Investor?s Guide to Financial Accounting

When people decide to invest in anything the first question they ask is, “how much money will I make from this investment opportunity?”  The multitude of investment options has made it more difficult for the average investor to calculate risk and determine the best investment for their money.  Bank deposits with conservative returns have evolved into certificate of deposits, mutual funds, hedge funds, futures and options to name a few.    Fortunately there are many resources available to help navigate these difficult waters.  Instead of using costly professional advice or independent analysis from resources like Morningstar, we will begin to invest with confidence using financial accounting to drive our decisions.

Accounting is the process of identifying, measuring and communicating economic information so users of accounting can make informed decisions about a company’s performance.  There are many types of users of accounting from management focused on day to day operations to investors focused on future cash returns.  Investors should focus on a company’s past performance because there is a strong correlation to future success.  Financial accounting provides investors with historical results of a company through financial statements.  These financial statements include the balance sheet, income statement, statement of cash flows and statement of owner’s equity.

The balance sheet provides details about a company’s assets, liabilities and owner’s equity.  Unlike the other three financial statements, the balance sheet is for a point in time.  Most balance sheets are done at the end of a company’s fiscal year to show the company’s financial position at that point in time.  The most important thing to look for when investing in a company is its assets are greater than liabilities.  According to the accounting equation, assets = liabilities + owner’s equity, if assets are greater than liabilities the owner’s have positive equity in the company.  If the company were to liquidate its assets and pay off all of its liabilities there would be money left for the owners to recoup some if not all of their investment.  A positive trend in owner’s equity is a strong indicator of a sound investment.

When investing, it is important to focus on companies that have the assets necessary to remain in operation.  Both positive working capital and a current ratio greater than 1 are strong indicators of this.   Working capital is current assets minus current liabilities.  Positive working capital means a company has the necessary working capital to reinvest in its operations and drive future revenue.  The current ratio, current assets divided by current liabilities, shows that a company has the necessary current assets to pay for current liabilities and remain in business.   A current ratio of 2.0 is a good rule of thumb for adequate liquidity.  This shows that a company has two times the necessary current assets to pay off any current liabilities.

The income statement is another key indicator of a company’s past performance.  At the end of its fiscal year a company will determine its profit or loss by calculating its net sales and subtracting the expenses necessary to achieve those sales.  Net income shows that a company is profitable.   A positive trend in net income over time means a company continually performs well and is a strong indicator of future success.  Net income shows up on the Statement of Changes of Owner’s Equity under retained earnings.  It is this money that is available to investors through cash dividends.

The Statement of Changes of Owner’s Equity as mentioned above details the total owner’s equity for a period of time.   Over time an investor would like to see a positive trend in owner’s equity.  This shows an investor that throughout the fiscal year there is an increase in owner’s equity through retained earnings.  These earning are available to reinvest in the company and make it stronger in the future.

The Statement of Cash Flows identifies the use of cash by a company during the fiscal year.  This details the cash flows from operating activities, investing activities and financing activities.  It is impossible for a company to survive over time with negative cash flow therefore it is crucial to review the trends in this statement to make sure the company has positive cash flow over time.  The ending cash balance detailed in the Statement of Cash Flows becomes part of the Assets in the Balance sheet.  Consistent reduction in cash will reduce the owner’s equity and in turn reduce a return on investment.

The statements detailed above are critical pieces in making sound investment decisions.  Understanding these documents combined with your existing resources for investment decisions will make you more proactive in your investment decisions and help mitigate risks in your portfolio.

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