MONEY 5 - FINANCIAL STATEMENTS

THIS IS MY FIFTH POST ON UNDERSTANDING MONEY TOOLS

Money! Money! Money!  When you are looking into a company to invest in or talking with an investment advisor it might be good to have a very fundamental understanding of an income statement and balance sheet.

An income statement/profit and loss statement gives you an idea of how the company is performing income and expense wise on a monthly or yearly basis.  Let’s look at the very basics with an income statement and balance sheet. With a balance sheet you have assets of the company and its liabilities. The assets must equal liabilities plus shareholder equity.

Income Statement:

The first line will be Gross Sales or Revenues

Less cost of goods sold (material costs/expense item if buying goods from a manufacturer as retailers do)

Thus, we get to Gross Income

Now, we need to deduct all expenses for running the company including, but not limited to, salaries, rent/mortgage expense, marketing/advertising, bank financing charges, entertainment, travel, hotels, rental cars, leased cars, etc. etc.

Then, bottom line we have net earnings profit, or loss pre-taxes.

Balance Sheet:

The first part contains the assets of the company including cash, machinery, real estate, accounts receivables, etc. etc. Tally up all assets.

Then, you have liabilities, and they are broken apart into long term and short term.  Liabilities are obligations of payment, or debt, like accounts payables, lease obligations, mortgage, etc.

Short term obligations might be a problem for a company if cash on hand is short and bank borrowing is not available, as is common in this current economic market.

Then, you have shareholder equity.

Again, the total of your asset column needs to equal all liabilities plus shareholder equity.

Now, let’s take a look at some other useful techniques for analyzing companies. 

1)    Price to earnings ratio (P/E Ratio) is one of the most common as you can then compare the ratio to other possible stock purchases or historical averages of the stock market in general. To get this ratio merely divide the price of the stock by the earnings, if there are positive earnings. There is also a PP/E or projected price to earnings ratio, that analysts have come up with projecting what should happen financially to the company.

2)    Liquid asset test.  Divide the assets by the liabilities and you will get a ratio.

3)    Beta test.  The beta of a stock is a number determined by several factors given out by analysts.  A beta of one is the average or a baseline determined from many stocks (e.g. S&P 500). A number higher than one is more volatile and thus a higher risk.  A number lower than one is less volatile and more conservative, less risky. These numbers are based upon past performance and don’t necessarily reflect future performance.

4)    Alpha test.  The alpha number is what a portfolio manager adds to the investment performance including mutual fund managers. This may also be used in a particular industry sector.  Similar to a Beta test one is used as a baseline, less than one, less volatility; and more than one, more volatility. As an illustration a 1.2 Alpha for a portfolio would be 20% more volatile than a portfolio reflecting a 1.0 Alpha.

5)    Standard deviation.  This is similar in ways to a Beta test.  It is a statistical measurement of how far a variable quantity moves above and below an average price.  The wider the range over a given period of time, the greater the risk.

6)    Sharpe Ratio.  Created in 1966 is the Sharpe ratio another tool for measuring risk in investments.  It is not used and referred to as often as the above tests.

7)    Company capitalization.  To determine a company’s financial size.  This is determined by multiplying a company’s outstanding shares of stock by the market price of one share of stock.

Next we will head into other types of investments and start off with real estate.