As a serious investor, you cannot buy a stock of a company before you have looked at its financial statements. It’s just rude. 🙂
The biggest mistake beginners make is just that, they buy stocks from companies and have never seen the financial statements. As a blind date. I doubt you would have married someone without getting to know each other well before. You don’t make a wedding decision based on an article or a newspaper picture and you can’t buy a stock based on it.
Such investing is tantamount to financial destruction and can only be afforded by stock traders (derogatory called speculators) who don’t care about the real value of the company they don’t even care what the company is called but just speculate which stock might rise and then buy it. It has nothing to do with investing and that is not the subject of this text.
The two most important reports compiled by all companies are the Balance Sheet and the Profit and Loss Statement (P&L). These are two documents, reports that seem to have nothing to do with each other. They are linked by a single figure that is copied from the income statement to the balance sheet. It is the net profit or loss for the current year. That is the only obvious connection.
When you understand the independence of these two documents you will be able to assess much better which company is undervalued or overvalued. Namely, it is necessary to look at both documents and then draw conclusions.
What is a Balance Sheet?
A balance sheet is literally an image (financial photograph) of a company on a particular day. Most often it is 31.12. every year. That picture only tells us what the company “looks like” on that day. The very next day the company would look a little different. A company is a living organism that is constantly changing, new invoices are constantly being issued, new jobs are being done, invoices are coming, salaries are being paid. All these changes are recorded in the accounting and then a balance sheet is prepared.
The balance sheet as a report shows the balance of assets, liabilities, and capital of the company on a particular day. It consists of two sides: assets and liabilities that are always equal. Assets contain assets, while liabilities contain liabilities and equity.
The assets or assets of the company are: machines, computers, cars, software licenses, material in stock, shares we bought, money in giro and foreign currency accounts, and all other assets of the company, including various receivables.
What are receivables? These are, for example, issued and uncollected invoices to customers and we call them trade receivables. In addition to customers, we can demand money from the state, employees (if they stole something from us or we paid them too much), other institutions, etc. We demand money from them. The assets are quite simple and understandable.
Liabilities in a way tell us whose assets (assets) or who is its “owner”. Understand this conditionally because ownership is something completely different. Liabilities consist of liabilities and equity.
Liabilities are all that a company is obliged to pay to others. These can be bank loans, payroll obligations to workers, tax liabilities, VAT, and trade payables. These trade payables are the opposite of trade receivables – these are invoices that we have received and have not yet paid.
Capital is in fact just the difference between assets and liabilities. C = A – L.
Capital consists of several items: subscribed (share) capital, reserves retained earnings of previous years, and profit/loss for the current year. If the company has previously made a loss then instead of retained earnings we have a loss carried forward.
Take the company you just started as an example. You paid USD 20,000 in share capital and founded your own company. Here is her picture.
What is its book value (BV)? How much would you pay for the company? If it were sold for $10,000, isn’t it obviously an undervalued company? Pay $10,000 for a company that has $20,000 in its bank account and has no obligations.
On the other hand, if someone wanted to sell me this company for $40,000, I would wonder what is so special about it. He may have signed a contract with a large company and secured the sale of his goods, and he will make a profit of USD $100,000 in the next year.
Maybe the company got free or very affordable office space to use from the City. Maybe it has a great name (title) that I really like and I’m willing to pay more for it. Some pay more for a special car registration number or phone number. These are just some of the things that are not seen in the balance sheet. There are many other things that are NOT visible from the balance sheet and that is why we need other reports, such as the income statement.
Profit and loss statement (P&L)
This is a report that shows us all the income and expenses that the company had in one year and at the end whether it made a profit or a loss. This profit is then reduced by tax and transferred to the Balance Sheet to the current year’s profit position. It’s a pretty simple report to understand, but I’m very interesting.
Total income is everything that a company has earned either through the sale of its goods, services, or fixed assets, including income from interest, loans, exchange rate differences, investments in other companies, and the like.
Total expenses are all that the company has spent: workers’ salaries, materials, raw materials, profit tax (but not VAT), company tax, bank fees, telephones, internet, DEPRECIATION, etc.
Depreciation is particularly interesting and deserves a special text and is I will not explain in more detail here. Just remember that fixed assets that cost more than 2000 without VAT are not recorded immediately under expenses but are gradually depreciated at certain rates. Instead of entering the expense of $2,000, we enter, for example, 25% of that amount over the next 4 years, ie $500 is our annual depreciation.
Profit and loss account for the period 01.01.-31.12. some fictional companies look like this (in 000 USD):
The company made a net profit of $220,000.
Is that good or bad? – we don’t know until we see how much she earned last year. Maybe the profit dropped significantly and the total income remained the same then that’s bad. On the other hand, maybe last year the material costs were much higher, and this year the company managed to reduce them and make more profit and then that’s good.
As you can see by the item names the profit and loss account has little to do with the balance sheet. A company can have huge assets and a large balance sheet, and it can make very little money and do bad business. Imagine big well-known companies that have huge buildings, branches all over, and are operating at a loss.
The reverse is also true. Someone can earn millions of dollars a year with one laptop. His balance sheet (assets) can be peanuts compared to the income and profit he makes. That is why it is very important to know both reports well.
You have to look at the last few years to analyze any report that you can compare them and see what the trend of the individual items is. The figure alone does not mean too much and we can only draw the right conclusions when we compare certain items of the balance sheet and profit and loss account and their interrelationships.