Monthly Archives: January 2017

Know more about an Income Statement

Making a profit: It’s the hallmark of a successful business. So whether you’re thinking about buying stock in a company, or you want to make sure that a current investment is still a good one, the income statement is a really important thing to look at. Now let’s take a look at how to make the income statement make a profit for you.

What’s an Income Statement?

First of all, the question should probably be “What is income?” For a company, as with an individual, net income is “take-home” pay. That means it’s the money that a company records as profit at the end of “the day.” The income statement is the financial statement that’s used to get to that oh-so-important number. An income statement is also sometimes referred to as a profit and loss statement (P&L) because the net income can either be a profit (positive net income) or loss (negative net income). The term “profit and loss statement” generally refers to something used by managers for internal accounting, not for the financial statements that investors are interested in. As far as the SEC is concerned, it’s called an income statement, so that’s what we’ll call it. Again, a company’s ability to turn a profit is paramount. Who wants to invest in a company that’s losing money? Because of this, net income, the number at the bottom of the income statement (“the bottom line,” see earnings), can have a dramatic effect on a company’s stock price. Why? Revenues – Expenses = Profit! In essence, companies get their profit (or income) by taking their revenues (money they bring in) and subtracting their expenses (money they spend). Despite the complexity in many large companies’ income statements, the same basic principle applies: Revenues – Expenses = Profit. This is generally also the way income statements are set up. There are two basic types of income statements, the single-step and multi-step. Singe-step income statements simply follow the equation of revenue minus expenses equals profit. For example:

Revenue: $100
 

Expenses: ($50)
 

Profit: $50

A multi-step income statement is a little bit more complex in that it differentiates between operating and nonoperating activities. Operating activities are any activities that are core to a company’s business. For example, if you own a clothing store, your clothing sales, store rent and manufacturing costs would all be operating activities. Nonoperating activities are anything else (this typically includes things like investment income or losses) that affects your store’s income.

The Risks of Investing

My father-in-law’s late business partner always said, “The world is in the hands of the risk takers.”

Risk, like volatility , is another one of those investment terms that tend to get thrown around very loosely. Personally, I believe that risk, like beauty, is in the eyes of the beholder. In this edition of “The Finance Professor,” I will explain several basic forms of risk to help prepare you for the next lesson, which will cover how you can manage risk.

 

What Is Risk?

Risk is not a single element but rather a collection of hazards that when taken together expose an investor to adverse consequences. Risk plays a role in many facets of our lives, including our health, our career, our investments and several others. (I will focus in on the investment risk and leave the other risks to other experts.) Every person has his or her own level of risk tolerance. In investment terms, increased levels of risk usually imply greater potential for financial benefit. We refer to this as the risk/reward relationship. There is good risk and there is bad risk. It’s kind of like cholesterol (LDL vs. HDL). You must factor out the bad risk and focus on the good risk. When you’re able to make this separation, you can ensure that the level of risk that you assume falls within your comfort zone. As an individual investor, some basic risks you should be cognizant of before and after you make any investment decision are:

  • Market risk
  • Systemic risk
  • Interest rate risk
  • Credit risk
  • Counterparty risk
  • Sovereign risk
  • Estimation risk
  • Extrapolation risk

 

Market risk:

This form of risk represents your exposure to the overall market. For example, if the S&P 500 were to go up and your portfolio would also rise, then you have market risk to that particular index. What gives rise to market risk is something that we call beta. Beta represents a stock or portfolio’s correlation to an index. (For those readers more statistically astute, beta is the correlation coefficient derived when performing a regression between a stock/portfolio and an index.) In other words, for every 1% movement in the index, your stock or portfolio would rise X%. Beta is typically displayed as a unitized number. Thus, a beta of 1.5 means that for every 1% move in the index, your investments would increase 1.5 times 1% or 1.5%. While I used the S&P 500 as an example of the market portfolio, your individual portfolio might more closely track the Dow Jones Industrial Average, Nasdaq 100 or Nikkei 225.

 

Systemic risk:

This risk is associated with a complete breakdown of an economy, market or segment thereof. Examples of systemic risk include the Great Depression in 1929, the Arab oil embargo in the 1970s, the Latin American debt crisis of the mid-1990s, the Russian financial crisis in the late 1990s, and the Asian contagion in the late 1990s. A systemic risk is the most formidable danger posed to an investor because of the difficulty or inability to predict its occurrence and manage its outcome.

 

Interest rate risk:

Exposure to all or part of the term structure or nature of interest rates will create financial danger to an investor. There are two aspects to these risks. First is the term structure. Interest rates are quoted based on time to maturity. Yield will vary by maturities, thus creating what we call the yield curve. The second facet of interest rates is the fixed and floating aspect of those rates. Fixed-rate investments will yield the same rate for the entire duration of the investment. Floating or variable interest rates will fluctuate over time. Interest rate risk will affect both lenders (bond buyers or mortgagees) and borrowers (such as mortgagers). Finally, while interest rate risk has a direct impact on fixed-income investors, there is only a secondary effect on stock investors.

 

Credit risk:

Not all companies have an equal ability to repay their debt. Credit worthiness is quantified by credit rating agencies such as Moody’s , Standard and Poor’s and Fitch. Each agency will carefully review a debtor’s balance sheet, cash flow, income statement, contracts and debt covenants to ascertain that company’s ability to repay its debt. Typically, the highest credit rating of AAA is given to the most creditworthy companies. This is followed by AA then A then BBB and so on. There are some variations between credit agencies such as use of smaller case letters or minus signs. There is a further delineation between investment grade and noninvestment grade. Investment grade is typically BBB-minus or better, and non-investment grade is typically BB-plus or worse.

Know more about a balance sheet

The company has a superb balance sheet… The balance sheet is solid… The balance sheet remains steady…The balance sheet. When it comes to stock analysis, it’s something that’s referred to a lot. But why?

Simply put, the balance sheet is one of the most important financial documents you can use to evaluate a company’s fundamentals ( “Getting Started: Fundamental Analysis” ). As one of the principal corporate financial statements, the balance sheet’s job is to essentially tell investors where a company stands financially. The balance sheet consists of two main sections: first, assets (usually presented on the left) and second, liabilities and shareholders’ equity (usually presented on the right). A company’s assets consist of anything it owns that has real financial value. The liabilities and shareholders’ equity (also known as owners’ or stockholders’ equity) section represents the ways that those things were paid for. Liabilities are anything that a company owes to someone else; bank loans and bond issues are common examples. Shareholders’ equity consists of the company’s stock (the kind you might have in your own portfolio) as well as the income the company holds onto from operations, called retained earnings. Each of these — liabilities, stock proceeds and retained earnings — can be used to purchase the assets listed in the other section of the balance sheet. Assets = Liabilities + Stockholders’ Equity The above accounting equation is what makes the balance sheet balance. It’s one of the original concepts in financial accounting: A company’s assets are equal to its liabilities plus its stockholders’ equity. It makes sense. Think about it: A company can’t buy stuff without taking out a loan or selling enough stock to pay for it. The accounting equation holds true for a business on any scale — even a kid’s lemonade stand. With $10 spent on lemons and sugar and another $5 borrowed from Mom and Dad to paint the stand, a kid’s lemonade stand balance sheet might look a little like this: Assets
Supplies inventory: $10
Property and equipment: $5
Total assets: $15 Liabilities and Stockholders’ Equity
Liabilities: $5
Shareholders’ equity: $10
Total liabilities and stockholders’ equity: $15
Even though the kid spent that $15 on his or her lemonade business, that amount remains on “the books,” both in the assets section (since the drink-making supplies are still on hand until the drinks start selling) and the liabilities and stockholders’ equity section (money the kid put into the company is his or her equity, and the kid still owes Mom and Dad that $5).

 

The Balance Sheet: Assets

Back to the real world and the assets section of the balance sheet: Some common assets you’ll likely see in this section are cash, accounts receivable, inventory, property, plant and equipment and goodwill. Some items, such as cash, are self-explanatory. Other items such as accounts receivable aren’t. Accounts receivable represents liabilities owed to the company in the form of credit sales to customers. Because they’re owed to us, they’re assets in our eyes. Property, plant and equipment (PPE) is the account used to value a company’s facilities. If you own stock in Apple, then its manufacturing facilities, corporate campus and retail stores would typically all be included under PPE. Assets are classified as either current or noncurrent. Current assets are readily convertible to cash or will be used up in the course of one business cycle (one year for most companies). Noncurrent assets, such as land, are those that are going to stay on our balance sheet a little bit longer. These classifications hold true for liabilities as well. But can you ever have too many assets? Possibly. Remember that every asset has to be paid for with either a liability or stockholders’ equity. If a company is buying superfluous assets with massive debt or stock issues that devalue the holdings of current investors, it’s probably best to steer clear of that company.

A Cash Flow Statement

Cash is the lifeblood of most companies, and many a company has crumbled from a lack of it. Why is it then that the statement of cash flows is probably the least understood of the big three financial statements ( “Getting Started: Fundamental Analysis” )? It’s time to get in the know about cash flow.

 

What Is Cash Flow?

Simply put, cash flow is the movement of cash into and out of a company. This is significant, because cash coming into a company during, for example, a given year isn’t necessarily the same thing as revenue. The statement of cash flows eliminates this difference, taking us back to the actual movement of cash. This difference is caused by accrual-basis accounting (in comparison, see cash-basis accounting). Under accrual accounting, revenue and expenses are recognized when the work has been performed — not when the cash is paid or received (for more on revenues and expenses, see “What Is an Income Statement”). Because of this, it’s not uncommon for companies to book revenue long before the bank ever sees a single cent.

 

Classifying Cash Flows

The statement of cash flows divides these cash transactions into three different sections that tell investors what the transaction (known as an activity) was related to: operating, investing and financing. Each of these sections can tell you a story about how the company is doing, both from a cash standpoint and in terms of its overall health.

 

Operating activities:

The operating section of the statement of cash flows tells you how cash changed hands as a result of a company’s operations. Anything that’s involved in what a company does to make money (for example, a shirt manufacturer making shirts) is considered an operating activity. Unlike operating items on the income statement, the operating section includes things such as dividend income and gains or losses from the sale of investments. Even though such items are not part of operations per se, they’re included in this section because they’re part of the company’s income. As an investor, you’ll want to see two things in the operating section: Cash inflows and cash outflows. Sure, a company that doesn’t have outflows sounds nice; lots of money coming in, none going out. But business is cyclical: Goods get sold, and materials get purchased to make more goods (and so on), so any healthy company should have a reasonable amount of both money coming in and money going out. Naturally, though, a positive net operating cash flow is a good sign.

 

Investing activities:

Like you, companies invest to make money. Unlike you, not all of these investments are in other entities; a company also has to reinvest in itself. For a company to grow, it has to spend money on upgrading things such as facilities, equipment and staffing — all of these cash flows are found under the investing section. Companies do often invest in stocks of other companies, and this also belongs in the investing section. But while the profit made from selling a stock might look like an investing activity, it’s not. The actual initial investment is an investing activity, but when the stock is sold, the gain is income, and it counts as an operating activity. The investing section of the statement of cash flow doesn’t necessarily have to have a positive net cash flow to be in good shape. Since spending money (cash outflow) helps the company in the long run, it’s perfectly acceptable to see a negative number at the bottom of the investing activities section.

 

Financing activities:

When companies need more money than they currently have, they raise it by engaging in financing activities. Financing generally comes in two forms: equity (stock) and debt (bonds). Each source of financing in any given period is listed in this section. Also included in the financing activities section are the dividends you receive from the company as a shareholder. Since you’ve taken a role in financing the company by buying stock, companies that pay dividends view their payment as a sort of cost to maintain your financing in the company. Generally speaking, you’ll see more financing inflows at newer companies that are growing at a faster pace than more-established ones. Remember, those investing activities may grow the company, but they also take a whole lot of cash — that’s why they’re often paid for through financing. Net Cash Flows = Cash Position The net cash flows at the bottom of the statement of cash flows are the sum total of the effects of operating, investing and financing activities on a company’s cash position. A strong cash position is important because it can say a lot about how liquid the company is and how secure its future is if it begins to fall on some tough times ( “Booyah Breakdown: Liquidity” ). When money’s not coming in, companies that can’t support themselves with cash and other assets often face the chopping block. A decent amount of cash on hand can help ensure that this won’t be the case.

 

Analyzing Cash Flows

Even though the statement of cash flows is less popular than its siblings — the income statement and balance sheet — it’s probably the easiest financial statement to look at to from an analysis perspective. The statement of cash flows is a relatively simple document to understand. It tells you straight up how much cash a company spent (outflows) and how much cash it has (inflows). Naturally, when cash inflows are greater than outflows, it’s a favorable situation for a company.