Investing 101

People who invest in stocks look at a number of measures of a company’s performance. Some look at charts to see how stocks are training. Some use sophisticated algorithms to predict market cycles. At the minimum, everyone look at balance sheets, income statements and cash flow.

1. Balance Sheet

A balance sheet in common parlance is just the assets a company has. From an accounting perspective, there are many more details of value but from a simple perspective a balance sheet is just the net cash a company has on hand. Think about a chocolate pretzel stand. Your daddy gives you $100 to start one. After 3 weeks, you have burned through $50 dollars on advertising, chocolate, pretzels and a stand. At that moment on your 22nd day, given that the residual value of your chocolate, pretzels and stand is $2, your balance sheet should show something like $52 of tangible worth. You have $50 in cash, presumably no liabilities and $2 in net recoupment in scrap if and when you go out of business.

2. Income Statement

While a balance sheet is a snapshot at any given moment of time of what you have, an income statement is a video movie of how you’ve done. Your chocolate pretzel stand sold 100 pretzels last month at $1 each. It has $40 in chocolate costs, $15 in pretzel cost and $10 in signage rent. Without paying yourself any salary, you have $35 in pre tax operating profit. Welcome to your first income statement. When you are a looking at a company’s income statement, it doesn’t take a rocket scientist to figure out that you should look at trends over time.

3. Cash Flow

Continue with the chocolate pretzel stand. You pay yourself $10 for salary and you’ve bought a stand for $25. Thus far your income statement shows you have 0 profits. The $100 of revenues is exactly offset by $100 of expenses. You predict that next month you will have the exact same sales results but next month is a much happier month. Why? Because you don’t need to rebuild the chocolate pretzel stand from scratch. In month 1, you spent $25 to build that stand. It sucked the remaining cash out of your bank account. But, in month 2 you don’t need to build it again and voila you have $25 in cash profits or cash flow from a business that is suddenly sweetened from all too sour.

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