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Pt. 2: Income Statement Ratios and Breakdown

Last week’s post had a simple explanation about the income statement and why it is important for investors. This part 2 is intended to expand on that, to explain more about the helpful income statement ratios and provide a line-by-line breakdown of this financial statement.

income statement ratios

Like I said before, the income statement is one of 3 important financial documents that each publicly traded company is required to file. These are:

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

What’s important to realize is that the balance sheet makes for a great LONG TERM indicator of company health, while the income statement publicizes the SHORT TERM health of a business. Ideally, I only invest in stocks with great financials in both of these. Finally, the cash flow statement explains what happens to excess cash that was made in the short term and where it exactly goes.

Income Statement Breakdown

Let’s now look at an example income statement from a real company, and I’ll go through a detailed line-by-line analysis. After reading this you should be able to take any income statement from a company’s 10-k and understand what the numbers are saying. [click to continue…]

Debt to Equity Ratio Example: RadioShack’s Demise

The situation with RadioShack is the perfect lesson about debt to equity ratio. I think they will be bankrupt soon. Don’t take my word for it though, here’s why I think RadioShack is the perfect debt to equity ratio example of how not to run a company.

debt to equity ratio example

The debt to equity ratio is a quite simple formula. It’s a great indicator for how risky a stock is, and I’ve written in length about this subject. For those of you who are unaware, here’s the formula:

Debt to Equity = Total Liabilities / Shareholder’s Equity

In the above equation, shareholder’s equity is also calculated in a very simple way. You can look it up in the official annual report, or you can just take a company’s total assets and subtract their liabilities. It’s just a measure of how much assets a company has compared to their liabilities.

As a shareholder, you most certainly want to see equity. You can even argue that a company without equity is useless. I mean, sure it might produce profits, but obviously they haven’t made much progress yet towards building a solid financial foundation. If you want to speculate on these kind of companies be my guest, but I’d prefer to invest in the stock with a fortress of a balance sheet.

Debt to Equity Ratio Example: RSH

All of this explanation leads us to today’s troubled stock: RadioShack (RSH). I’ll show you exactly how dire their situation is right now, and it’s a big part due to their debt to equity.

As you’ll soon see, this company’s equity has quickly eroded at a sickening and destructive pace. This destruction of equity in turn causes their debt to equity ratio to skyrocket, but it doesn’t stop there. [click to continue…]

Simple Income Statement Analysis for Stocks

Last week I taught you about the importance of balance sheets, and now it’s time to shift gears into income statement analysis. The income statement is also called the “consolidated statements of operations” or “consolidated statements of income” in the official annual report. It’s also loosely referred to as the P&L in the corporate world, or the “profit and loss” sheet.

The income statement is a crucial part of analyzing a stock. Even if a company has a solid balance sheet doesn’t mean you can automatically invest and figure to be successful. The company must also be currently profitable if you want a good chance at continued success. Just look at any stock that used to be strong and then went bankrupt, it happens all the time when a company’s main product becomes obsolete. What you’ll see is that the lack of sales will affect the income statement first, and then eventually carry over to the balance sheet. You don’t want to wait around and have to endure the damage.

income statement analysis

Now there are just two crucial numbers that we must take a look at for income statement analysis: net sales (also called revenue) and net earnings (also called net profit). Both tell us a story about how the company is doing.

Net earnings is #1. This is what makes Wall Street go ‘round. Don’t let anybody tell you otherwise, but at the end of the day net earnings determines success or failure. Sure there are times when the market becomes irrational and puts less emphasis on earnings, and this is usually a good indicator that the market is about to crash.

Net earnings are so important because without them, companies couldn’t pay shareholders. Sure they could issue some short term debt, but they wouldn’t be able to pay shareholders consistently without net earnings. Companies wouldn’t be able to reinvest in their own businesses without net earnings (again, in a sustainable way). Without payments to shareholders, shareholders have little incentive to take on so much risk. Thus, the whole concept of the stock market would collapse if companies didn’t have positive net earnings.

How the Statements Fit

If you look at the 3 financial statements (income, balance sheet, cash flow) and understand their relationships, you’ll better get how it all fits in. First is the P&L (income statement). Sales go in, expenses go out, and the remainder is the profit. The profit then shows up in the cash flow statement. It’s cash we have on hand. If that cash goes back to shareholders, or is used in any other way than buying assets, it gets deducted here. Finally, some of that cash is used to buy assets, reinvesting in the business and helping it grow. That’s when you’ll see it show up in the balance sheet. The balance sheet also accounts for any debts we’ve accrued as well.

So that’s how the 3 statements are all related. The P&L shows us how the company is doing RIGHT NOW, the balance sheet shows us the scorecard of the company LONG TERM, and the cash flow statement details where all the excess cash and profits are going.

The second crucial number of the income statement is net sales. While earnings are crucial, they can be unreliable from year to year. The truth is, you can manipulate earnings from a perfectly legal point of view just based on when you decide to account for certain expenses or revenues or other events. Sometimes these things fall in between years, and so earnings can be jumpy from year to year. Revenue numbers, on the other hand, are harder to manipulate are usually grow at a much steadier pace than earnings. Look at any income statement from several companies and you’ll see that this is the case. Another way of saying that is this: long term success will not happen to a company without a good long term trend of revenue growth.

You need to measure sales as much as you do earnings. Just like all things in investing, you can’t just rely on just one metric. Like with the balance sheet, the most important metrics are those that every single company shares and is required to submit into their annual reports by the SEC, and for the income statement that’s revenue and net earnings.

Now that we know the two most important numbers of the income statement, we must also learn the two important ratios that are drawn from these numbers. Any research with a sliver of credibility will at least consider the following: P/E ratio and P/S ratio. [click to continue…]

Pt. 2: Balance Sheet Equation and Ratios

The last post showed you how simple balance sheets can be. Now we are going to examine a bit further into another important balance sheet equation, as well as a couple of examples to see if we can understand every last detail. If you haven’t seen part 1 of this post, be sure you check it out.

balance sheet equation

So the first thing to understand is that balance sheets will differ from industry to industry. The balance sheet of an insurance company, for example, will vary in the line items from one of a retailer. Their business models are just so different.

But there are 3 important line items that every single balance sheet shares. It’s really the only 3 categories I’ll look at when I am analyzing and comparing stocks. Those 3 are:

1. Total Assets
2. Total Liabilities
3. Shareholder’s Equity

If you were paying attention, these are the same 3 I talked about in Part 1: Simple Balance Sheet Analysis. So of course, we have to know about them because they add up all of the other rows of the balance sheet.

Assets are pretty self explanatory. They are anything that the company owns that has value, and that can be sold for cash. Think of things like inventory, real estate, and even just straight up cash. Yes cash is an asset.

Liabilities are anything that the company owes. Whether that’s short term or long term debt, or accounts payable. Anything that a company is financially responsible for goes in the liabilities section.

Finally we have shareholder’s equity. It’s called shareholder’s equity for a reason, because it is the equity that shareholders are entitled to. Like I mentioned in part 1, this is one of our golden eggs. It’s a very tangible way to see how much value we are getting in a stock.

Balance Sheet Equation

Now I already explained how we can use the P/B (or price-to-book) ratio to find value in the balance sheet with the part 1 post. But there’s another helpful balance sheet equation that we can use to evaluate companies.

This ratio helps us minimize risk. Period. Companies with more debt are more risky, it’s so simple yet so many people forget it. But it’s not just total debt numbers. Instead, it’s all about how much debt does a company have compared to its assets and equity? If we had a way to find this out, we could avoid the riskier companies. [I talk about this in my 7 Steps to Understanding the Stock Market guide].

Debt to Equity ratio tells us exactly this. There’s several ways to calculate Debt to Equity ratio, but I like to use the simplest version. It’s the most useful because it covers our backside in case of strange accounting gimmicks. I use this balance sheet equation:

Debt to Equity = (Total Liabilities) / (Shareholder’s Equity)

Some people just use short term debt to calculate this value, but why do that? Don’t we want to know all of a company’s debt? What if they are just stacking all their debt short term, or long term?

A simplified equation like this one prevents us from getting blindsided by an accounting trick. And it lets us see the whole picture, and get a consistent ratio throughout all companies (this is because the GAAP accounting rules of the U.S. require every company to submit total assets, liabilities, and shareholder’s equity numbers).

As a general rule of thumb we always want a company that has a Debt to Equity of less than 1. Why? It makes sense when you think about… any company with a debt to equity over 1 has more debt than their equity. So if all their debt was called tomorrow, they’d be bankrupt. Is that a situation you want to get in to?

Of course, we are talking about extreme and worst case scenarios, but who really would’ve thought that a big bank like Lehman Brothers would’ve failed? I’d prefer to be safe rather than sorry, and I think you should be too.

Now the one caveat to the debt to equity rule is that many financial companies keep their debt to equity ratios around 10. So they are about 10 times more leveraged than the average company (with a debt to equity around 1). Financial companies are banks and insurance companies.

But just because all the cool kids are doing it, doesn’t mean we should just blindly follow the blind. For example in the insurance industry, I’ve found several companies with much lower debt to equity ratios than 10. All trading in the S&P 500. Don’t be afraid to turn over more rocks.

Proof about Debt to Equity

I realize I can tell you on and on about how good debt to equity ratio is. But it’s better to just show you. So here you go.

Check it out, the debt to equity for several recent big name bankruptcies: [click to continue…]

Simple Balance Sheet Analysis for Stocks

The other day I was talking with a friend about balance sheets. We both work corporate jobs, and he has a degree in finance. There was some confusion about how the money gets accounted for, and it’s a common trip up for people just starting out. We were able to hash it out and he gets it now… if you’re confused about balance sheets then this is the post for you.

balance sheet analysis

If you open any Accounting 101 textbook, you’ll see the same simple equation when balance sheets are explained:

Assets = Liabilities + Equity

My wife took a course on accounting, and seriously half of the questions they would ask you about on the homework and tests just used this one equation. It can get confusing though, because the way that money flows inside a company is not as simple as your personal finances.

For example, if you get paid $2,000… everybody can agree that you now have $2,000 more in your checking account. Maybe you had a garage sale, this still becomes $400 into your checking account. It’s easy to track because it’s all in one place, and your income streams are usually limited in number.

Take a multimillion dollar corporation however, and one single checking account can’t ever be enough. There needs to be payroll accounts, expense accounts, accounts for inventory, accounts for revenue, accounts for profits, accounts to pay shareholders… you get the picture.

So when a company makes a big financial decision, the impact of this decision will depend on several factors such as which financial statement is impacted. Again take a basic example where a company is raising cash by selling some of their real estate. Simple minded individuals like ourselves might look at the situation like we do our checking accounts… “well surely the company must have more money to spend now.”

This isn’t the case though. There are 3 major financial statements that every public company is required to submit. This requirement makes it easier for us to understand how any extra money can be used.

The 3 statements are:
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

Creating cash by selling real estate doesn’t mean the company can suddenly hire 10,000 more people. An asset like real estate belongs in the balance sheet, but the extra cash from this sale will show up positive on the cash flow statement. You see, the cash can only show up on one statement at a time.

Where does the Money Go?

It’s simple when you realize this. The balance sheet has assets and liabilities. When you sell an asset, you lose it off the balance sheet. So your “assets” total on the balance sheet goes down.

But the cash you generated goes somewhere too. It doesn’t go in the income statement (also known as a P/L or Profit and Loss), because it wasn’t generated from your company’s sales. An increase of 50,000 sales and $250,000 more in profits goes in the income statement, but not cash from the selling of an asset.

So you see, the cash from a sold piece of real estate shows up in the cash flow statement. Now we can start to understand why a company can’t just go on a hiring spree now.

It’s because of this: hiring more workers is an expense. It goes in the income statement. When this example company sold its real estate, their income statement didn’t get affected. So if they just decided to hire like crazy, the income statement would be affected and profits would plummet. This would scare the heck out of investors, and just cause panic in general.

Understanding this helps us see why CEOs oftentimes have harder decisions than how it seems on the surface. (Like why did Microsoft just cut 18,000 jobs? They are oozing in cash… it’s not that simple)

If you can understand the 3 financial statements you can give yourself a fighting chance in the stock market. Let’s start with the balance sheet because it is the simplest to learn. [click to continue…]

July 2014 Monthly Report

Just a quick post for today. These past months have been crazy busy, and I’ve been doing some exciting things behind the scenes. For one, I’m working on a podcast with 3 other financial experts that is scheduled to be released September 1st. We have already recorded 3 episodes and will record the 4th tomorrow. Also released a special product to my email subscribers.

Keep checking in for more great things happening with this brand.

Andrew Sather’s Model Portfolio

Screen Shot 2014-08-13 at 11.02.17 PM

Today’s stock pick: BRCD
Value Trap Indicator: 128.41

As always, keep patient and continue collecting dividends. The longer you invest, the greater your chances of success.

Trading for Beginners – Sasha Evdakov, Tradersfly

It’s important to get as many different perspectives on the world of investing as you can, and this is why I specifically sought out Sasha Evdakov from Tradersfly. As a trader who has very different strategies than myself, Sasha has been so successful in both trading and teaching trading for beginners that he’s never had to find a job in his life.

I’m fascinated by Sasha’s story, about how he started his entrepreneurial journey when he was young and also about his very humble beginnings. His story is inspiring and educational, and we are lucky to hear about the whole thing with this interview.

trading for beginners
We cover a broad range of topics that you’ll definitely find value in. Although our stock strategies are vastly different, we share many similar mindsets and ideas. Like the importance of patience and a long term horizon. Also avoiding emotional investing and seeking out the abundance in our lives.

The perspective shared today was unique and helpful. From what I observed, I can easily see how Sasha is able to find success through his objectivity in viewing the market and trading. You can tell that he really loves what he does, as his passion shines through in his work and with our interview.

I want to thank Sasha for taking the time with us and also for being very authentic. I really enjoyed hearing all of what he had to say and felt motivated to learn more and improve myself as well. We need more people in the world like him.

Feel free to pass along this interview with other people who you think would benefit from this message. Anybody with entrepreneurial aspirations or just even aspirations to make more money (through investing or otherwise) will find value with what was talked about here. We offer our best insights all for free with this conversation, but it’s up to you to take advantage.

Sasha Evdakov Interview part 1:

  • how Sasha was able to become an entrepreneur and never have needed to work a job
  • why the “get rich quick” scheme leads to failure and how to succeed
  • Jesse Livermore’s Reminiscences of a Stock Operator (book)
  • how emotions affect the market and how to find a balance
  • a common mistake that beginners make regarding losses and how you can avoid this mistake
  • why being wrong is just part of the game

[click to continue…]

Good enough is really good – WW #73

Humans are all the same. We all naturally strive for perfection. It’s just in our DNA.

This quality is mostly beneficial for humans. It’s why we continue to build towers and hotels that reach higher, and electronics and computer chips that go faster. Growth, ambition, the pursuit of perfection, these are all really great things.

However there is a dark side to every story. Too much ambition can destroy a family life or personal health. Too much growth without solid foundations can lead to catastrophic failures. Too much perfection can mean nothing gets done.

balance

In the end it all comes down to balance. I’m a Libra. They are supposed to be good at balance. I’m the exact opposite… When I want something I go hard. So the struggle to find balance is really my daily struggle, my life struggle.

I know I’m not alone in this. People tend to put effort where they want results. It’s makes us feel good. Like we are getting stuff done.

But this natural tendency will absolutely kill you in investing. [click to continue…]

I’m so excited to share this interview with you guys. Recently I had the opportunity to interview Ryan Hops from Wall Street Survivor, and we had a great back and forth.

If you don’t know about Wall Street Survivor then shame on you. They are a start-up that has been helping investors since 2007, and they are very well known for their Wall Street fantasy game, where they have over 420,000 users picking virtual stocks and improving their strategies.

They also have a library of great investing videos over on YouTube, and it was their videos that helped inspire my own channel. With everything going on at the company, the guys of Wall Street Survivor have just launched their new courses marketplace– which has been widely requested and is finally here.

wall street for beginners

In the second part of this interview, we talk about the new courses marketplace in-depth, along with the problems they solve for investors. Ryan and I see eye-to-eye on a lot of issues due to the fact that we are both actively trying to educate the rest of the world about finance. From our short discussion I can tell that Ryan has the heart of a teacher who is focused on giving value.

I highly recommend that everybody check out this two part video interview. I really enjoyed our conversation about the mindset of investing, the strategies involved with investing, the importance of fundamental analysis and ideas for great analysis.

You get to hear about Ryan’s short experience with naked options that taught valuable lessons about trading and day trading in particular. In addition to learning about this negative experience we get to hear insights that have netted positive results, such as avoiding a focus of price through market timing and having a long term horizon.

Seriously, seriously find the time out of your busy schedule today to watch these videos. It’s not everyday that you get the chance to listen to someone with insightful personal experiences and a part of a very exciting start up company like Wall Street Survivor.

At the very least, check out one of their videos. Their only a few minutes long but they are super informative and entertaining.

Ryan Hops Interview Part 1:

  • how Ryan used his bad experience with naked options to learn a lesson and find a better plan
  • the Warren Buffett way and buying shares in a company as an owner, not a speculator
  • why “the best holding period is forever”
  • the importance of investing in companies that you know and businesses you understand
  • the consequences of trying to time stocks
  • techniques to deal with volatility and limit downside risk [click to continue…]

Ever felt like you need a parenting guide for your money? New parents don’t fear, today’s guest is the expert for you. In this interview with Matt Becker from MomandDadMoney.com, we cover specific financial issues that parents face.

The great thing about Matt is that he knows exactly what you are going through. Being a new parent himself and not being able to find the right resource to speak to his particular situation and concerns, Matt took his financial background and created the resource to accomplish this.

parenting guide

One of the biggest choke ups that young people have when investing is finding that money to invest. In a time when you are learning so many new things at once, it can be easy to get discouraged about your budget and break it.

Matt presents a guaranteed way to set up your budget so that you always hit your savings goals. With this method you don’t have to know how to budget, or even expend energy towards thinking about it. This technique is called un-budgeting, and it’s explained in part 1.

Another issue with new parents is their need for safety and security. Matt breaks down exactly which protections you need to set in place, and ways to make that happen.

Then we talk about what to do with your money after that. We dive into an interesting metaphor between investing and the casino, but it doesn’t turn out like you might think. In fact there’s a way to be the house instead of the gambler, and we break down ideas for that.

Finally, we get into a great discussion about how it’s ok to make mistakes and it’s ok to not know everything. If you are really hesitant about getting your investing started, this part of the interview is for you. We’ll inspire you and encourage you, and show you why it’s so important just to start.

You can find that discussion in part 2, where of course we also share Matt’s number #1 tip for beginners. I really enjoyed this conversation and the ideas that Matt presented. I learned a couple things that I should be doing to really get that coveted peace of mind.

If you have a friend who just had a kid, I implore you to spread this link to them. Trust me, between changing diapers and making sure this child is fed, there’s not much time to think about other really important things like finances. They need to hear this message, and they will appreciate you giving it to them. [click to continue…]