- Part 3: Understanding the Balance Sheet - June 12, 2016
- Part 2: How well you performed – The Income Statement - May 15, 2016
- Part 1: Your quick guide to financial statements - April 27, 2016
So, you want to start investing, but you don’t know where to begin.
Just as how we start learning about the alphabets by reciting our ABCs, an understanding of accounting is essential to investing. Incidentally, accounting begins with the letter ‘A’ too!
Ok, so what do you need to know?
There are 3 simple things to first understand to get started on accounting:
Just like how people measure their worth, every company records its financial performance on 3 different accounting statements. These financial statements are produced yearly to reflect how well the company is doing:
First: The Income Statement
The income statement records the company’s financial performance in a year. Just like how we calculate how much we have earned in the current year less expenses in a year to determine our savings amount, companies do the same.
Key things to look out for in a company’s income statement:
- Operating Profits
- Net profits
However, one thing to note is that not all net profit figures are cash – this is due to an accounting principle called the accrual basis for accounting. This reflects reality – a company who records a sales figure may not have actually received cash for the sale due to credit terms given by suppliers:
Second: The Balance Sheet
Again, to make things simple, I equate the Balance Sheet to knowing how many assets one has and measuring it any loans taken against the assets. What’s left is something called Equity – what you actually own!
Take for example a Singaporean who buys a property and takes a partial bank loan to finance the property:
Likewise, a company’s balance sheet captures this. It reflects the company’s financial position at any one point in time, which represents the company’s financial health.
As you can see, the balance sheet must always remain in balance with the accounting equation: Assets – Liabilities = Equity
Key things to look out for in a company’s balance sheet:
- Net Asset Value/Book value
- Debt Ratio (The ratio of long term debt to assets of a company)
- Cash and cash equivalents
Third: The Cashflow Statement
As mentioned before, what a company captures as net profit in its income statement does not equate to the actual cashflow it receives.
Here’s a question for you: how do companies like Amazon, which are still not making profits, survive? Answer: Cash flow.
Generally, the faster the companies receive cash, the better.
Cash is the life and blood of a company: think of the numerous companies still surviving even without making a profit!
Key things to look out for in a company’s cash flow statement:
- Operating cash flow
- Capital expenditure figures – i.e. net amount spent on capital equipment
- Total change in cash flow
In short, understanding what these key financial statements are crucial to begin investing. In the subsequent series, we will explore in greater detail the accounting principles behind the 3 financial statements mentioned above.
Follow me on this series, Accounting Principles, as we delve deep into understanding a company’s financials: