|
Mike opens for business while the crowd is gathering for the parade and sells 30 hot dogs at $1 apiece. By noon, half the hot dogs, buns, condiments, and charcoal are gone, so Mike’s “cost of goods sold”, is $10, or half the $20 he spent to buy supplies. Seven people didn’t have cash on them, so Mike let them buy their dogs on credit – which means we need to record $7 in account receivable, which is the money that folks owe to Mike.
|TABLE 4 – Sells 30 hot dogs at $1 piece ($10 worth of inventory) with $7 worth being sold on credit (cash not received yet)|
In the middle of the day, Mike runs out of buns, so he has to run over to the corner grocery store to buy more. But when he arrives, he realizes he left his money back at the stand, so he promises the grocer he’ll come back with the money on Monday, when the hot dog biz slows down. We post $5 to accounts payable, which is money that Mike owes to the grocery store for the buns. (Think of accounts payable like your credit card. If you buy a shirt or a stereo on your visa, you can use it right away – but you still owe the credit card issuer some cash.)
|TABLE 5 – Buys $5 worth of buns on credit|
At the end of the second day, Mike realizes that his tongs aren’t working as well as they used to, and it’s taking him longer to grill each hot dog. The accounting name for this wear-and-tear is depreciation, which lets us record the fact that Mike’s equipment isn’t as productive as it used to be. (In the real world, depreciation isn’t recorded at the moment something starts wearing out. It’s actually a regular charge that assumes that an asset wears over a set time period – as long as forty years for a building, and as short as three years for a computer.) depreciation is a cost of doing business, just like buying hot dogs and buns, because Mike will eventually have to buy another set of tongs if he wants to stay in business. Because all costs have to be recorded – accounting is funny that way – we post $1 to depreciation.
|TABLE 6 – Records wear and tear on tongs|
After a long day of serving up delicious dogs to parade-goers, Mike’s income statement is shown in figure 7, and his balance sheet in figure 8.
|TABLE 7 – Income Statement for the day|
|– Costs of goods sold||10|
|= Net Profit||19|
|TABLE 8- Simple Balance Sheet for Mike’s hot dog stand|
|+ Accounts receivable||0||7|
|+ Net PP&E||70||69|
|= Total Assets||100||124|
|Total Liabilities & Equity||100||124|
The eagle-eyed reader will notice that although Mike’s net profit was $19, his cash account went up by $23 -from $10 to $33 – on his personal balance sheet. Why the difference? Let’s find out by developing a statement of cash flows from the income statement and balance sheet information what we have available. By following this example, you’ll see into the heart and soul of accounting.
To understand how much cash Mike’s little business generated, we start with his $19 in net profits, which is the difference between what he paid for the hot dogs, buns, and condiments, and what he received in payment for the hot dogs. But to arrive at the cash profits, we first need to add back the $1 in depreciation. You see, although we need to keep track of the expense that Mike incurred by partially wearing out his grilling tongs – remember, accounting is all about keeping score – Mike didn’t have to pay out $1 in cash to cover the wear and tear. He’ll have to replace the tongs eventually, but ay yet, he still has his slightly worn-out pair, and he hasn’t laid out any green to fix it.
This is THE critical difference between accounting profits and cash profits – accounting profits match revenues (hot dog sold) with expenses (a worn-out set of grilling tongs) as closely as possible, whereas cash profits measure only the actual dollar bills flowing into and out of a business.
Next, we need to take into account the fact that Mike used up half his original inventory of hot dogs and buns, as well as the fact that he went out and bought an additional $5 worth of buns. His inventory went from $20, to $10, and back to $15. This net decrease in inventory from $20 to $15 is a source of cash. In other words, Mike had 20$ of capital tied up in inventory at the start of the weekend, but now he has only $15 of capital invested in inventory. As a result, he converted $5 in inventory to $5 in cash.
However, mike also is owed $7 by hot dog eaters who haven’t paid him yet. Because Mike had to pay to produce the dogs they ate and they haven’t yet given him any cash, he’s used up some money by letting those folks nosh on his tasty dogs on credit. In other words, Mike paid out cash to get the ingredients he needed to make the hot dogs, but he hasn’t yet received any cash in return, so his decision to extend credit used up $7 in cash.
Finally, let’s not forget that Mike himself is the beneficiary of credit because he still owes the grocer $5 for those extra buns he bought. Because Mike received something without paying out cash for it, his cash account increases by $5.
We can follow the trail from Mike’s $19 net profits to hi $23 in cash flow with this simple table :
Net profits = $19
+ $1 depreciation
+ $10 inventory (hot dogs sold)
-$5 inventory (extra buns purchased)
-$7 accounts receivable (money owed to Mike)
+ $5 accounts payable (money owed by Mike)
= $23 in operating cash flow.
As you can see, the $23 in operating cash flow differs from the $19 in net income because of the choices Mike made in running his little business. For example, if Mike hadn’t let anyone buy on credit, but had the same amount of sales, his cash flow would have been $30 ($23 +$7). Conversely, if the grocer had forced Mike to pay cash for those extra buns, Mike’s cash flow would have been $18 ($23 minus $5.) in both cases, however, Mike’s net profits would have remained $19.
The key takeaway here is that the income statement and cash flow statement can tell different stories about a business because they’re constructed using different sets of rules. The income statement strives to match revenues and expenses as closely as possible – that’s why we had to deduct $1 in depreciation from Mike’s profits, and that’s why Mike gets to record the $7 in sales that he made on credit. But the cash flow statement cares only about the dollar bills that go in and out the door, regardless of the timing of the actions that generated those dollar bills.
If you look only at the income statement without checking to see how much cash a company is creating, you won’t be getting the whole story by a long shot. This simple concept- the difference between accounting profits and cash profits – is the key to understanding almost everything there is to know about how a business works, as well as how to separate great businesses from poor ones. In Part II, we’ll move from our simple hot dog stand to real-world companies to learn how to analyse all three of the financial statements in detail.
- The balance sheet is like a company’s credit report because it tells you how much the company owes (assets) relative to what it owes (liabilities)
- The income statement shows how much the company made or lost in accounting profits during a year or quarter. Unlike the balance sheet, which is a snapshot of the company’s financial health at a precise moment, the income statement records revenues and expenses during a set period, such as a fiscal year.
- The third key financial statement – the statement of cash flows – records all the cash that comes into a company and all of the cash that goes out.
- Accrual accounting is a key concept for understanding financial statements. The income statement matches sales with the corresponding expenses when a service or a good is provided to the buyer, but the cash flow statement is concerned only when cash is received and when it goes out the door.
- The income statement and cash flow statement can tell different storied about a business because they’re constructed using a different set of rules. To get the most complete picture, be sure to look at both.