LEARN HOW TO INVEST

GUIDE FOR BEGINNERS: Module 6

Michael Santos Presents

HOW TO UNDERSTAND FINANCIAL STATEMENTS

Learn how to understand financial statements to become a better investor.

Learn how to understand financial statements

Learning how to invest requires that you learn how to understand financial statements. Financial statements help investors determine the merits of an investment. As investors, we must understand how to read balance sheets, income statements, cash flow statements, as well as other charts that give us a snapshot of the investment. 

In this chapter we will continue to use Liberty Hot Dogs as a case study to help us learn: 

  • How to understand a balance sheet
  • How to understand an income statement, or Profit and Loss
  • How to use financial statements to assess health of an investment

Liberty hot dogs balance sheet

So let’s recap where we stand. As founder, I formed Liberty Hot Dogs as a corporate entity by filing appropriate paperwork with the state and federal government. When I established Liberty Hot Dogs, I kept 1,000 shares and I sold 500 shares to Frank, an investor, to raise capital. All shares were valued at $1 per share.

Liberty Hot Dogs also raised $250 in capital by borrowing money from Tom. Liberty Hot Dogs issued Tom a note, pledging all corporate assets as a guarantee for the loan.

We have not done any business yet, but we need to account for the assets and liabilities of the corporation. A balance sheet will help us keep track of where the corporation stands. At the start, a balance sheet would look something like this:

Assets:

  • Cash Deposits:
    • $750
  • Good will:
    • $1,000
  • Total Assets:
    • $1,750

Liabilities:

  • Note Owing:
    • ($250)

Equity:

  • Shareholder Value
    • $1,500
  • Equity per share:
    • $1

Frank and Tom invested in Liberty Hot Dogs so the company could become an operating business. As founder, it was my responsibility to execute the business plan and perform. I would need to redistribute those assets.

To start the business, I used the corporate resources to invest in a hot dog stand. I also purchased inventory that included hot dogs, buns, condiments, and serving napkins. The cost of those investments follows:

  • Hot dog stand: $300
  • Inventory: $200
  • Total investments: $500

When I made those investments, I adjusted the balance sheet to reflect how the assets of the corporation had changed. The balance sheet tells a story of how well the leadership of the corporation is using resources.

CATEGORIZING ASSETS

It’s important to note that not all assets are equal. Some assets are cash, or easily convertible to cash. We call those current assets.

Other assets are not so easily convertible to cash and they may depreciate in value over time. We need to account for that depreciation when we create the “income statement,” which we will cover next.

We record depreciation as a non-cash charge, because although we haven’t spent the money, we must retain money to replace the fixed asset some day. The hot dog stand would be an example of a fixed asset. We need the hot dog stand to operate our business. But we anticipate that we will need to replace the hot dog stand in five years. So we will give the hot dog stand a useful life of five years, and each year we will record a $60 non-cash charge on the income statement to depreciate the asset. Although we won’t spend the $60 in depreciation each year, the charge will count against our income, or profit statement.

Another type of asset is inventory. We will use the inventory to operate our business. Theoretically, by using the inventory, we will generate a profit.

After we make the investments, our balance sheet will reflect the change:

Current Assets:

  • Cash Deposits:
    • $250
  • Good will:
    • $1,000

Fixed Assets:

  • Hot Dog Stand:
    • $300

Inventory:

  • Hot Dogs, buns
    • $200

Total Assets:

  • $1,750

Liabilities:

  • Note owning:
    • ($250)

Equity:

  • Shareholder Value
    • $1,500
  • Equity per share:
    • $1

SHAREHOLDER EQUITY

Although shareholder equity remains the same, the balance sheet shows that I have made investments in the company. That investment allowed me to begin operations. And with those operations, I was able to generate revenues by selling hot dogs. 

As I sold hot dogs, Liberty Hot Dogs brought in money, but it also had some expenses to fund operations. We’re going to keep this financial statement simple by making some assumptions as we track the first year of operations for Liberty Hot Dogs. Let’s assume the following: 

 

  • We sold hot dogs for $1 each
  • We sold 800 hot dogs over the course of the year
  • We had labor costs of $530

INCOME STATEMENT (P&L)

Based on the business operations stated above, we can now create a second part of the financial statement. It’s known as an income statement or a P&L, which is short for profit and loss. The income statement tells us how well the business is performing. We can use that information to assess the value of our investment. 

Our income statement highlights the following: 

Revenue:

  • Hot Dog Sales:
    •  $800
    • We sold 800 hot dogs at $1 each.

 Expenses:

  • Labor:
    • ($530)
  • Cost of Goods Sold:
    •  ($200)
    • This assumes that we used our inventory.
  • Depreciation:
    •  ($60)
    • This non-cash charge accounts for the value loss of the hot dog stand, because we’ll have to replace it in five years.
  • Total Expenses:
    • ($790)

Gross Profit, before interest and taxes:

  • Revenues-Expenses:
    • $10

Our income statement shows that we didn’t make much money. If we divide the gross profit by the revenues, we see that we only have a 1.3% gross-profit margin. 

But remember that we owe $25 in interest to the debt holder. We need to take that money as an expense, too. That interest expense will turn our gross profit into a net loss. 

Interest expense:

  • ($25)

Net Profit (Loss):                  

  • ($15)

As a result of the fact that we lost money, we do not have to pay any tax.

USE FINANCIAL STATEMENTS TO ASSES HEALTH OF INVESTMENT

As investors, we can look at the balance sheet and the income statement of Liberty Hot Dogs to assess how well we’re doing. We lost money. If we take the net loss, and we divide that by the total number of shares outstanding, we see that each share lost about 1 penny in value. 

What should we do about this investment? 

Should we close shop and move on? Or should we continue with the business plan? In the next chapter, we will continue learning from the case study of Liberty Hot Dogs.

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