You might wonder why individuals with backgrounds in IT, healthcare, or even transportation should have a grasp of financial statements.
The reason is straightforward: the success of your investment hinges on the future growth of a company you invested in.
While predicting the future with absolute certainty is impossible, having insight into a company’s current financial health can aid in anticipating its growth trajectory.
Those who understand a company’s current condition are better equipped to gauge its growth potential than those who lack this knowledge.
“Now, what if others (i.e: stock market trading app) have already presented comprehensive data, historical information, the latest updates, growth analysis, and future forecasts for the company? Can’t we simply make use of theirs?”
– Uninformed Investor 🕵🏻
This assumption is dead wrong. In reality, comprehending the innards of a company is crucial for making sound investment decisions. This entails understanding the company’s history, typical challenges it faces, and how its management envisions the future.
Having depth of knowledges in the company, will gradually build up your confidence to the stocks you’re currently focusing on.
Relying solely on data from others prevents us from constructing a psychological stronghold with unwavering confidence in the business, particularly the stocks.
As Seth Klarman aptly put it:
“Investing is the intersection of economics and psychology.”
🫀 The Cornerstone of Financial Health
Financial Statements serve as the cornerstone of understanding a company’s financial health. They provide a snapshot of its economic well-being, and this data is vital for investors, executives, and stakeholders alike.
Imagine walking into a doctor’s office. The doctor takes your vital signs, measures your temperature, and reviews your medical history before diagnosing your health. Similarly, a company’s financial statements provide key metrics and historical data that allow us to diagnose its financial well-being.
📊 The Trio: Income Statement, Balance Sheet, and Cash Flow
To demystify financial statements, we need to break down the three key components: the Income Statement, the Balance Sheet, and the Cash Flow Statement. These documents provide insights into a company’s revenue, assets, liabilities, and cash flow.
- Income Statement: Think of this as the company’s “earnings report.” It summarizes revenues, expenses, and profit or loss over a specific period. The income statement is the scorecard that tells us how much a company earned and spent.
Companies will report its profit and loss starting from Revenue/Sales, which will be reduced by various types of expenses until reaching the bottom line, which is Net Income.
Net sales – Cost of sales = Gross Profit
Gross profit – Oprt. expenses = Oprt Profit (EBIT)
EBIT – Interest – Taxes – Other expenses & losses = Net Profit
Balance Sheet: This is the company’s “financial screenshot.” It shows the company’s financial position at a specific point in time, including its assets, liabilities, and shareholders’ equity. The balance sheet is like a snapshot of the company’s financial health, revealing how much it owns and how much it owes. Keep in mind that both of these should always be BALANCE.
How much it owns represented by asset position. Basically there are only 2 types of asset, which are: current assets; and non-current asset.
How much it owes represented by liability position. Generally there are 3 types of liability: 1. long-term; 2. short-term; 3. shareholder’s equity.
Yes. At the end of the day, your equity is a liability in the stand point of a business, because the businesses will have to repay it back to you sooner or later.
Occasionally, businesses will pay its liability (long-term & short-term) in installment plus interest, while paying shareholder’s equity in the form of dividends. But if majority investor don’t want the business to pay dividend, business can keep the profit as retained earnings.
All of this activity, will be captured in the Balance Sheet.
- Cash Flow Statement: This is the “cash diary” of the company. It details how cash moves in and out of the business, helping investors understand the company’s liquidity and ability to meet its financial obligations.
Some say, this is a truer form of Income Statement. There is a nice little saying from famous economist Alfred Rappaport that goes “profits are an opinion, cash is a fact.”
Cash flow statement comes in three different shape:
1. Cash from operating: Result of good businesses process.
2. Cash from investing: Most of the time, are just money out. Some other times, jackpot.
3. Cash from financing: Same with the above, just a little bit more “certain.” For example, bank loans and dividends.
Later in your investing career, you will understand that cashflow statement is the holy grail of Investing—if you’re able to digest Income Statement & Balance Sheet correctly.
🦶🏻Don’t Overlook the Footnotes
Financial statements aren’t just about numbers you see at first glance. It’s crucial not to miss the footnotes. These footnotes provide additional information and context, offering a deeper understanding of the numbers presented. For example, they might disclose significant accounting policies or details about contingent liabilities.
These footnotes are always there, but people still skimmed past them and miss the important messages.
Below is the example of how a footnotes tell reader about specific accounting policies being used in the financial statement.
🧠Make Informed Decision as an Individual Investor
Financial statements are not just for professional analyst. They are valuable tools for individual investors who want to make informed decisions. As an individual investor, understanding these documents can help you make more confident investment choices. By analyzing financial statements, you can assess a company’s profitability, financial stability, and growth potential.
For instance, if you’re considering investing in a business, the income statement can reveal its revenue growth trends, the balance sheet can indicate its debt levels, and the cash flow statement can help you determine if the company is generating sufficient cash to support its operations and investments.
📈Essential for Financial Literacy
Finally, understanding financial statements is essential for financial literacy. It’s like knowing how to read a map when you’re going on a road trip. Without this knowledge, it’s easy to get lost or make poor financial decisions. Whether you’re planning for retirement, managing your personal finances, or evaluating a potential investment, financial literacy is your compass.
In conclusion, financial statements are not just numbers on paper; they are powerful tools for understanding the financial health of a company. By breaking them down into the Income Statement, Balance Sheet, and Cash Flow Statement, and paying attention to the footnotes, you can make more informed decisions as an individual investor. In an age where being financially literate is essential, demystifying financial statements is your key to navigating the complex world of finance with confidence.
Don’t shy away from financial statements; use them as your financial compass, guiding you toward better investment decisions and a more financially secure future.
Hi!
This is the first post from my Value Investing Crash Course (I don’t really have a name, yet). I am planning to limit the course to member only post.
Don’t worry, you can always sign up for free here.
I don’t know what to say, but if you really have time to read this, I just wanna say thank you for your time. Let’s grow together. FNK.