How to Become an Investment Ninja (Part 2)
Thanks for caring so much about finance! I mean, you care a little, you're reading this. Don't hide it. Let it out.
In Part 1 of Investing 101, we talked about Tesla's stock quote and I promised we would cover the Balance Sheet and Income Statement in this section. Stay tuned for Part 3 when we tie it all together with Financial Ratios.
First a quick overview.
The Income Statement tells us how much money the company is making (or losing). The Balance Sheet tells us how much assets and debt (a.k.a. Liabilities) the company has. Ratios are shortcuts to see a company’s financial health quickly.
Assume the income statement is your monthly budget and the balance sheets is a summary of the properties you have and how much money you owe to your bank or on credit cards. In this scenario, you could think of your credit score as a Ratio.
We have to look at this information to discover companies with good earnings that are sustainably growing earnings over time.
Other questions you might want to ask yourself are:
How profitable is the business?
Is the company growing?
How is the company’s financial health? (assets / debt)
To answer these questions, we have to be able to understand the numbers behind the company with the data we can find in the financial statements.
As we said earlier. The Income Statement tells us how much money the company is making (or losing).
We will go over these again in Part 3 when we talk about ratios, but practice makes perfect!
Revenue / Sales is all the money collected from the sale of the company’s products. That means that Tesla sold $7 Billion worth of cars in 2016. Not bad right?
Cost of Goods Sold (COGS) are the costs directly associated with making the company’s products. In Tesla’s case, COGS would include the metal used to make the body of the car, the rubber for the tires, and the battery components.
Gross Profit is Revenue minus the Cost of Goods Sold (COGS). Tesla's Gross Profit is $1.6 billion, so they are not keeping that much of their revenue. We will go more in depth in Part 3 (Ratios) but for now all you need to know is that it is important to compare companies to their specific industry. Car manufacturers usually have lower margins than, say, social media companies because car manufactures are more capital intensive.
The following four lines are Operating Expenses, which are all other expenses the company incurs. Selling, General and Administrative (SG&A) expenses include salaries for sales people, marketing costs, accountants and other admin expenses. Research and Development include costs associated with creating new technology and products such as engineering salaries, equipment, etc.
Earnings Before Interest and Taxes (EBIT) is also referred to as Operating Margin. EBIT is Gross Profit minus Operating Expenses as described above.
Earnings Before Taxes (EBT), is just what it sounds like! It's EBIT plus interest and other expenses.
Net Income is EBT minus taxes.
Yay! Almost done. Time for the Balance Sheet!
The Balance Sheet tells us how much assets and debt (a.k.a. Liabilities) the company has.
First thing you should know about the balance sheet is that Assets equals Liabilities plus Equity. This is the Golden Rule. Never Forget it!
Let’s say you want to buy a house for $200,000. You can pay for the $200,000 house with either your money ($50,000) or a bank loan ($150,000). So your assets are $200,000, which are equal to your Liabilities of $150,000 plus your stockholders equity $50,000.
Assets are split into current assets and long-term assets. The difference is that current assets can be converted into cash in less than 12 months as opposed to long term assets, which take over 12 months.
Current assets include Cash, Short Term Investments (investments that can be converted into cash in less than a year). It also includes Inventory, Prepaid Expenses, Net receivables, and Other Current Assets. Let’s define each below:
Inventory includes products the company has that haven’t been sold. For Tesla this would be the finished cars. Note that Inventory can also include unfinished cars or just parts like the batteries and tires. This is also something you have to compare to other companies in the industry (i.e. car manufactures). Car manufacturers usually would have higher inventories since cars are pretty expensive and manufacturing is capital intensive.
Prepaid Expenses are expenses that you’ve already paid for. Think of your rent. You usually “pre-pay” rent for the upcoming month.
Net Receivables a.k.a Accounts Receivable is when you have sold something, but haven’t gotten paid for it yet. Let’s say that you sold your Xbox to your buddy for $200. He paid you $150 right away and said he will pay you the other $50 next week. So in this case, your accounts receivable is $50. Hopefully he has a good credit score :)
Other Current Assets are anything else that can be turned into cash in less than a year.
Long term assets include:
Property & Equipment is any equipment, buildings or other physical objects that belongs to the company. ie: A factory (or plant) that is used to manufacture goods or a piece of land that was bought with the intent of constructing an office.
Goodwill is not on every company’s balance sheet. However, if it is, it is generally due to a merger or purchase of another company.
Intangible Assets are assets that are not physical but still provide economic benefit to the company, such as a patent.
Long-term Investments include stocks, bonds, or real estate. In short, it refers to investments in other things that are not the core business of the company.
Other long-term assets includes anything else that a company has that will be beneficial in the future. For example, a tax benefit that can be credited in the future (deferred tax assets).
Liabilities are obligations the company owes to others. Same as with assets, Liabilities are split into current liabilities and long term liabilities.
Current Liabilities include:
Note Payable or short-term debt is when a company borrows money from a bank by signing a line of credit or a short-term loan (less than 12 months).
Accounts Payable are Invoices owed to suppliers. Generally, payment terms could be anywhere from 30 to 90 days. As an example, a restaurant will pay their meat suppliers within 30 days of delivery. So every amount owed to suppliers will appear in accounts payable.
Accrued Expenses are any expenses that have been used but not yet paid. Like electricity that has been used but the bill has not yet been paid.
Long-Term Liabilities have maturity of more than 12 months. These include:
Long-Term Debt can be a loan from a bank or a bond issued by the company that takes more than 12 months to pay back. Companies do this to obtain cash to finance a capital expenditure or finance the purchase of a building.
Other Long-Term Liabilities are a variety of debts such as fines and other debts that don't fit in any other field.
Shareholders Equity represents the net value of a company.
It is the value you get after subtracting all liabilities from the company’s assets. Here are the main items:
Common Stock represents ownership in a corporation. Common stocks may or may not have voting rights, receive dividends (if the company decides) and elect the Board.
Preferred Stock is similar to common stock, but it generally has no right to vote but it can have a fixed or adjustable dividend. Preferred stock has priority over common stock in case of bankruptcy (i.e. the company goes belly up).
Retained Earnings is the accumulated Net Income the company has ever made, minus any dividends (if they pay them), or purchases of its own shares.
Treasury Stock is where a company accounts for shares when they buy back stock. They can keep it on the balance sheet until they cancel or reissue.
There you have it!
Now you're ready to learn about Ratios and get closer to doing your own research. Stay tuned for Investing 101 (Part 3).