You have to understand accounting and you have to understand the nuances of accounting. It's the language of business and it's an imperfect language, but unless you are willing to put in the effort to learn accounting -- how to read and interpret financial statements -- you really shouldn't select stocks yourself.
-- Warren E. Buffett
Now that we've established how important accounting is for investors, let's take a look at the three primary financial statements an investor will wrestle with in trying to assess the quality of a business and its financial health.
Income statement ("Profit and Loss statement," "P&L")
The income statement is the financial statement that most investors focus on, because it provides a financial overview of a company's business activity over a specific period of time (quarterly or annually, generally).
The income statement begins at the top with the revenues (or "sales") that a company generated over a period and works its way down through the various costs the company incurred in the conduct of its operations in order to determine the company's profit:
Cost of sales: This the direct cost associated with producing the goods and/ or services that the company sold during the period. Subtracting the cost of sales from revenues gives the gross profit.
Operating costs (or "operating expenses"): These are the costs incurred to support the company's operations that are not directly associated with the goods and services sold. These include, for example, the salaries of the human resources executives, research and development costs and the depreciation of equipment, and other long-lived assets.
Subtracting operating costs from gross profit yields the income from operations ("operating income," "operating profit," or EBIT -- earnings before interest and taxes). Dividing that figure by revenues is the operating margin -- a key measure of profitability.
Interest income/interest expense: Add the amount of interest earned on any of the company's interest-bearing assets or cash accounts and subtract the interest paid on any outstanding debt: You have the earnings before taxes (EBT).
Subtract taxes to obtain net income ("net profit"). Hopefully, it's actually a profit rather than a loss.
Dividing net income by the number of shares outstanding produces the earnings-per-share figure that investors, analysts, and the financial media fixate on.
The balance sheet is a snapshot of a company's financial condition on a specific date. There are two sides to a balance sheet:
Left side: assets, which reflects a compact accounting of the things the company owns and from which it derives its value. These include tangible assets such as plants, property, and equipment, and intangible assets, such as patents and trademarks.
Right side: liabilities and shareholders' equity, which describes the means by which the assets have been financed, either through debt and other owings (liabilities) or through the equity that shareholders stumped up, along with retained earnings (shareholders' equity).
The two sides are inextricably linked through the basic accounting equation:
Assets = Liabilities + Shareholders' Equity
Another way of stating that equation is:
Shareholders' Equity = Assets - Liabilities
In other words, the accounting value of a company that is attributable to its shareholders is equal to the total value of its assets less the value of all the liabilities it carries (that is why shareholders' equity is sometimes referred to as "net assets").
One way to think about this is in business liquidation. If the owners sell all the assets and repay all outstanding liabilities, shareholders' equity is an accounting estimate of what is left for the owners.
Many investors don't spend enough time examining the balance sheet, but it's extremely useful, not least because it enables one to assess the level of a company's indebtedness. Prudent investors avoid companies that are highly leveraged, as a high debt load can cripple a company and put equity owners' value at risk.
Cash Flow Statement
The cash flow statement does not get anywhere near as much attention from analysts and journalists as the income statement, but it is nonetheless vital (remember that a company's intrinsic value is the sum of all future discounted free cash flows, not discounted earnings).
Cash -- not accounting earnings -- is the oxygen that keeps a business alive. Furthermore, protracted deviations between earnings and operating cash flow are a red flag for investors.
As the name suggests, the cash flow statement is a full accounting of all of the company's sources and uses of cash during the period and is organized into three sections: Cash flow from operations, cash flow from investing, and cash flow from financing.
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