Learning How To Speak The Business Language
Hello everyone! This is the second installment of my three part Investing series. If you are just now checking in, please read the first installment here.
All of you are ready to invest. You made the choice to be a Smart Military Investor and you have been equipped with the definition of Value Investing. Before you dive in prematurely into the stock market, do you even know the language that CEO's, company executives and stock brokers speak? See! I thought so.
Investing takes time and practice, but most importantly it takes the ability to be literate in the language of business. In this post, I'm going to break down the Business Language to you in a way you probably never heard it before. I am going to spare you the high level accounting jargon and just have you focus on the cues that make us Smart Military Investors so good at understanding what businesses are trying communicate to us.
First thing first, what is the Business Language? Is it some secret society that requires a MBA to get in? Well, no, it isn't. Contrary to what the Big Whigs on Wall Street want to lead you to believe, the Business Language is rather simple. So simple that you only need to be familiar with these three things: The Balance Sheet, The Income Statement, and The Cash Flow Statement.
A clear understanding of those three statements will help you deploy your Value Investing techniques with precision. Let's get started.
The Balance Sheet
The balance sheet is a summarized document of a company's assets, liabilities and owner's (shareholder) equity. Assets are what the company owns. The liabilities are what the company owes. And owners equity is the total capital investors have put into the company.
These three entities make up components to the Accounting Equation:
ASSETS (own) = LIABILITIES (owe) + OWNER's EQUITY(investors capital)
As you can see the assets must balance out to equal the sum of the liabilities and ownership equity. That's why it's called the balance sheet. If you are following me so far, then you almost have a third of the Business Language down pat.
When looking at a company's balance sheet you need to focus on a few cues. First, in the assets portion, you need to take a look at the Accounts Receivable account. This is the account that displays the amount of money a company can and should collect from its customers. The catch to this account is the company physically hasn't received the money. So yes, it is an asset by definition, but it isn't necessarily a good asset. Are you ready for your first Business Language cue?
If the accounts receivable total has increased much faster than sales, then there is a red flag with the company. Here is a quick example:
ABC Company 2015 Q1:
Revenue: $1,000,000 (found on income statement)
Accounts Receivable: $50,000
ABC Company 2016 Q1:
Accounts Receivable: $100,000
Quick Note: You should always compare the same quarter year over year. For example, if you are analyzing the first quarterly statement of a company in 2016, you should be comparing that statement to the first quarter of the prior years. You can go one year back or five years back, just make sure you using the same corresponding quarter.
Whoa! You see what happened there? The revenues are the same but the Account Receivable doubled. This could mean a multitude of negative things. It could mean that this company has a problem collecting payments from its customers. If this trend persists, the company, which still seems to keep up its revenues, will run out of money. This could potentially lead to companies getting into bad debts. Stay away!
The next cue is the accounts payable. This the account is displayed in the liabilities section of the balance sheet. This account is what the company owes. The cue is simple. If the accounts payable account is increasing quarter over quarter or year over year, stay away. That company has issues paying their bills. There is no long term value in companies that does not have control of their liabilities.
We are still on the balance sheet and we focused on the accounts receivable and accounts payable. If you are lost, don't worry. Just sign up for a free consultation and I'll be happy to answer all of your questions.
On to the next cue! You want to look at the cash account. The company should have enough cash in their assets to cover the short-term debt in liabilities. On the balance sheet, it will differentiate between short and long term liabilities. If the cash account is too low and can't cover the short-term debts, then you know the company runs on too much debt. Stay away!
Next, if year after year the cash account goes higher, but the liabilities total stay relatively the same, this could mean the company has problems with management. Why would you own a business that has cash rolling in and fail to use that cash? Management is showing that they do not want to expand the business. No expansion means no opportunity for growth. No growth means no value. No value means, STAY AWAY!
Now take a look at the companies inventory account. The potential problem here is if the inventory figures are too high the company could have these two problems. First, where are they going to put that increasing inventory? Storage costs money. When a company's cost of business increase, they tend to lose stock value. Paying to store inventory is a great way to increase business costs. Stay away folks.
Secondly, their inventory has been rising but the sales have been stagnant. This is a huge red flag. They are not finding new customers. The Business Language is screaming at you to stay away, but are you listening?
The last cue on the balance sheet is probably the most abstract, but it's important to know. Look at the company's intangible asset account. Yes, I said intangible. The things you cannot see or touch. In business, this account represents the brand names, patents, logos and slogans. Huge, well-known companies like Coca-Cola have large intangible asset accounts. This means their brand is worth a lot. Look for companies who have increased their intangible assets. This could be the difference between buying a future household name and buying a company that won't survive the next economic down period.
The income statement summarizes all business operations. How much service are they providing? How many products have been moved? What amount of taxes do they pay? What are the costs of operating the business? All of these questions are answered in the income statement.
There is only one cue here and that is the earnings per share. Every business has a certain amount of shares the public can buy. Those shares are typically called shares outstanding. The EPS puts a numeric value to each of the company's outstanding shares. It takes the net income and divides that amount by the total amount of shares the public can by. For example, if a company has $10M in net income and 500 million outstanding shares then the EPS is $0.02 per share. Don't worry you shouldn't ever have to do that calculation yourself. Most companies do them or you can find them on sites like Yahoo! Finance.
For Smart Military Investors, we want companies that increase their EPS's year after year. That means their shares are increasing in value.
Now don't get EPS confused with the stock price. It's possible the stock price stays the same but EPS has been skyrocketing. That could mean the public sentiment towards stocks are low but that company is still churning out income similar to how Ezekiel Elliot eats up yards on the football field.
A situation like this could mean the stock is undervalued and its a great time to buy.
If the EPS has been stagnant or is trending down, then stay away from that company.
The Cash Flow Statement
This statement summarizes how a companies cash flows in and out.
The single cue from this statement comes from the Free Cash Flow amount. A company sells or provides services for cash, they also get cash from us investors, and, lastly, they spend cash to finance their company. The free cash flow amount is the amount of cash after all their business is complete.
Think of the FCF as a company's fun money. This allows them to pay investors dividends or expand business operations. The cue is simple. The FCF needs to increase from year to year. If not, then you guessed it, stay away!
Wow! You guys are amazing. You made it this far and showed me you really want to learn. Guess what? If you understand everything in this post you now understand the Business Language. You can read companies financial statements and be able to understand how well their respective companies run.
Stay tuned for my next post. It will detail how my service can help you unlock the budding investor that's growing inside of you.
Please, do me a favor and share this with your friends and family.