Accounting sounds boring, but to actively invest in stocks, we need to be able to
understand what a company is made of, and how its operations affect those components. There
are three financial statements that every publicly traded company reports.
The income statement looks at how the company makes money. The top line is
revenue , all money made by the company for selling a good or service. After subtracting the
direct costs of that good or service (such as the cost to buy inventory from a supplier), gross
profit is calculated. Subtracting overhead costs (SG&A) like rent for headquarters and
marketing yields the operating income. Operating income is also known as EBIT, or earnings
before interest and taxes. Subtracting interest and taxes from operating income yields net
income, the bottom line of the income statement, and the profit that the company has managed
The cash flow statement looks at how the company created or used money during a
certain period. It is broken down into three main parts: cash flow from operations, investing, and financing.
Cash flow from operations includes net profit generated by the company. Cash flow from
investing includes any transactions with assets, like buying a new factory or selling stocks. Cash
flow from financing includes what the company did to raise money, such as issuing debt. The
bottom line of the cash flow statement is the total change in cash over a period.
The balance sheet is a static representation of the company at any point in time. It will
tell you how a company consists of, but not what the company is doing or has done in order to
generate profits. The balance sheet has three main portions: assets, liabilities, and equity.
Assets are things that the company owns and operates, like factories, money, or
inventory. Because assets are worth a certain amount of money, the company must somehow
obtain money to acquire these assets. In general, a company has assets in order to generate a
return from them, since the goal of every company is to generate a return for its owners. For
example, a steel company owns factories in order to produce steel and make a profit by selling it.
The two ways that companies can raise money are through liabilities and equity. Liabilities are things that the company owes, such as debt. When a company takes on debt, they receive a certain amount of money (called a principle) with the understanding that they will pay back the principle and a little more in the future. A company can also raise money through equity. If a company wants to raise more money, they can go to investors, who will give them money in exchange for ownership over a portion of a business. In this way, everything that a business owns is financed through equity or liabilities.
If taking on more liabilities allows a company to buy more assets, then why are liabilities
generally known to be bad? Taking on too many liabilities may be risky for a company. Think of
liabilities as a loan; the company will eventually need to pay back the entire value of the loan
plus some interest to make it worth it to the lender. If a company takes on too many liabilities,
they might not be able to pay off all the interest. If this happens, then the company defaults.
The ability of a company to pay off its debts is measured by its liquidity. Liquid assets
are assets that can be readily converted to cash, like stocks. Since interest payments
are made in cash, if a company is extremely illiquid, it won’t be able to pay off its debt.
The measure of how much debt a company takes on is leverage. A highly leveraged
company has taken on a lot of debt compared to its equity. A common ratio to measure this is its
debt/equity ratio. A balance sheet always balances by having assets = liabilities + equity.