Let’s begin with basic finance accounting principles.
Everything involves accounting. Although finance and accounting are distinctly separate industries, accounting is crucial for learning how to record and report the economic condition of your or other people’s money.
Income Statement
The Income Statement, also known and a Profit and Loss statement, is a statement that measures a company’s financial performance over a specific accounting period. Financial performance is determined by how the business incurs its revenues and expenses through both operating and non-operating activities. It also shows the net profit or loss incurred over the same period, usually over a fiscal quarter or year. The income statement is what possible investors use to assess the financial health of the company for the future based on past results, financial ratios, and more. The income statement is comprised of four parts: the gross margin, operating earnings, and net/gross income.
Gross Margin: This is how much money a company has left over after paying for the production of that service or product. This amount is calculated by subtracting the cost of goods sold from revenue.
Operating Earnings: This is the income that a firm generates after expenses such as employee salaries, marketing expenses, and all other expenses have been accounted for.
Earnings before Income Tax: Quite simply, how much a company makes before taxes. This is important because a company’s earnings before the income tax expense is its number one indicator of profitability. There are also a number of ways to minimize or even avoid taxes that affect their reported income so this is a significant component of the income statement.
Net Income: The total of the company’s profits. This is otherwise known as a company’s “bottom line”, and can be a negative number if expenses exceed revenues
The Balance Sheet
The balance sheet summarizes what an individual or company owns and owes. It has three main components: assets, liabilities, and shareholder’s equity. A company’s assets will always equal the sum of its liabilities and shareholder’s equity, as a company pays for everything it owns (assets) either by borrowing money (liabilities) or getting it from shareholders (shareholder’s equity). It is often described as a snapshot of a company’s financial position at a particular place in time. Using this, investors can assess how much cash a company has currently, how much money is owed, and what its most valuable assets are.
Assets: Anything a company has that is of value. Assets can be either current or non-current (meaning that they are expected to provide benefits for a period greater than one year).
Liabilities: This is what a company or individual owes to external entities. These debts and obligations arise during normal business operations and can be current (debts payable within one year) or non-current (debts payable over a period greater than one year).
Shareholder’s Equity: This is the shareholders’ interest in a company from two main sources: investments in the company and retained earnings that the company accumulates over time through its operations.
Statement of Cash Flows
The Cash Flow Statement outlines the flows of cash into and out of a business over a given period of time. It is a reflection of a firm’s liquidity, or its ability to use cash to settle an outstanding liability. There are three main components: cash from operating activities, cash from investing activities, and cash from financing activities.
Components: Cash from operating activities: This includes the flow of cash in and out of the company that results from the sale of goods and services.
Cash from investing activities: This includes the purchase and sale of long-term assets such as property, plant, and equipment, as well as investment in one company by another.
Cash from financing activities: This is a little different and includes transactions that generate new funds from investors, banks, and shareholders, or return funds to these parties are captured here.
Now, let’s check out some finance markets.
The Equity Markets
When companies require financing, they usually turn to one of two primary sources: equity or debt. Equity can be thought of as an ownership stake in something of value, and in the case of public companies, is represented by stocks (shares).
The Stock Market
The popular stock market is a place where shares of public companies are bought and sold by investors. Once companies “go public”, this allows companies to raise capital as investors must pay to acquire the stocks of a given company. In return, investors become part owners of the firm and have a claim on its assets and earnings. There are many intricate factors that move the stock market, but at the most fundamental level, supply and demand are responsible for changes in stock prices. Intuitively, if more people want to buy a stock than sell it, the price will move up. Stock exchanges are the marketplaces that facilitate fair and orderly trading. The New York Stock Exchange (NYSE), NASDAQ, Tokyo Stock Exchange, (TSE), London Stock Exchange (LSE), and Toronto Stock Exchange (TSX) are among the largest in the world. For more on stock markets, click here to learn the basics of trading.
Lastly, let’s check out some market terminology.
Valuation
Valuation is the process of determining the current worth of a company. Because there are so many factors that affect the company’s stock, share prices are not always the best way to gauge a company’s worth. As a result, a number of valuation procedures are used to determine a company’s true and fair value.
Market Valuation
This practice is used only for publicly traded companies. By multiplying the number of shares outstanding by the stock price, you come up with the market valuation. The resulting figure is then used as the company’s “market capitalization”.
Comparable Companies Analysis
These analyses compare companies in the same industry with similar fundamental characteristics. Companies can be grouped based on a number of criteria including industry focus, size, products and services, customers, geography, and growth characteristics. From here, financial information is collected and a number of key statistics and multiples that reveal information about each company’s value are computed.