If you want to invest in stocks and understand companies, you need how to understand how to determine the financial health of a company. You see, companies are just like people. They pay taxes, some die young, and some seemingly live forever. By understanding how to read a financial statement, you are a doctor to the company. You will be able to understand how healthy that company is. By determining the financial health of a company, you will know if it is a smart idea to give them your money.
Let’s start off with the financial statements of a company.
The first thing you must understand is a company’s revenues. Revenues are the amount of money that a company receives for a certain time period. For example, when you go to Starbucks and buy a latte for $4, that money is revenue to Starbucks. This is money that a consumer (you, in this instance) exchange for a product or service. Revenues are at the very top of the income statement. It includes all the money that a company brought from their business activities. When a company is healthy, their revenues grow at a steady pace. A company who’s revenues grow at a rapid pace can be a great opportunity to make big returns, but there is also a risk that the fail to maintain such a steady revenue stream.
The next item is also on the income statement. Net income is the company’s total earnings after taking away expenses. Companies have a large number of expenses, so let’s go back to our Starbucks example above. We already established that when you spend $4 on a latte it is revenue to Starbucks. To arrive to net income you have to take away certain expenses. You must subtract out what it costs Starbucks for the espresso, milk, and syrup used to make that latte. You must also subtract out the cost you pay employees, and any other costs associated with running the company (such as taxes). After you remove these expenses, you arrive at net income. Net income can help you determine if the company is actually making money. If net income is a negative number that means the company is losing money after netting their revenues and expenses. Companies whom consistently have a negative net income are not good investment options. There may be times when a negative net income is not a bad thing, but I will explain that in a later post.
The next item you must consider is a company’s assets. Assets are things that a company owns which will benefit them in the future. Let’s once again consider the Starbucks example above. Starbucks has coffee makers. Those coffee makers are assets to Starbucks because they will allow Starbucks to create a product that will make them money (benefit them) in the future. Assets can be any number of items for a company. Cash, investments, and equipment are all assets that can benefit a company in the future. Assets are important to understand because they will be used in ratios and other metrics used to measure the financial health of a company.
The opposite of assets are liabilities. Liabilities include things, like debt, that you are obligated to pay back for past transactions. You may have friends who use credit cards to buy things, like a brand new TV. As you know they are obligated to pay back the credit card company for that past transaction in which they bought a TV. Companies work in a very similar manner. They borrow money to buy things (assets) which they must pay back at a later date. Liabilities are important to understand. While a liability is not necessarily a bad thing, it can be bad if a company has too much. Having too much debt can hurt a company just like they can hurt your friends. It can get them in hot water if they can’t afford to pay them back. You want to watch out for a company that has a large number of liabilities when compared to their total assets.
These four financial statement items are very important to understand when you first learn how to invest. In part two of this article I will explain some simple ratios you can use while making investment decisions.
(*Quick is a subjective term that I use very loosely here to describe how your money can multiply over a period of time of 25 or more years. I mean really, that’s pretty quick you consider just how old the Universe is.)