“When in Rome, do as the Romans do,” goes the famous saying. What this saying suggests is that you need to know the language and customs of people when you visit an unknown society. Doing so is polite, and also advantageous.
The same holds true when you enter the ‘investing society’. Before you enter, your gate pass must show that you understand the language of business.
And what’s the language of business? Numbers.
Numbers speak the language of business.
If you don’t understand the numbers that businesses use to communicate with you, the investor, the investing society can be like a maze. You won’t know where you are, and you won’t know how to come out in case of a fire.
But believe me, if you can read a nutrition label on your box of corn flakes, or you know how to read your home loan statement, you can learn to read basic financial statements.
The basics aren’t difficult and they aren’t rocket science.
Show Me the Money
We all remember Cuba Gooding Jr.’s immortal line from the movie Jerry Maguire, “Show me the money!”
That’s what financial statements do.
These statements appear in the company’s annual report, and are broadly classified into three categories:
1. Balance Sheet
It is also known as the Statement of Financial Position and reports on a company’s assets, liabilities, and equity (also known as shareholders’ funds) at a given point in time.
The assets side of a balance sheet shows what a business ‘owns’ – the factory, building, car, machines, computers, etc. The liabilities side represents what a business ‘owes’.
Assume you bought a house using a housing loan, and also put in some money from your own pocket. In this case, your house will fall on the asset side of your personal balance sheet. The housing loan will be a liability. The money you infused from your own pocket will be your equity.
There are several others assets and liabilities that are included in a balance sheet, as you can see in the following image of an actual balance sheet. Pick up a high school accounting book, and you can learn it all from there.
In simple terms, a balance sheet shows how a company stands at a given moment. There is no such thing as a balance sheet covering the year 2010. It can only be for a single date, for example, March 31, 2010.
2. Profit & Loss Statement
Also known as the Statement of Comprehensive Income, the Profit and Loss statement (or a P&L) reports on a company’s income, expenses, and profits over a period of time.
So if you start a business manufacturing televisions, all the money you spend on buying raw materials for manufacturing television sets, and all money you earn selling them in a year will come in the P&L.
3. Cash Flow Statement
The cash flow statement is the most important of all statements, because it shows the movement (inflow and outflow) of all cash during a year. And cash, as you must know, is the most precious resource for a business.
How these statements help?
So these were the three key financial statements through which businesses talk to investors. These statements help businesses showcase:
- Performance during the year gone by – Whether the year was a good one of bad one for the company.
- How strong the business is – The stronger a business, the more capable it is to face slowdown and competition.
- The level of profitability – a highly profitable business gets the maximum investor attention.
- Whether the business is guzzling cash or releasing a lot of it – The former type of business is hated by intelligent investors, and the latter loved.
The ability to read financial statements and understand what they convey will open up several areas for you to analyse stocks, buy the good ones, and ignore the bad ones.
By knowing how to read and analyse financial statements, you will be able to:
- Understand how a specific company has performed in the past.
- Understand whether the company is doing a profitable business or is running loss-making operations.
- Separate well-performing companies from the bad ones that are losing money for shareholders.
- Know if a company is using faulty accounting to inflate its sales and/or profits.
- Realise that some stocks you already own in your portfolio, are actually dud businesses that are doomed to fail.
Yes, this fifth realisation is the most striking aspect of your understanding of the financial statements.
I have met several investors over the past few years – some from within my extended family, some from among my previous company’s clients, and some just by the way.
What has amazed me is that a majority of these investors – and several have been old timers in the stock markets – know little or nothing about identifying a good balance sheet from a bad one. And it’s not by chance that almost all these investors have a large proportion of their portfolios invested in bad stocks/weak companies.
But I don’t blame them for their ignorance, which they have misunderstood for bliss all these years.
Their source of stock ideas have been brokers, friends and relatives – people whom you can consider least likely to tell you how a good/bad balance sheet looks like.
Probably you might have been one of their types. And if that’s the case, don’t worry.
We have just studied the key financial statements that you need to read in a company’s annual report to make out how it is doing.
Now, let us move a bit deeper, and understand some key financial terms and ratios that you must know in order to make a judgement on a good business versus a bad business.
This is going to be a pretty long lesson, so you can read it over the next few days before you get the next lesson. While the subject is boring by nature, I’ve tried to make it as easy and interesting as possible.
So let’s get started.
10 Finance Terms You Must Know
1. Sales/Revenue
Sales is what a company earns by selling its products or services. For example, if Company A sells 100 units of a product at Rs 50 per unit, its sales will be Rs 5,000 (or 100 multiplied by 50).
While the sales figure is just the entry point to your understanding of a company’s financials, it is important to know how the company is doing on this front. For, without sales, there won’t be any business.
Tracking a company’s sales growth over a number of years (at least 10 years) gives a good indication of its size and stability. A company with a stable growth in sales over a 10-year period is generally considered better as compared to a company that has a rapid yet volatile sales growth history.
2. Net Profit
This is ‘the’ figure most investors look out for in a company’s P&L account. Net profit represents the money left over with a company after reducing all kinds of expenses from its sales. Net profit is akin to your monthly savings after paying for all household expenses from your monthly income. Like sales, looking at the long term performance of net profits gives a good indication of a company’s financial health and stability.
3. Operating margin, or Profitability
Profit (like net profit, as we discussed above) is what a business earns after it reduces all expenses from its sales. But profit is a number and does not explain much on an as-is basis. What is more important for you as an investor is the ‘profitability ‘, which is equal to the money a business makes for every rupee of its sales.
Assume Company A sells toys worth Rs 100 in a year and earns a profit of Rs 40. Company B sells toys worth Rs 50 in the same year and earns a profit of Rs 30. Here, the profit of company A is higher than profit of company B (40 > 30).
But when to comes to profitability, that of company B is better than that of company A (30 divided by 50 is greater than 40 divided by 100). Always remember, profitability is more important than profit in understanding how a business is doing.
In highly competitive industries, a more profitable business has a greater flexibility to reduce prices to fight competition. A more profitable business also generates more cash to spend on its expansion and pay dividends to its shareholders.
4. Depreciation
All the fixed assets, except land, that a company owns (like plant, machinery, computers, automobiles, etc.) are subject to a gradual loss of value through age and use. The allowance made for this loss of value is known as depreciation (or obsolescence, depletion, and amortization).
The amount of depreciation to be charged each year is based on the value of the property (usually taken at the cost it was bought at), its expected life, and the salvage or scrap value when it is retired.
Let’s understand with an example. You buy a car for your personal use at a cost of Rs 500,000. The expected life of this car is 5 years, and your expected scrap value is Rs 50,000 (at which it can be sold off after 5 years). In this case, the annual depreciation charge will be 1/5th of Rs 450,000 (Rs 500,000 minus Rs 50,000). This gives Rs 90,000 as the annual depreciation charge. A company will reduce such an amount from its operating profits every year.
However, note one important thing here. Depreciation is a non-cash charge i.e., a company does not have to ‘pay’ depreciation to anyone. It only needs to reduce the depreciation amount from its operating profits.
Now, since it reduces this amount from its operating profits, the tax it has to pay to the government also gets reduced (as net profit before tax comes down due to reduction of depreciation expenses from the operating profit. Money so saved can be used by the company to replace the depreciated asset after the end of its useful life.
This is the core reason behind the concept of depreciation – it enables companies to save taxes every year so that it can accumulate money so saved to buy replace its old assets after cross their useful lives.
Note: In case you have any doubts/problems understanding the financial concepts as explained in this lesson, please fee free to send me a message using the Contact page, and I’ll be able to explain you further.
5. Equity
Also known as shareholders’ funds or book value, equity is the money shareholders (like you) put in the business. Equity is a very important concept in financial analysis because a very rough relationship tends to exist between the amount invested in a business and its earnings.
It is true that in many individual cases we find companies with small book values earning large profits, while others with large book values earn little or nothing. Yet, as Benjamin Graham suggests in his The Interpretation of Financial Statements (one book you must read to understand financial statements), in these cases some attention must be given to the book value situation, for there is always a possibility that large earnings on book value/invested capital may attract competition and thus prove temporary.
6. Debt
Equity is what belongs to the owners of the business (shareholders like you), debt is what is borrowed (from banks and others) by the owners of the business. While the owners of equity (shareholders) have a claim on the company’s earnings (by way of dividends), those that extend debt to companies (like banks) receive interest payments every year.
While debt isn’t a dangerous figure on the balance sheet, too much debt can be a cause of concern. This is especially when this debt is not backed by almost equal or higher amount of equity.
So, as a thumb rule, a debt to equity ratio (D/E) of higher than one, and consistently for several years, is a cause for concern. However, a reducing level of D/E, or one that is already less than 0.5x (or 50%), is a comfortable situation.
7. Working Capital
As you can see in the sample balance sheet as shown above, there are two items named ‘current assets’ and current liabilities’.
Current assets are those that are immediately convertible into cash or which, in due course of business, tend to be converted into cash within a reasonably short time (maximum one year). Such assets include:
- Cash and equivalents
- Receivables (money that a company has to receive from its customers for the goods or services that have already been sold)
- Inventories (goods that the company has produced but are waiting to be sold, or raw materials and semi-finished goods that the company holds in its stock)
Since these assets can be converted into cash in a short time, they are collectively known as ‘current assets’.
On the other side, i.e., on the liability side of the balance sheet lie ‘current liabilities’ that represent the amount a company owes to its vendors who have supplied it with raw materials to semi-finished goods, and are waiting to be paid. Such vendors are known as creditors of the company. Apart from creditors, all the debts of the company that will be repaid within one year are classified under current liabilities.
Now, coming to ‘working capital’, it is the figure arrived at by reducing current liabilities from current assets. So,
Working capital is a consideration of major importance in determining the financial strength of a manufacturing company. This is because the study of working capital results in knowing whether the company is in a position to carry on its normal day-to-day business comfortably without any financial constraints.
Shortage of working capital (when current assets that can be converted to cash and not enough to cover current liabilities that must be paid out soon) results in slow payment of bills.
This results in poor credit rating of the company, which subsequently means that the company not just needs to borrow short term funds to meet its day-to-day expenses, it also has to pay higher interest in the money so raised.
An important ratio you can work out here is the amount of working capital per rupee of sales. Lower the ratio, lower is the working capital requirement of the company, and the more financially strong it is.
Note: In case you have any doubts/problems understanding the financial concepts as explained in this lesson, please fee free to send me a message using the Contact page, and I’ll be able to explain you further.
8. Free Cash Flow
Cash (as you can see in the balance sheet above) is what a business holds in banks and other investments. But the concept of free cash flow (FCF) is entirely different.
FCF is what a business is left with at the end of every year after it takes care of its capital expansion and working capital needs. So if you look at the cash flow statement in the previous slide, the FCF will be calculated as:
FCF = Cash flow from operations – Capital expenditures
= Rs 3055.79 lac – Rs 722.13 lac
= Rs 2333.66 lac
In simple terms, FCF tracks the money a business has generated by the end of each year. It’s the cash that is left over with the company at the end of the year, after it pays all its bills and pays for any new capital expenditures. It is what it has left over to pay investors. And that is why FCF is one of the most important numbers you must track as a shareholder in a company.
9. Return on equity
Return on equity, or ROE, is one of the most useful tools to determine how well management creates value for shareholders. The formula is:
We’ve already discussed both ‘net profit’ and ‘equity’ in this lesson, so you must not have any problem calculating the ROE.
The legendary investor, Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.
As such, the higher the ROE, the better it is for shareholders, as it indicates that the management has allocated capital (equity) in a profitable way.
A higher ROE also means that surplus funds can be invested to improve business operations without the owners of the business (shareholders) having to invest more capital.
It also means that there is less need to borrow, which is a positive sign for the business (we read above the perils of borrowing more).
10. Dividend
One of the most loved words in a shareholder’s dictionary, ‘dividend’ is a payment made to the shareholders (owners) of a company, out of the company’s profits. Most Indian companies usually pay dividends on a yearly basis while some also do it quarterly.
So why is dividend important? Simply because it comes out of a company’s profits. Or, more specifically, its free cash flow. A consistent, rising dividend payment is usually a hallmark of a solid, well-run business that generates substantial, consistent cash flow.
All things equal, that equates to a relatively stable business and a stock that might be a little less volatile than the market at-large. In other words, companies that pay consistent and rising dividends are usually lower risk than companies that don’t pay dividends.
Note: In case you have any doubts/problems understanding the financial concepts as explained in this lesson, please fee free to send me a message using the Contact page, and I’ll be able to explain you further.
Parting thoughts
See, these are some of the basic yet among the more important concepts that you must know as an investor. You will get data for all these terms and ratios in a company’s annual report.
Your just need to pull out the relevant data, make necessary calculations, and check for yourself the financial health of the company.
Anyways, I won’t go further into the subject here, as that would require the space of a book.
What you can do is pick up a high school accounting book or basic book on finance and that will teach you everything you’ll need to know about understanding financial statements.
You might ask – Is there a way I can invest without understanding financial statements?
Of course, there’s a way. But it’s very much like climbing Mount Everest without knowing mountaineering.
You might still reach the peak, but the chances are miniscule.
You know that, don’t you?
Anyways, we’ve covered the following key topics in the first four lessons of ‘Value Investing for Smart People’:
- Lesson #1: Why invest in the stock markets
- Lesson #2: What is investing and how it is different from speculation
- Lesson #3: Importance of understanding the business behind a stock
- Lesson #4: Identifying your circle of competence – businesses you can understand
- Lesson #5: Importance of understanding the language of business (the current lesson)
Over the next few weeks, we’re going to talk about how you can value a business to ascertain whether its stock is available cheap or expensive.
This is where we would work on some basis maths related to investing.
Don’t worry a bit! I promise that you’ll find it a cakewalk with Safal Niveshak on your side.
P.S.: Got here via a link from a friend, or a forwarded email? This is the fifth lesson of the 20-lesson free email course on the essential pillars of becoming a successful investor, Safal Niveshak-style. We talk about simple investing strategies that will work for you, and make you a smarter and successful investor.
Learn more about the course or simply sign up here.