How to Understand Financial Statements

In this podcast, Motley Fool senior analyst John Rotonti discusses:

• How to understand balance sheets and income statements.
• A key metric that can tell you about a company's pricing power.
• What you're actually purchasing when you buy a stock.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on April 2, 2022.

John Rotonti: Pricing power is if you can increase the price of something to offset input cost inflation without decreasing demand for the product. That's pricing power and one of the main places we see that and capture that in the numbers in the story is from the gross profit margin.

Chris Hill: I'm Chris Hill, and that was Motley Fool Senior Analyst John Rotonti. What are you buying when you buy a stock? No, really, what are you buying? Today John kicks off a two-part series on the basics of financial statements, including what goes into a balance sheet, how the sale of a burrito at Chipotle (CMG 0.40%) become shareholder equity, and how financial statements work together. 

John Rotonti: Fools, John Rotonti here. Today we are going to be talking about the three primary financial statements: the balance sheet, the income statement, and the cash flow statement. Let's just start with the balance sheet really quickly. The balance sheet, Fools, is called the balance sheet because it must balance at all times, and the simple formula is assets equals liabilities plus shareholders' equity, and that must always balance. A must always equal L plus SE, assets equals liabilities plus shareholders equity. Let's just look at a quick example using Chipotle, ticker CMG. Chipotle has total assets, so assets of 6,653 million. Then it has total liabilities of 4,355.6 million and total shareholders' equity of 2,297.4 million. If you remember, A, assets, equals liabilities plus shareholders' equity. So if we take the liabilities of Chipotle of 4,355.6, and we add the shareholders' equity of 2,297.4, you will get the total assets of 6,653 to the penny. To the penny, Fools, the balance sheet must balance at all times. Assets must be equal liabilities plus shareholders' equity. Then, of course, we can reconfigure that basic formula to get shareholders' equity is equal to total assets minus total liabilities. All we've done is move some variables from one side of the equation to the other. Shareholders' equity is equal to total assets minus total liabilities. Assets minus liabilities is how you get shareholders' equity. If we do that again, if we take total assets of 6,653, and we subtract total liabilities of 4,355.6, you will get total shareholders' equity of 2,297.4. Now that is why it is called the balance sheet. The left-hand of that equation, A equals L plus SE, assets, is what the company owns; liabilities, what the company owes. Now, when you're looking at a balance sheet, it starts at the top of the balance sheet with the most liquid assets, and it moves down the balance sheet. As you move down the balance sheet, those assets become less liquid. The definition of liquidity is the speed and ease at which you could turn the asset into cold, hard cash. The very top line of the balance sheet is cash and cash equivalents. That's already cash. That's the most liquid, Fools. You don't need to convert it to cash. That's why it's at the top.

Then we move down the balance sheet, and we get things like account. I'm not going to go line for line because if I was teaching this class at an MBA level, I'll probably spend three or four full classes, just on the balance sheet. So I can't go line by line. But then you have things like accounts receivable, which is money owed to Chipotle that has not yet been paid. That's an asset. It is owed to Chipotle. Those receivables, when people buy on credit and stuff, they're going to receive those pretty quickly. So that's pretty liquid. It's going to be turned into cash pretty quickly. Inventories, the raw materials, the food that they plan to sell, you can turn that into cash pretty quickly too because we're talking about a restaurant here. Those raw fresh ingredients that Chipotle is known for, they're going to spoil. They're going to expire. They have to use those ingredients and sell them within a day or two or something like that. They can convert inventories, which is another asset to cash pretty quickly, so it's liquid. But then you move down that balance sheet, and you get things like property, plant, and equipment, literally, buildings, facilities, all of the expensive kitchen equipment they have, property, plant, equipment. They can't turn that into cash immediately. If they wanted to sell that stuff, they'd have to get a broker, find a buyer, write up some contracts, some agreement, it takes time. So it's less liquid. There's other long-term investments as well, such as goodwill.

Every company start with zero goodwill, believe it or not, zero goodwill. A company only gets goodwill on its balance sheet when it acquires another company and pays above book value. That's how you acquire goodwill. It's something that ends up on your balance sheet when you buy another company, and it's an asset. Then you have liabilities. You have payables. That's money that you owe, but you have not paid yet. You have short-term debt. You have short-term leases, then you have long-term leases. You have long-term debt. There are other liabilities as well, but once again, you move from the most liquid down through the balance sheet to the least liquid. Now shareholders' equity has two other names. They all mean the same thing. They're synonyms. Shareholders' equity is also book value. How do you calculate book value? Total assets minus total liabilities. Book value is literally the value of your assets, what you own minus your total liabilities, what you owe. The other synonym for total equity is net worth. This is the company's net worth. Just like you can calculate your personal net worth based on your total assets, what you own, minus your total liabilities, what you owe. So total shareholders equity is equal to book value is equal to net worth. One last thing before I move on to the next financial statement. Think of assets, as we've said, that's what you own, that's the left-hand side of that equation. The other side of the equation, liabilities and shareholders' equity is the sources of funds to buy those assets. Think about it this way. This is going to be exciting. Assets are the uses of the funds. That's the uses of the funds. The company takes the right-hand side of the equation, the liabilities, i.e, debt, and shareholders' equity, i.e, what owners contribute. Those are the two primary sources of funds, and the company takes those to buy or build assets, the left-hand side of the equation, the uses of those funds. That's the balance sheet, Fools, called the balance sheet because it must balance at all times.

We're going to switch over to the income statement really quickly, sticking with Chipotle here. Some people call this the profit and loss statement, the P&L. We went over this in a prior segment, but it's important to review again because we're going to need it for when we get to the cash flow statement. So bear with me really quickly. The sale or revenue, think of those words as synonyms. I think a lot of companies that actually sell a tangible product use the word sales, and companies like software that don't sell tangible product that you can touch and feel use the word revenue. Think of sales for products, and revenue for software and services. But honestly, I've seen product companies use the word revenue, and I've seen software and services company use word sales. It doesn't matter. Honestly, sales and revenue are the exact same thing, and they are the top line of the income statement. They are the top line because they are at the top of the piece of paper. The sale is what happens at the point of sale.

In Chipotle's case, it is when the customer goes into the store, and orders, and pays for it at the point of sale system. These things used to be called cash registers. Now they're like little square iPads or whatever, but it's a point of sale computer system, called a POS, or when someone orders online and press "Buy" online, that's the point of sale. That is the sale. So you go into Chipotle, you buy a $7 chicken burrito or whatever and a drink. I think the average chicken at Chipotle is probably somewhere around $12 with tax, all in, I think. But let's just use a $7 burrito, that's the sale. From that, we subtract the cost of goods sold. That is all of the input costs as well as the employee wages that go into making that burrito. This does not include the salary of the CEO, and the COO, and everything else back at headquarters. This includes the people working in the Chipotle kitchen, on the frontline, on the backline, contributing in making that burrito. Those are wages that are included in cost of goods sold. It also includes all of the food, all the raw materials, all the ingredients. You got to have the chicken, or whether it's beef, or pork, whatever you're putting in your burrito. Avocados, those things are expensive. Those things are going through the moon. Avocados, tomatoes, onions, other basil, and spices that go into their spices and their sauces. Lettuce, I said onions, peppers. The chips, can't go to Chipotle without getting those chips, right? The tortillas, the wraps, anything that they need to make that Chipotle goes in that cost of goods sold. You take revenue, the $7 burrito, you subtract your cost of goods sold, and you get a number called gross profit. This is what we talk about when we're talking about unit economics.

If a company can price its products higher than its input costs, it will generate a gross product at the burrito level. That's the unit level. So that's its gross profit. Now, if you want to calculate the gross, we just said gross profit, sales minus cost of goods sold, you get gross profit. If you want to calculate the gross profit margin, you simply take that absolute gross profit dollar amount, the gross profits, and divide it by sales. When you are calculating a margin, you simply take the profit dollar amount that you're looking at and scale it by sales, divide it by sales. So gross profit margin is gross profit divided by sales. Now when you're talking about gross profit, you are talking about unit economics, you're also talking about pricing power. What if sales grow a little faster than cost of goods sold grow? You know the answer. That means your gross profit margin is going to increase over time, a sign of pricing power. Pricing power is if you can increase the price of something to offset input cost inflation without decreasing demand for the product. That's pricing power, and one of the main places we see that and capture that in the numbers in the story is from the gross profit margin. So we have gross profit. From that, we subtract operating expenses. You got to keep the lights on. You got to pay your utilities. You got to pay your water bill. You have to pay all of the other salaries and expenses back at headquarters, if there's research and development, the research and development cost to come up with new recipes, sales and marketing. So R&D, research and development, sales and marketing, all of these things are operating expenses. These are cost of doing business. That's operating expenses. So gross profit, you subtract these operating expenses, you got to keep your lights on, you get operating income.

Now if you haven't been paying attention, you should start now. Operating income is also called earnings before interest and taxes, E-B-I-T or EBIT, earnings before interest and taxes. That's operating income. From operating income or EBIT, E-B-I-T, we subtract the interest expense on the debt, if the company has any debt, of which Chipotle does. Notice debt holders get paid first. They have a primary claim on a company's cash flows. There is a packing order, Fools, to who gets paid. Debt holders, or creditors, they get paid first. We just paid the I, the interest expense. Remember, we had E-B-I-T. We just pay the interest, so now we are left with E-B-T, earnings before taxes. So who gets paid next? The government in the form of taxes. So debt holders get paid first, and then the government in the form of taxes. Now what is left over after the company has paid its cost of goods sold, after the company has paid all of those other operating expenses, utility bills, research and development, sales and marketing, after the company has paid its interest on its debt, if it has any, after the company has paid its taxes to the government, if there is money left over, that is called net income, or net profit, or net earnings.

The three words mean the same thing, and that, Fools, is what you are buying as a shareholder. We get the residual claim of what is left over after all of those expenses we just went through are paid. We get residual claim. We get the bottom line. Why is it called the bottom line? Because it is at the bottom of the income statement. We get what is leftover. We have a residual claim on a company's cash flows. When you buy a stock, legally, what are you buying? When you buy a stock, you are buying a claim on the company's future net income, or future net profits, or future net earnings. You are buying a very small percentage of the company's future net income. That, Fools, is the income statement. Now why do I want to go through that? Because when you buy a stock, that's what you're legally buying, but also because we need to go to the cash flow statement, the third financial statement. Now remember how I just said net income is the bottom line of the cash flow statement? Guess what, net income, the same exact number that's on that income statement, then becomes the top line of the cash flow statement. [MUSIC] This is critical to understand. This is critical. The bottom line of the income statement, net income, becomes the top line of the cash flow statement.

Chris Hill: That was part 1. Next Saturday, on part 2, John will dig into the cash flow statement and all the places your money can go before it gets to shareholders. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening. We'll see you tomorrow.