Town Builders

Block 13: Accounting

Accounting is the language of business. It is how investors figure out how a business is doing financially. There are three accounting statements that public companies have to file quarterly and annually.

 

The three are the balance sheet, the income statement, and the cash flow statement. Without any accounting knowledge, these numbers might as well be hieroglyphics but they actually tell a story if you know what you’re looking for. We’ll go over them individually but if you want a more in-depth explanation, click here.

 

Balance Sheet

 

The main equation is: Assets = Liabilities + Equity

 

To keep with the lemonade example, assets would be the lemons (inventory), the cups (supplies), or the stand (property). Liabilities are any debts you owe. If you had used a credit card to buy the supplies then that would be recorded under this section. If you have no debts, then the equity (ownership) will equal the assets, meaning you own all of the assets.

 

As an investor, the main thing to look for here is debt, usually demarcated by “long term debt.” For instance, if you bought all the lemonade supplies with your credit card, then you will be charged 16% interest as that is the standard rate. If you don’t sell a lot of lemonade, you won’t be able to make the payment and, either, get bailed out or go bankrupt. So preferably look for a business with more equity (sometimes called shareholder’s equity) than liabilities, but some industries allow companies to handle more debt. Like utilities, since their revenue is so predictable and the industry is very regulated they can afford to take on debt to magnify their returns.

 

Income Statement

 

The main equation here is:

Revenue – Cost of Goods Sold – Operating Expenses – Interest Expenses – Taxes                                                           

                                                         = Net Income

 

That seems like a lot and it kind of is but let’s break it down. We know revenue, it is sales of lemonade (# of cups sold * price). Cost of goods sold would be the supplies that directly go into the lemonade (i.e. lemons, cups, sugar, ice cubes). Operating expenses are the costs of the scientific research on the lemons, the advertising and the new hire. Interest expenses are the fees associated with debt (just like the credit card interest rate). Taxes are well, taxes. And then finally we have net income or net profit. This is the income statement.

 

Here you should look for gross margins (revenue – cost of goods sold)/revenue)) to increase over time. Also you should look for revenue to be increasing over time. It is a good idea to calculate the year-over-year growth. Then check the net margins (net income/revenue). Make sure these are not decreasing rapidly. Essentially you want to make sure the business is performing well. Is it able to increase prices and sell more while not letting costs get out of control. Of course, there is more complexity as you learn more and more but this is a great starting point.

 

So now try pulling up a company’s income statement and start doing some of those calculations. It will lead to more questions like: is 12% good revenue growth or are 25% gross margins considered poor? Here is where it is a little gray because it depends again on the industry.

 

Costco and Walmart have very low margins but high revenues because their businesses don’t have a lot of pricing power because there businesses are built on selling for the lowest prices. If Apple grows 10% it will be a lot more impressive than if a small software company does the same because of the absolute dollar value. This is where it just takes some time to read over enough income statements where you start recognizing patterns. As time goes, we will build out a rolodex to differentiate industries and you can access that here to widen your circle of competence.

 

Cash Flow Statement

 

The main equation you need to know here is: 

 

Operating cash flow (or cash from operations) – Capital Expenditures (or property, plant and equipment) = free cash flow.

 

There are three sections of the cash flow statement: operations, investing, and financing. As you may have guessed, the cash flow statement details where the cash went during the reporting period (yearly or quarterly). So cash from operations could be items like inventory (extra lemonade cups). Cash from investing could be money that went toward building a new lemonade stand. And financing is something like taking out a loan.

 

What you’re looking for here though is that the company is cash-flow positive. That means that when you subtract capital expenditures from operating cash flow, the free cash flow is a positive number. This just means that the company is not losing cash. If, on the other hand, this number is negative; be careful. Check the balance sheet to see if the company has enough cash on hand to fund operations for a while longer. This is called the burn rate.

 

Let’s say a company’s free cash flow was $-10 million for a quarter. The company’s burn rate would be 40 million a year because $10 million * 4 quarters. If you check the cash under the assets section of the balance sheet and the company only has $40 million in the bank, then it is in trouble. It will either have to raise more money, taking on debt or dilute shareholders by offering up more shares.

 

Let us explain what we meant by the second half of that last sentence. Diluting shareholders. So a company can actually offer up more shares to raise cash. Just like in the IPO, it offered up shares, it can do that again on the open market. The only thing is that current shareholder’s shares are less valuable. If you owned 1 share of a company with 1 million shares and it offers up another million, your piece of the pie just got halved. So shareholders generally do not appreciate that. And that is why it is important to keep tabs on the cash.