How to understand financial statements in 1 hour (without studying accounting)
Preface
Sebastian
Jakarta, Indonesia,
June 2022.
Introduction
My promise
Chapter 1 What is finance?
Dictionary definitions
Chapter 2 Why is it important?
Useful
Chapter 3 Where to get money?
Money in
Chapter 4 How to spend money?
Money out
Chapter 5 Why financial statements (not all reasons are good)?
Personal
Chapter 6 The Income Statement, for net profit
Sales
Chapter 7 The Balance Sheet, must balance
Cash
Chapter 8 The Cashflow Statement, cashflow is king
Last not least
Chapter 9 How the financial statements work together
Up, down, accumulate
Chapter 10 How to know if you’re making money?
Money in > money out
Quiz
Can you remember these ten things?
- If you think financial statements are hard & that only those who have studied accounting for years could ever understand them, but you wish that you could also gleam an understanding, but without the years of studying accounting … then this short booklet is for you!
- It’s also written by someone, me, who for years was in exactly the same position as you are now, despite working in a financial markets job! In reality finance is much easier to understand than you might think.
- Finance is easy because it involves everyday items which we all have in our daily lives; income, expenses, interest, tax, investments. Once you realize this, understanding financial statements becomes much, much easier. Read on!
Sebastian
Jakarta, Indonesia,
June 2022.
Introduction
My promise
- I promise you that at the end of this booklet which will only take a few tens of minutes (20 to 40) to read, you will have a better understanding of financial statements than you do now.
- That’s because I’m going to show you what I have personally learnt about financial statements over the last 29 years….
- & if you still have questions about things at the end, I will share my email address & you can write me & I’ll answer.
- When I was a young boy living in London, I used to dream of finance.
- I saw things in newspaper adverts that I wanted to buy, like a calculator watch. I worked out how many weeks of pocket money it would take to buy.
- But unfortunately I never was able to buy one as my pocket money never lasted more than a week...
- The problem was the pocket money was too small.
- After school & university I became an investment banker. My job was to talk about finances & financial statements. But no one ever taught me & I didn’t really ever understand how the financial statements work.
- I got to know all the words, but I couldn’t explain a financial statement to you at that time.
- But I now had more money, & was able to buy the things I had wanted to have as a child; I even finally bought a watch with a calculator on it (Apple Watch). A lesson, more money is good.
- After investment banking I worked in investor relations for a listed palm oil company. I learnt something new; about a special industry, plantations & palm oil.
- I also learnt more about finance, but still not enough to explain financial statements.
- Finally I told myself, I have to learn all about financial statements.
- I had lots of information, but I couldn’t make a financial model which is the key to understanding how the financial statements work.
- It was hard to do it by myself & took many many failed attempts, but eventually I could make a financial model & have been working to perfect my modeling skills ever since. If I can learn, anyone can.
Chapter 1 What is finance?
Dictionary definitions
- I’ve always found that when you want to learn about something, the first thing you need to know is exactly what it means.
- This involves doing some research. Google is your friend as you can find out anything there.
- The simplest way to find out what finance means is to use Google to look up the dictionary definition of ‘finance’.
- If you Google the dictionary definition of finance, you will find out that it is a noun.
- The meaning of the noun is the management of large amounts of money. One example they give is government, but another is large companies. The definition mentions specifically financial statements.
- I would argue finance doesn’t need to be large, it can be small.
- Management of money, but what is money? Money is something we all know about because we use it, but what is it?
- Once again we can go to the dictionary definition. The Cambridge dictionary defines money as a measure of the value of what someone owns. Money is a measure of value.
- It’s also of course physical coins & notes.
- Before we had money, people used to exchange goods. If you caught fish, you could exchange them with the person who grew vegetables.
- But what if he wanted meat instead of fish? To help out, money was invented to exchange as a measure of value.
- The first modern money was the British pound sterling, at that time worth a pound of silver!
- Today a pound is worth much less than that. Another lesson is that the value of modern money goes down, fast. That means you need more & more money to keep up.
- Today the amount of money has increased tremendously & there are many more types like digital money.
- But one thing is the same, money remains a measure of value.
Chapter 2 Why is it important?
Useful
- What is so important about money? Lots of people like to tell you that money isn’t important. But that is probably because they don’t have much.
- We all know that money is very important & very useful. You can use it to get whatever you need to help you, your family, your friends & your company.
- More money is good.
- Anything which is good is good to look at as often as possible. If money is important then it’s a good idea to look at it every day.
- On a personal level, I try to look at how much money I have in all of my accounts every morning.
- As a company we have monthly, quarterly & annual financial statements.
- By looking at it & following the progress of bow much we have, we can measure how successful we are. Money is probably the best measure of success.
- Every morning when I look at the money in my accounts, I add the latest data to a chart.
- If the chart is going up, I’m happy. If it’s down, less so.
- If you know what you want in life, you can use money as your goal or target for how to get there.
- You can decide all the things you would like to have & then find out how much money it would cost to get then.
- Then you will know how much money you need & put that as your target.
- You can also use money to tell if you are doing things right or not.
- If you check your finances every day, & if the chart is going down, then you know you are not doing the right things.
- If you check your money every day & the chart starts moving up, you know you are doing the right thing.
Chapter 3 Where to get money?
Money in
- If money & finances are good & useful, then you need to find more money. I’d like to introduce you to a simple concept of a financial statement which is called ‘money in’.
- As the name indicates, this is getting money into your house, your bank account or your company.
- The question is how to get money to come in?
- As we know, money is a measure of value, so to get money in, you need to create value.
- I suggest there are three ways to create value.
- First way is to come up with a great idea. The second way is you can make something physical which other people want. The third way is you could provide a service.
- But just creating the idea, good or service does nothing. You then need to go out & sell it to customers.
- First you need to go out & find the potential customers in the market place.
- You then need to persuade those customers that what you have is very valuable, so that they give you the money you want for it.
- There’s another way to get money in. You can also use the word finance in another way. Finance can mean to raise money.
- One way to raise money is to borrow it. This is most likely going to be from a bank. Persuade the bank & they will lend money ‘in’ to you.
- But later you must pay it back ‘out’.
- Another form of finance other than borrowing or debt is called investment or equity.
- If you can find investors who have money, you can ask them to invest it into your company as equity owners.
- Equity & borrowing are both liabilities which means you have to pay them back. The difference is equity has no fixed date to pay it back.
Chapter 4 How to spend money?
Money out
- If money is good then of course it’s great to have money to come in. But doing all the things to get money in also means spending money.
- Spending is the other simple way to look at financial statements, which we can call ‘money out.
- Money out is considered very important in financial statements & takes up most of the space, but money in is much more important.
- One way money can go out is when you consume or buy things from other people or companies.
- This could be something basic like food & water to run your body. It could be something like electricity or fuel which is used to run your machines.
- It could be salaries like paying your accounting team to help make financial statements.
- The second way money can go out is to pay for the cost of the money you got in by borrowing from banks.
- Banks get money from depositors who ask then to pay interest.
- That means when the bank lends the money to you or your company, they charge you interest. You have to pay out the interest every month.
- ‘Pay to Caesar what is Caesar’s’. As the famous saying goes, there are two certain things in life & one of then is taxes.
- As an individual, you have to pay income tax. As a company you have to pay corporate tax to the government.
- The tax is calculated based on a percentage of the profit you make before the tax.
- The final type of ‘money out’ is investment spending. If you build a plantation, you need to clear land & plant trees first.
- Then later you need to put in roads & to build a mill to process the fruit into oil.
- An investment is money you spend on something which later generates sales or ‘money in’.
Chapter 5 Why financial statements (not all reasons are good)?
Personal
- If money is important & if tracking financial performance helps you to see if you are doing the right thing, then this is one reason why we have financial statements.
- It could be your own financial statement.
- As I mentioned before, this could be as simple as tracking the amount of money you have in all your bank accounts daily.
- If you are a company, you keep a financial statement to see your progress.
- You want to know how your sales are doing. You want to know the salaries you pay. You want to how much customers owe you & how much you owe suppliers.
- You want to know how much you borrowed & how much money you’re paying out in interest.
- Investors would like to get updates on how their investment is performing.
- They want to see the sales growing. They want to know how much money is going out. They want to know the money coming in minus the money going out.
- If it is positive they know you can pay back the money you owe to them in loan repayments or dividends.
- The accountants you pay (money out) to help prepare the financial statements, are of course interested in financial statements.
- One thing to remember here is there is a bit of a conflict of interest... The more work they do, the more they get paid.
- This means accountants would probably like to make your financial statements as complicated as possible, not just the simple money in & money out...
- Another group interested in financial statements is the authorities to whom you pay tax.
- Financial statements are used to calculate how much tax you pay. As the tax is calculated based on the profit before the tax, it is profit which is most important for tax.
- But as tax is money out, this is not what is most important to you.
Chapter 6 The Income Statement, for net profit
Sales
- There are three financial statements. The first & most famous, is the income statement which measures net profit over a period of time.
- Financial statements are read like a book, top to bottom. At the top of the income statement is sales. This most important part of the financial statements is amazingly the only item which is money in.
- The rest of the income statement is costs, money out.
- The first cost is not money out right now, it’s an accounting treatment of money out from investment spending from before & is called depreciation. Instead of a one time cost, it’s spread out over time to make it smaller.
- It starts when the investment produces sales & lasts for the life of the investment.
- For example our oil palms last for 25 years, producing sales after four. The depreciation is spread out over twenty years.
- The next cost or money out is operating costs.
- This is spending to create the product you sell. It includes transport to customers, staff salaries, money paid to suppliers & for services like to accountants.
- In most financial statements, the operating costs is quite simple & already includes the depreciation. Details of all the individual costs are in the financial statement notes.
- Next after operating costs is financial costs. This is the cost of the money you borrowed.
- This money out is interest that you have to pay on all the loans you received.
- This interest goes up & down depending on how much you borrowed & what the latest interest rate is. For example, interest rates used to be higher, but now they’re lower.
- The sales ‘money in’ minus the operating costs ‘money out’ including the depreciation, minus the financial interest costs is then called the profit before tax.
- If this profit is positive then the tax is calculated at the latest rate & added as another cost or money out.
- The pre tax profit minus the tax is then called. the final net profit.
Chapter 7 The Balance Sheet, must balance
Cash
- The second financial statement is called the balance sheet, which measures the accumulation of assets & liabilities up to one fixed date.
- The balance sheet has two sides, left & right & one side must total the same as the other. On the left side is the assets. The assess are positive things & are also read like a book from top to bottom.
- At the top is the most simple asset which is the cash in your bank accounts.
- Underneath the cash are the other assets. These are made up of things which can be turned into sales ‘money in’. Quickly like inventory & payments due from customers...
- ... or more longer term like the investments you made into plantations & mills.
- When you add up all of these assets, you get a total, called simply total assets.
- On the right side of the balance sheet are liabilities. The liabilities are things which will result in future costs or money going out.
- At the top are things which require money out soon like short term loans or payments to suppliers or tax payments not yet made.
- Then there are longer term liabilities like all of the bank loans.
- Also on the right side is the equity. The equity can come from two sources.
- First, investors can give you money which in return gives them ownership of the company. Second if you make net profits it is added to the equity.
- Equity is a liability because it is supposed to be paid out to the investors, but with no fixed date.
- The balance sheet balances.
- If investors start a company with one dollar, there will be one dollar cash on the left & one dollar equity on the right.
- If the company borrows one dollar, the assets will now be two dollars cash & the liabilities will be two dollars; 1 dollar loan & 1 dollar equity.
Chapter 8 The Cashflow Statement, cashflow is king
Last not least
- The third financial statement is the Cashflow statement which measures Cashflow over a period of time.
- In most counties this statement is put at the back as it is usually considered to be the least important. But as is often the case, what many think is the least important is actually the most important.
- Cashflow is KING, so if you see a company put the Cashflow statement at the front, buy their shares...
- The cashflow statement shows how it is the most important out of the three by having the most parts.
- The income statement is made of really just one part. The balance sheet is made up of two parts, the assets & liabilities.
- The cashflow statement is made of three parts. The operating Cashflow, the investment cashflow & the financial Cashflow.
- The operating Cashflow is similar to the income statement. It has the ‘Money in’ which is the sales at the top.
- Then it has all the costs which includes the cash paid to suppliers, the cash paid to employees. It also includes the interest paid out to the banks & the taxes paid to the government. (Note another way is to take the net profit & add back all the non cash costs).
- Operating cashflow is different to profit in that it does not include the depreciation.
- The second part of the Cashflow statement is the investment Cashflow.
- This includes all the money out for investments. For example it could be for planting trees or building a mill or a factory.
- While investment spending is normally money out, it can be positive money in if you sold a long term asset (or a short term investment) , but then you’d have less income from that asset in the future.
- The third & final part of the Cashflow statement is the financial Cashflow. This is where we put all of the financing.
- That means the loans, it could be money in from new loans or money out to pay loans.
- It also includes the equity. It could be money in from new investors or paying money (dividends or share buybacks) back to the equity investors. (Note, cashflow from operations & investing is good for investors if it’s positive. Cashflow from finance is good for investors if it’s negative.)
Chapter 9 How the financial statements work together
Up, down, accumulate
- The income & the Cashflow statement measure income & cashflow for a period of time; one day, one month, one quarter or one year.
- They can go up & down from one financial statement to the next.
- The balance sheet is accumulating everything up to a fixed date & so it (normally) increases from one financial statement to the next.
- If you raise financing ; loans from the bank or equity from investors, the liabilities will increase on the right side of the balance sheet, the cash & the total assets will increase on the left side & by the same amount.
- This will change the financial Cashflow & the balance sheet.
- The opposite will happen when you pay the money back.
- When you spend money to invest in assets, the cash on the left side will go down. The other assets also on the left side will go up.
- There will be no change in the total assets & no change in the right side liabilities.
- This will affect the investment Cashflow & the balance sheet, but not the income statement.
- If sales increase & after subtracting all the costs there is a profit, then the cash will increase on the left side of the balance sheet...
- ... & the equity will increase on the right side of the balance sheet. The balance sheet will still balance.
- This will affect all three financial statements, the income, the operating Cashflow & the balance sheet.
- But how about the non cash accounting treatment like the depreciation which is in the income statement but not in operating Cashflow?
- Doesn’t that unbalance the balance sheet?
- The depreciation in the income statement which reduces the profit on the right side of the balance sheet is subtracted from the assets on the left side, so the balance is maintained.
Chapter 10 How to know if you’re making money?
Money in > money out
- Your job as an Individual or as a company is to make money to pay for the things that you want, to cover the declining value of money & to pay loans back to the banks & investments to investors.
- Making money means that money coming in must be more than money going out.
- But how do we use financial statements to know if you’re making money or not?
- Does net profit tell if you’re making money? Many people think yes net profit is the most important measure.
- But there are two problems. First net profit includes accounting non-cash pluses & minuses like depreciation which might make it too high or low
- The second is net profit doesn’t include money out for investments which might make the profit look too high.
- The correct way to see if you’re making money or not is to look in the Cashflow Statement.
- The operating Cashflow is like profit, but doesn’t include the accounting non cash items like depreciation. The investment Cashflow does include the investment spending.
- The combination of operating & investment Cashflow is the correct measure. If this combination is positive then you’re making money.
- However, it’s good to have some double checks. Here’s two.
- First, if you’re making money & the combination of operating & investment Cashflow is positive, then you will be able to pay back money you borrowed from loans or equity investors. This means the financial Cashflow will be negative.
- If financial Cashflow is consistently negative over time, then you’re definitely making money
- Here’s a second double check, If you’re not making money you need to borrow more or use up cash, so the combination of cash minus liabilities will reduce.
- If you are making money, your cash will increase & you can use it to pay back the liabilities. This means the combination of cash minus liabilities will increase.
- Use all three of these to double check if you’re making money.
Quiz
Can you remember these ten things?
- Financial statements are measuring _____.
- Money is a measure of v____
- More money is g___
- ‘Money in’ is only s____ ‘Money out’ is everything else.
- Profit & cashflow are periods of time, the balance sheet is a f_____ date.
- Profit includes non c___ c___ like depreciation & is used to calculate government ___
- The balance sheet will _______.
- Cashflow is ___.
- Money in minus money out is ________ & __________ Cashflows combined.
- 10.If it’s positive, you’re making money which can be paid back to i_______s.
As promised, if you have a question, contact me at sebastian@sharpfokus.com