How to Use Financial Statements (Investing 101 Vol. 2) - 7investing 7investing
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How to Use Financial Statements (Investing 101 Vol. 2)

7investing lead advisors Austin Lieberman and Simon Erickson describe the financial statements, and what investors should look for to make them the most valuable.

May 14, 2020 – By Simon Erickson

One important aspect of investing is understanding the financial statements.

The Balance Sheet, Income Statement, and Cash Flow Statement each tell an invaluable story — about how well a company is operating, how strong its financial footing is, and how its management is making decisions.

In our eighth official 7investing podcast, lead advisors Austin Lieberman and Simon Erickson walk through the financial statements and describe the most important things that investors should keep an eye on. Then, in football-commentator style (with Simon as the play-by-play announcer and Austin as the analyst), they dig through the most recent financial statements of Apple (Nasdaq: AAPL).

We hope you enjoy our 7investing podcast! Please leave us a review or a star rating, and send your ideas and questions to!

Companies mentioned in this podcast include: $AAPL, $AMZN, $FSLY, $NFLX, $RST, $SHOP, $UI. The 7investing team may have active positions in one of more of these companies.

This podcast was originally recorded on May 12, 2020 and was first published on May 14, 2020.

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Simon Erickson: Hello, everyone, and welcome to the eighth official 7investing podcast. I’m 7investing advisor Simon Erickson. Joined by my colleague, also 7investing advisor, Austin Lieberman. Austin, hello and happy Tuesday to you, my friend.

Austin Lieberman: How’s it going, Simon?

More importantly, to our millions of listeners out there, how are you doing today? How how’s your week going? Hope everyone having a good week out there. And now. Thanks for listening, as usual.

Simon Erickson:  Absolutely. Millions of listeners. We’re doing pretty good in these last couple of weeks, if that is correct. We’re continuing today on our investing 101 series where we’re kind of looking at some of the basic concepts of investing and how they’re important to investors out there. Today, we’re going to be looking at the financial statements, specifically the three most common financial statements being the balance sheet, the income statement, and the cash flow statement. So we’re going to look at what these statements are, why they’re important, and then we’re actually going to be using a well-known fruit company called Apple as an example to walk through and make each one of these terms and ideas more concrete.

And by the way, Austin, we should probably notify our millions of listeners as well that we’ve agreed to do this “Sports broadcast style”, where I’m going to be the play by play announcer for these and you’re going to be the color commentator analyst on this. We’re going to go back and forth and an unscripted way talking about kind of what each one of these terms means and then what it kind of means for investors as well.

Austin Lieberman (aka Tony Romo): Yeah. So if you listen out there, you can think of me as your resident, Tony Romo, minus the athleticism, the NFL salary, the TV salary, and everything else that’s cool about Tony Romo.

Simon Erickson (aka Jim Nantz): That’s right, and I’m Jim Nantz. I’m the play by play guy. Or if you’re watching Fox. I’m Joe Buck and he’s Troy Aikman.

Let’s start at the ten thousand foot level, though, of why do we even have financial statements in the first place and why are these really important?

The reason that really we have these is a couple of reasons. The first is they’re required by the S.E.C. If you’re a publicly traded company, you have to file these in a timely manner every quarter. The second is, really internally, they’re a great way to organize information about your company. So you can kind of see how things are going, see how you’re performing, see how much you’re producing profits, and doing other things that you should be focused on as a company. And then thirdly, for purposes of this project, of this podcast, really a great way for external investors to really size up a company, make sense of that information and see if they would be interested in investing in a company by looking at information kind of a consistent manner. There’s a couple of different reasons we have these.

Let’s jump in first to the balance sheet, which is really you can think about this at the high level of what does a company own and what does a company. Oh, and so we’ll walk through Apple for a couple of examples.

But just to set the scene here, the balance sheet is arranged into assets, liabilities and shareholders equity. And you can think about the assets are what the company owns right now. The liabilities are what it owes to creditors, to suppliers, to other people that it’s paying bills to. And then shareholders equity is what it would owe as well to the early investors and the people who back the company.

So we’ll go down the first part of the balance sheet is on the assets side, so this is what the company owns. And it’s called current assets.

And by the way, before I jump, too, too far into this, I do want to also put up the disclaimer that this could probably be an entire semester long course in an MBA program that’s just focused on financial statements. Me and Tony Romo here have only got about forty five minutes. So we’re going to breeze through this rather quickly. Please send us any of your questions to @7investing on Twitter or to e-mail. Or even, you know, leave us a star rating or a review directly on these podcasts. We’d love to hear from you all. And love to hear if you have more specific questions.

Austin Lieberman: The other thing I’ll say to real quick, Simon, is that, you know, we’re going to cover these and these can be some ultra dry terms. Right. And it can also be a little bit intimidating to hear about some of these terms and and think, oh, I’ve got to know all this stuff in order to be an investor. That I you know, to me, it’s important to have an understanding of these concepts and know how to look them up, where to find them. And then as you’re looking through this stuff, it’s OK to have to reference the definitions and and look back and understand it more. So that’s what that’s what we’re trying to do today, is provide that info.

And then just just help people got guide people in knowing what to look for. Not not make people feel like you have to know all this stuff to a T. in order to be an investor.

Simon Erickson: Yeah, absolutely. No test at the end of this podcast. But the whole goal is to kind of help people get more familiar with the story about a company that’s told in the financial statements.

And so at the top of the assets are current assets. And these are things that can easily be liquidated or sold. If you needed to raise cash really quickly and in fact, the top current asset is cash and marketable securities themselves as money in the bank or things, you can very quickly liquidate within a year’s time. But also includes other things like accounts receivable, inventories and other current assets, too. So, so often these are kind of the things that if if a company, you know, really needed the cash or it’s not really putting these assets to use, it’s got them on the balance sheet available right now for it if we’re putting it in people terms.

Austin Lieberman: It’s almost like your emergency fund or something that’s easily accessible money or resources that you can get to and access when you need them, basically.

Simon Erickson: Yeah. And looking at Apple specifically, we just got the quarterly report out of Apple that says that when you add up the cash, those marketable securities, accounts receivable, everything, that’s a current asset for them. It’s one hundred and forty four billion dollars. I mean, that is a lot of current assets is about half of the company’s total assets. So long kind of storyline for Apple has been that it’s been hoarding cash. It’s been not using a lot of these assets. There are good things and bad things that come from having a lot of current assets. Right, Austin?

Austin Lieberman: Some people will look at that as a major advantage. Even even Berkshire Hathaway has a lot of cash. Right. But. One of the things I think about when it comes to these these large companies with these huge cash positions, especially if they’ve had them for a while, is really what are they going to do with that in it? Almost with Apple, it almost feels like they have so much money and it’s such a large company that there’s nothing that they’re going to go out and do tomorrow using that money that’s going to drastically improve the outlook for the business.

So I wouldn’t expect that that money on Apple’s balance sheet, I wouldn’t expect that to give them an opportunity for the stock price to jump 10 percent or 20 percent immediately buy some big investment that they go make.

But what I do believe it does is it provides them with a sense of security and safety for unexpected things, like when something like the coronavirus happens that impacts everybody’s business. No one is concerned with Apple going out of business or going bankrupt in. One of the reasons is because of this huge cash position.

Simon Erickson: That’s right. And the other type of assets that a company has on its balance sheet are, as you would expect, non-current assets or sometimes called long term assets. And these are the things that can’t just be easily liquidated within a year, but are important and they’re valuable to the company itself. To one of them is property, plant and equipment, which shows up on every company’s balance sheet. Apple is no different. They’ve got a headquarters building out there in Cupertino that’s worth five billion dollars where people work and can do productive things out there. But in addition to kind of having the shorter term assets, you’ve also got longer term assets that are kind of the building blocks that grow on top of each other that the company builds over time.

Austin Lieberman: It’s a shame. Think about Apple has this amazing headquarters. There’s a lot of built companies with these great headquarters. And I’m just curious how that whole landscape and environment is going to change in the future. And I think we’re going back to work someday for sure. But, you know, we’re very likely in a scenario where companies like Apple are going to offer remote work opportunities for employees. For more employees almost indefinitely. And so it’s interesting to see how that landscape is going to change with headquarters building, stuff like that. So Apple is not going to go and get rid of that building, I’m sure. But it’s just an interesting factor to think about.

Simon Erickson: And so much of it depends on the industry, too, right? We’re talking about Apple. But it matters what kind of investment you’re looking at, too.

If you’re looking way back in the day, at oil refineries. Standard Oil days, you know, whoever had the most refineries that could churn out the most amount of oil. That was a huge, huge benefit for the come as a huge competitive advantage.

It’s kind of taken on a different shape of how we think about long term assets and more and more property in larger plants, especially in the recent couple of years, as we’ve kind of seen a move from operating companies to more digital software companies. You want to be lean and you want to be efficient. But there are certain instances where a long term asset like this could be a huge advantage to any other thoughts on assets or should reach removal onto the liabilities.

Austin Lieberman: Now keep it rolling. Next play. Next play. Second down.

Simon Erickson: [laughs] Here we go on to current liabilities, which is at the top of the liabilities section of the balance sheet. This is what a company owes to others. To its suppliers accounts payable. It might owe other current liabilities to other short the current portion of long term debt that it owes to its creditors. These are things that the company needs to pay within the next 12 months. And we categorize those by total current liabilities. Apple’s got ninety six billion dollars of current liabilities. But when you think about that in terms of the one hundred and forty three billion dollars of current assets, this is something that’s got a lot of a lot of firepower that it can use to to really take care of all the liabilities. It’s got nothing. Any thoughts on current liabilities?

Austin Lieberman: One of the things as an investor that I do look at with any company is kind of just the ratio between total debt to their cash position. And I’d just like to make sure that they don’t have significantly more debt than what it looks like they’re able to handle or able to maintain with their cash cash position. And then also what they bring in on a quarterly basis from the revenue that they make. So that’s kind of how I look at the debt to equity of a company.

Simon Erickson: Yeah, really good point. That a huge red flag would be if you see the current portion of long term debt, which means the company has to pay down this much long term debt within the next 12 months. And they don’t have anywhere near that amount of cash. They’re going to have to do something in order to pay back the credit. Debt doesn’t just go away if you can’t pay for it. So there are certain red flags. You can see if if there’s a huge balance of current liabilities on the balance sheet.

The other section of liabilities is the noncurrent liabilities, long term liabilities. This includes long term debt, which is not due within the next 12 months, but it still is owed back to the creditors over time and then kind of other non non current liabilities, too. This is something that a company just has to manage. Debt can be a great way to raise money at attractive interest rates, especially right now in the economy. But you’ve got to make sure that you have that under control. It’s definitely a red flag for investors of a company just taking on gobs and gobs of debt out there without a game plan on how they’re going to pay it back.

And then the last section on the balance sheet is called Shareholders Equity. This is something that that isn’t owed to creditors and the terms of debt, but it’s owed it is owed to the investors and the shareholders of the company themselves.

So, example, if you are, you know, unshockable on Shark Tank and Mark Cuban decides that he wants to give you a million dollars for 50 percent stake in your company, he’s giving you cash to work with. But he also now controls 50 percent of the company. And by book value or at least what’s shown on the balance sheet, that would be something he’d be very interested in. Of what portion of the company is due to him as a shareholder’s equity as opposed to what’s owned, what is owned in assets minus what is owed to others and liabilities.

And make sure I can spit this all out at the same time here. But, you know, this idea of shareholders equity is basically like if you take out everything that you owe and everything that you own, what’s left for the shareholders and the investors themselves. And you can create value as a company over time, too, in the form of retained earnings, which is also shown in this section of the balance sheet. Where if you’re if you’re stockpiling cash or generating cash flows, you’re your business is healthy, you’re creating value.

The value that is attributed to shareholders continues to increase too. And so the shareholder equity line item of the balance sheet is known as the book value of the company.

And an important, distinct distinction here, as I continue on my play by play: the rest of the balance sheet is that the book value on the balance sheet is different than the market value that is traded out there for investors.

And so the book value is really a line item on the balance sheet. It’s a number when you subtract out all of the liabilities from a company’s assets. That’s by the book, which is what the company is worth. That may or may not be what is the company is trading for out there in the open market. So a lot of value investing really pays a lot of attention to book value versus market value. See if there’s a huge disconnect between what a company is worth on paper and what’s trading for out there in the market.

Austin Lieberman: People who have made book value famous are Ben Graham and then obviously Warren Buffett, who has been a major proponent. I invest mostly in tech companies and software companies. I really don’t even look at book value for companies at all. And so there’s certain types of companies that book value might be important for and then certain companies where it doesn’t it’s not really applicable at all.

And the other thing, Simon, about the shareholders equity is something to watch out for, especially in fast growing tech companies. And a lot of times smaller companies is the amount of common stock issued and the share based compensation. Sometimes that can get a little bit excessive in in newer companies or at tech companies, because in order to save on expenses and having to pay salaries and stuff like that, a lot of times these companies will issue a lot of shares to their employees and especially executives to make up for the compensation so they don’t have to pay it out in salary because they might not have that cash to actually pay out. Or it’s just the way that they incentivize people joining a company because it’s competitive out there. And sometimes to get talent, they you know, you offer a pretty generous, generous equity in the company for people that are that are joining. So that’s something to watch out for, for fast growing textile companies.

Simon Erickson: Yep, that’s a great point. And one final point as we as we finish up here with the balance sheet is by definition, by accounting definition, a company’s assets must equal their liabilities plus their shareholders equity.

That’s very important in accounting. You see something that does not match, then that means that’s an accounting problem that needs to be audited. Always make sure that that equation holds true, that assets equals liabilities plus equity.

So let’s jump to this second financial statement that we’ll talk about here today, which is the income statement.

This is kind of the balance sheet is more of a snapshot of time. You know how much your company has, what it owes, what it owns. The income statement is more of how the company’s operations have performed over a certain period of time. And so we can look at those over each quarter, over three months, or we could look at that over a year, an annual number.

But the idea is basically take all of the company’s sales, deduct all of its expenses that cost to get those sales. And then at the at the end is how many profits to the company make off of that. So we always think of sales, top line, top of the income statement. What was your revenue? And this is always something that’s should be looked at, I think, by every investor. When you’re looking at the income statement, it’s not only what is revenue look like in absolute terms compared to the market that this company is in. But also how quickly is it growing. And ask — and I know that when you’re looking at a lot of tech companies — a lot of these companies are growing incredibly quickly on the top.

Austin Lieberman: Yeah. Most of them, in fact, are not profitable. And so they actually have negative net income. And it’s something that I watch out for investing in the styles of companies that I do. But the perfect example is Amazon, who was unprofitable. And I have even looked closely if they were profitable or not in their most recent release. But the point is what I look for and the companies that I invest in, in in any company people should look for this is are they showing that they have the ability to be profitable and to have a positive net income soon or at some point in the future?

And so Amazon, for the longest time, the story was, hey, you know, sure, we’re unprofitable technically, but we’re doing that because we want to grow. And so we’re sacrificing profitability because we’re piling all of that money back into investments to grow the business. And with Amazon, it’s been incredibly successful with Netflix. It’s been incredibly successful. And even Apple, I’m sure at one point their history was the same story.

But what you have to watch out for is are they sticking to the strategy and what management says, are they becoming more profitable over time? And there’s been multiple times where Amazon has shown with profitable quarters that they can be profitable. And so that’s a good indication if it’s going in the opposite direction and they’re they’re burning more and more cash and net income is getting worse and worse when management’s story is, yeah, we’re you know, we have a path to profitability and we’re just gonna have to extend it two quarters or a year or something like that. For me, that raises red flags. And and I’m probably not as interested in a company with that narrative.

Perfect example. Companies like Uber and Lyft do not interest me for exactly that reason. Super expensive business. They have to spend a lot of money and I’m not convinced. I guess Uber is supposedly getting better, but I’m I’m not convinced about either of their paths to profitability. And there’s easier investments out there. There’s there’s better investments out there in my in my opinion.

Simon Erickson: Yeah, there absolutely is. And every one of these tells a story too. For Apple specifically, we always look at the income statement of change a year over year basis. The total sales for Apple are basically flat at this point in time and 2020 versus where we were a year ago and 2019.

And you can drill down even farther because Apple discloses both its products and its services revenue, too. Which is interesting because the products revenue is the actual sales of things like the iPhone, the iPad, tablets, whatever it might be. That actually decreased a little bit year over year. But the products still account for seventy five percent of total revenue.

And the other line item within sales is the services revenue. So every time you buy a phone, you get the Apple care package to replace certificate’s damaged the cloud for backing up your data. Things like this are becoming a larger and larger portion of Apple’s business. And another important component of that services is the App Store. Apple gets about a 30 percent cut from every transaction that takes place across the thirty thousand third party apps that are downloaded on Apple devices.

30 percent, Austin!

So, I mean, every time that somebody is downloading something on iPhone, it works on IoS system. They’re going to get a good cut out of that. That’s going directly to services revenue. And that actually increased more than enough to offset basically the loss from from product. So there’s a lot of different storylines within a bunch of companies. Apple definitely with this large of a company, is this is that it really helps to drill down into the income statement, see what’s going on.

You mentioned some other really big companies that are there, especially tech companies that have kind of got these separate paths on how they’re making money. A lot of them are kind of interconnected with an ecosystem, but a lot of them have different ways that they’re raising money and spending money as well, too.

Austin Lieberman: And one of the one of the things that has fascinated me about Apple. Is really how well they have innovated as such a large company and, you know, it was a couple years ago now. I don’t remember exactly the year, but Apple hardly had any services revenue. And I remember the narrative of Apple’s a product, a one product company. They had the iPhone and that’s it when iPhone demand dies. Apple’s dead.

And they have been able to really under Tim Cook, been able to kind of shift the strategy in the direction of the company away from that single product company. And, you know, services is still a small part of their revenue when you when you look at total revenue. But it’s growing. It’s growing significantly. And it’s clearly a major part of Apple’s future. And that’s just been fascinating to watch. And you look for the details on the financial statements and the balance sheet.

But as an everyday investor or an everyday person, you’ve been able, as a customer of Apple, you’ve been able to feel this happen as we’ve had more and more options for apps and services and subscriptions through through our iPhones and I watches and all kinds of stuff or Apple Watch. So it’s just me. Fascinating to watch. We’re obviously super nerds. But even if you’re not looking at at their S.E.C. filings, you still can experience this stuff as you’re interacting with these companies, which is so interesting to me.

Simon Erickson: Yeah, absolutely.

And so the top line, you know, revenue. That’s how much money that sales that the companies are bringing.

Now, when I start talking about the expenses that deduct away from those sales and the first being the cost of goods sold, which is directly related to the sales that a company produces.

So these are the things that go directly into manufacturing things. This could be the products for Apple. It could be the casing or the radios that go into their phones for services. It could be something like running the infrastructure that that all of those services have to have. The point of this is cost of goods sold goes directly into the products themselves.

And when we deduct a company’s revenue, when we deduct out the cost of goods sold, we get what’s called a gross margin. So this is a metric that basically can track how much is the company making when it pays out all those costs directly related to the products that it’s making or the services that it’s selling? And so for Apple specifically, we take that all the costs of the products we take out, all the cost directly attributed to the services that it has, it had a gross margin of about twenty two billion dollars loss last quarter, and that was about thirty eight percent of sales.

Now, there’s no hard and fast rule of what a good or a bad gross margin is because it changes based on the industry that you’re in. But all of the things considered, you want to have a higher gross margin, a gross profit margin, I should say. All the things that equal it should be higher rather than lower. And a company should push that higher as it’s leveraging its business.

Austin Lieberman: Yep, and that that is something that I value greatly in the types of investments I look for.

And this is why I personally prefer companies that have less capital expenses and really don’t produce products that they have to sell or fuel, that they have to sell or whatever, because that stuff can be expensive. It’s risky when you have to produce even clothing companies like Under Armour. When you have to produce something that costs money to produce for every one that you produce, you have to pay X amount of dollars and then you have to sell that in order to make money off of it. In order to have more sales, you have to spend more money to build more things that can present a type of risk for a company.

And this is one of the reasons that Apple has transitioned and had to transition away from relying solely on products, solely on iPhones and devices to bringing in that services revenue because it’s more reliable, it’s subscription revenue.

So when we look at a lot of the software as a service companies or tech companies that I like, some of them have gross margins of 70 percent, 80 percent and 90 percent. And that’s because they produce software where in order to sell another subscription, literally costs zero dollars to produce because they have to go build a new thing. It’s just giving another membership to or contract to a customer. And they don’t have to spend more to produce these these fixed assets.

Now, plenty of risks associated with software companies. And that’s not what this podcast is specifically about. But it’s just something to think about is too, like you said, Simon, is to make sure whatever business you’re looking at. Even with Apple, that the gross margins are either staying stable or trending up as as the business scales. Because as Apple has grown, they’ve been able to get more efficient with their processes and they save money in in their contracts with different producers and by producing their own things. And so, therefore, their gross margins have improved over time.

Simon Erickson: Yeah, that’s a really great point, especially for Apple, too, because everyone talks about the ecosystem. Right. You see all the headlines about this is a service company now, all the ecosystem it and matters like obviously you want to be seeing Apple selling more iPhones, but it’s also pretty awesome for investors to see everybody that has an iPhone now, you know, downloading those apps.

How much money does it cost Apple, you know, to just take a 30 percent cut of somebody else’s out the day develop? That’s just, you know, provided on there on their phones. It’s very low.

And that’s why Apple’s gross margin is so much higher in percentage terms for its services group than it is for its products group. Even with that decline in revenue of products year over year, it’s still managed to grow its gross profit margins because of the transition for that for the company. So we love to see companies build on top of something. They already have to create new revenue lines. That increases, like Austin just said, those gross profit margins too.

And so walking down the income statement to the next section. Now we start looking at the operating expenses themselves. This isn’t directly related to the manufacturing or the components of a company’s products, but this is more of the research and development on how they get to creating those products or the selling general and administrative expenses to run the business that are in support of those those products as well.

So for a company like Apple, R&D could be, you know, going out and creating the next features that would be a part of the next iPhone. Maybe it’s going to be the next device, you know, whatever that’s going to look like in health care or something else that it’s working on, that it’s not selling right now, including the salaries for anybody who’s worked in the R&D and design departments of Apple.

And then there’s selling general and administrative, this is things like the buildings where executives and employees are working. This could be these stores and paying the light bill for the stores that Apple has all around the world. The commercials. You know, you’ve got to do a lot of marketing to get people interested in buying your products. And so kind of all of those together, our company’s operating expenses, they don’t go directly into the products. This is in support of the rest of the business.

And generally, I think it’s safe to say that what we’d like to see in investing is the percentage of operating expenses as a percentage of revenue decreasing over time, meaning that a company’s revenue is growing faster than the expenses that are required to support that growth in revenue.

Austin Lieberman: Yeah, exactly. And we can calculate this on our own by looking at some of these different the balance sheet and income statement.

Or we can use tools to do that, and some of them are paid, some of them aren’t. We use Ycharts at 7investing and it gives a super easy look into that exact metric. And that’s something that I specifically look at. And so something that’s really interesting right now and the time that we’re in, Simon, is what companies, Apple included, are able to operate more efficiently and cut some of those operating expenses to make up for some of that lost revenue or some of the unpredicted or unpredictable impacts of COVID and anything. Right.

And so one of things I’m looking for in companies right now is who are agile, who can reduce their expenses in order to protect the company, but also helps sustain some of their profitability during this time. Because if they can do that and keep their sales up, then that’s a good sign for me, for the company in the future.

Simon Erickson: Yeah, and there’s no hard numbers that support this. But rule of thumb, I’d love to see a company that’s got higher than 30 percent operating margins.

So after it pays all the cost of goods sold and all of the operating expenses, I consider a company that’s churning out 30 percent operating margins very, very high.

And one other thing that I love to look at as an investor is when a company is willing to spend at least fifteen percent of sales on research and development.

And that might be counterintuitive, right? You might say, oh, well why do you want to see companies spend so much on R&D as opposed to so little? But to me, that really means that they’re willing to invest in their future. They’re willing to put the money in to developing the next thing that’ll keep them relevant, because really, you want to have cutting edge products. If you’re going to pay more money for rather than just try to glide by on something that’s legacy that’s been out there for for several years.

Austin Lieberman: Yeah. And something I look at Simon, especially in software companies, is the percentage of revenue that they spend on sales and marketing and. Oftentimes in newer companies, especially software companies, will see that in the 60 percent range.

But as the company gets more well known and they prove their product than they earn trust. I look for that number to come down to 50, 40, 30, and then, you know, hopefully even less than that as a percentage of revenue. And so just some things we can look for as as investors to see that our companies are improving over time.

Simon Erickson: Absolutely. Underneath the operating expenses, there are some more kind of one off categories. These are other expenses. This will require multiple cups of coffee, if you would like to talk with us on another podcast. They are complex. A lot of it is equity style accounting. If a company owns a stake in another company, for example.

And then also, of course, the provision for income taxes, companies pay taxes off of their earnings. Not not a royalty off of revenue, but off of the earnings that they’re making. So you take out taxes as well.

And that leaves us with the bottom line. A company’s net income as a percentage of sales would be the net margin. This is kind of how much money a company reported, at least on the income statement. And if we can break that apart into per share figures, when you divide that net income by the number of shares that are outstanding out there.

So if you hear things like earnings per share, that’s something that is reported a lot of times a lot of people react to in a quarterly report that’s just walking down the income statement from sales down to net income and dividing that by the number of shares outstanding.

And a lot of times you’ll see companies move significantly whether or not their earnings per share, they actually report, either exceeded or fell short of what a consensus of estimates we’re expecting for those companies to do. We don’t worry as much about that, though. And we tend to focus more on the longer term and what the company is accomplishing rather than the short term quarterly results.

Austin Lieberman: And that’s a great point is and I’ve made mistakes selling companies too early, which is one of the things I love about our model. At 7investing we really buy great companies and hang on them. And don’t sell because the biggest mistakes I’ve made aren’t the investments I made that went down 20 or 30 percent. The biggest mistakes I’ve made were selling Shopify in 2017. And this is off my head when it when I owned it and it went up 50 percent or 100 percent or whatever, and the share price was fifty dollars a share or something like that. And you look at it today and Shopify is, what was it, seven hundred dollars per share. Right. So. It’s it’s good to look at these quarterly reports and just make sure that things are tracking in the right direction. I have made a lot of mistakes making knee jerk reactions off of one quarterly report.

Netflix is another great example. The company has dropped 50 percent. I think like four or five times in its history, and if you look at it over time, it’s up twenty thousand percent since. Since the year 2000 or something like that. So, yes, quarterly reports important to make sure that things are going in the right direction.

But we look in terms of years and multiple years when making a decision on. Is this a good investment? And is this a company that I want to maintain an investment in?

Simon Erickson: And I think that’s one of the biggest advantages that we have as individual investors, is that actually digging into the story that’s contained on each one of those line items, because the earnings per share number is not the gospel. You know, if they hit or missed on quarterly earnings, that’s not telling the whole story of whether this is a good or a bad investment.

It really comes down to, do you trust your management. That they’re making the right decisions by putting the right money into the right projects? You’re promoting their business through sales and marketing. Are they leveraging their business or is scaling their business so that they’re they’re capturing a larger piece of the sales pie every quarter? I mean, there’s so many storylines that you can kind of look into. It’s every every chapter of the book of the income statement is an interesting one.

Austin Lieberman: And I actually I look for management that’s willing to make decisions that are better for the long term. That might hurt the next quarter or two quarters after that. And so maybe they’re going to miss their short term price to earnings. Or even short term revenue, because they’re making decisions that are going to positively impact the company long term.

And so you might see the company sell off 10 or 20 percent if they miss those targets because of these active managers making knee jerk reactions and selling because they missed their target by one cent or something like that. Just ridiculous. And then you look at this company over a period of 10 years or 15 years, and, you know, it’s up hundreds of percent or thousands of percent as an investment. So sometimes the ability of management to ignore the pain of the short term in order to make good decisions for the long term is a major benefit to long term shareholders.

Simon Erickson: So lots of different ways to grow your company’s value. They don’t always have to do with the earnings that are reported.

The other thing that’s important to remember is that the numbers reported on the income statement. Earnings per share is not the amount of cash that is going into the company’s bank.

And so to reconcile the difference between earnings and cash, we also have a statement of cash flows or a cash flow statement. It really reconciles, you know, what’s the difference between the earnings that are reported on the income statement and the actual cash that is generated from the from the business itself.

And so this takes out a lot of those non-cash expenses. There’s a lot of accounting going on here. There’s a lot of earnings trickery that could be going on for certain companies in there. But really, the cash flow statements is something that we think that investors should take a look at, too, just to have an idea of how much cash a company is actually generating on a quarterly or an annual basis.

And so we start with net income on this one. And then we kind of just walk the line item through line item about the non-cash expenses. Depreciation and amortization is a big one. Depreciation of an asset is as a non-cash charge if you build a building. It’s not taking out billions of dollars from you every quarter. At least I hope it’s not! Maybe someone’s in the walls taking that if it is, but it shouldn’t be.

And that’s a depreciation non-cash charge that you add back because you’re not paying that every quarter. Stock based compensation, big one here, Austin, especially for tech companies. When you’re paying employees or executives in stock, you’re not handing them dollar bills. You’re giving them ownership of the company. And so we add back in stock based compensation into the cash flow statement before we get any farther on the line items that we talk a little bit about stock based comp, because you mentioned that one earlier. How do you think about stock based compensation, especially for those tech companies that you’re looking at?

Austin Lieberman: I realize and accept that it’s a part of the way that they do business. But what I look for is just red flags. And if they’re increasing that significantly from what they have been doing over time or if I just see drastic changes in it, then it makes me dig a little deeper. So it’s one of those things. I’m aware of it, but I don’t pay super close attention to it.

Simon Erickson: Yeah, great points. And, you know, this is something it’s kind of a catch 22, right. It’s kind of nice that a lot of especially tech companies, like we’ve said, are able to pay employees with stock rather than cash. So you don’t have the immediate drag of cash coming out of the bank account to pay people for salaries. But on the other hand, if there were one hundred shares and the companies were the hundred million dollars, and then all of a sudden they issue another hundred shares. Now there’s two hundred shares, but the company is still worth a hundred million dollars. So everybody’s stake in that company’s valuation is less.

So you kind of got to keep an eye on how much stock based compensation a company is issuing. Fair amount is definitely fine. There’s nothing wrong with issuing stock, which is we want to make sure it’s not too egregious out there. And then there’s a lot of operating asset and liability adjustments that, you know, are just kind of changes in the balance sheet quarter over quarter, year over year. This is things like changes in accounts receivable, changes in inventory, changes in accounts payable when you’re actually paying down the payments that you owe to others, to your suppliers, or you’re collecting on the payments that are owed to you by by others as well.

You make adjustments for those and those show up on the cash flow statement. They also show up on the balance sheet. So those should articulate when you’re collecting cash, you’re adding that back to the cash flow signal. And you’re when you’re actually paying off the debts that you owed, you’re reducing that. And all of these kinds of things are operating adjustments that show up in the operating cash flows of a company.

And just to jump a few steps ahead here. After you account for all of those together, we report something called cash generated by operating activities, operating cash flow as a short form referred to as investors.

And this is something that I always look at when I’m looking at financial statements. It’s very important to me to see, even with earnings per share or net income that is reported. I always like to compare it to other companies making more or less than that number in terms of cash flow.

There’s also another group called Investing Activities. So after you pay off all of your operating costs and make all of those adjustments, there are other things that companies can do to invest in its future as well. So we talked about buildings that would be a capital expenditure like Apple building out that five billion dollar building in Cupertino. That’s not going directly to the products.

It’s not an operating expense like inventory. But that’s something that is a capital expense that is captured in the investing activities, part of the cash flow statement. There’s other things, too, like if it’s buying other companies, an acquisition of a business would show up as an investing activity. There’s a whole bunch of other investing activities, too, but I think those are the two really big ones.

And in fact, also we often look at a metric called free cash flow, which is complex. But the short version of it is if you take a company’s operating cash flow, you pull out those capital expenditures, the remaining free cash flow is very important for investors because that’s the the cash that has options of what that can be used for, for the good of shareholders and the owners of the company.

And the next statement here is something that I would like to, in the future, run an entire podcast to talk about.

You have a company that is profitable. They’re creating free cash flow. And now they’ve got to decide what they’re going to do with it. Right?

So you have you’ve gotten to the ideal situation. The Holy Grail, you’re creating free cash flow. And now companies have options. So what they do with that?

One of them is they just continue to grow the business. They start plowing into hiring more people. You want to expand internationally. You want to spend more money in the future than you’re spending today. Let’s grow the business. That’s one option.

Another option is to just sit on it. You keep building up your cash balance because you don’t know what to do with. We’ve seen a lot of companies do that.

Another idea, you could buy back shares. We talked about issuing stock to executives or employees as a way to incentivize and compensate them. How about if you buy back shares of stock so you reduce the number of shares are outstanding for your investors.

You could pay down your long term debt as another option. Which is, you know, if companies I’ve got a lot of long term debt, they’re creating free cash flow. OK, let’s reduce that. Take some of the risk off of our balance sheet.

Or the final one as you pay a dividend. You just say, hey, we’ve got a lot of cash flow generated. We’re going to pay this cash out to you, Mr. Shareholder or Miss Shareholder. And you can figure out what you want to do with it on your own.

And so capital allocation really refers to if a company is generating free cash flow or even if they’re not generating free cash flow, what are they doing with their with the cash that’s coming into the business? And this is a very complex topic, but it’s a very, very important one being that it directly impacts the returns of shareholders in so many different ways.

And so kind of putting all of those together, the cash flow statement is comprised of the operating activities as the first section, the investing activities as the second section, and then the financing activities as the third section. Between the three of those, you kind of get a nice snapshot of, of how the company is operating, how it’s generating cash, how it’s using that cash and if it’s investing enough in for its future.

And so Apple is a very profitable company, you know, generated forty four billion dollars of operating cash flow this last quarter. It’s spent, it looks like, about about four billion of that on property, plant and equipment. And it is buying back shares and paying dividends and repurchasing 40 billion dollars worth of stock in the last quarter.

Austin Lieberman: So there’s a lot to like in this company that we’ve we’ve grown to love over the years called Apple. They’re doing a lot of things right for their investors. And I would add note, you know, such a novel concept of selling fruit that they’d become the world’s largest fruit company.

Simon Erickson: Amazing. Amazing, isn’t it? The other thing that’s really interesting to just, you know, we’re kind of wrapping up, going through the financial statements, but everything can be kind of tied back as a percentage of sales. So we’re talking about free cash flow. About operating cash flow. We’re talking about dividends paid. Share buybacks.

It’s kind of an interesting way to think about it as a percentage of sales. So you can think of for every dollar that a company is selling out there, what percentage of that dollar is being spent on these various activities?

And it’s really interesting when you see companies like Starbucks, which are paying a ridiculously high percentage of sales on buying back stocks. A good portion of every cup of coffee that you’re paying for at Starbucks is going right back to buy back shares.

And so it’s kind of interesting perspective on how these companies are making money and then how they’re spending their money.

Tony Romo, I think that that officially concludes the play by play analysis for the balance sheet, the income statement and the cash flows. Thing is, we’re kind of wrapping up. Any key takeaways in the financial statements that investors should be paying attention to in the grand scheme of things?

Austin Lieberman: So, you know, we covered a lot of numbers here. A lot of terms. But at the end of the day, you know, one thing I want to talk about, too, Simon, is how we use these numbers.

And I’ll start with myself. Right. As an investor. I don’t create I don’t use these numbers and input them in a spreadsheet and track them number by number, quarter by quarter, and come up with price targets for the companies that I’m recommending. There’s people that do that. And I think there’s people that have been successful doing that. But it’s not it’s just not my style as an investor. I don’t have an MBA. I don’t I don’t have a background in finance other than reading, learning and loving, investing and studying companies.

So what I do is really just what we say is I have a base understanding of these concepts. I know where to find them. Ycharts. There’s a glossary, a terms glossary. I know where to find him if I need to reference them. And then I’ve just learned the things that I look for and appreciate as an investor in companies that I want to be a part owner of.

And I look at at the company, the size of the company, how fast they’re growing their sales, the potential size of the industry. And I say, can I see this company doubling in size from here or tripling in size from here or 10x thing in size from here.

And one of my first recommendation for 7investing — and sharing knowledge here, but our our members have already benefited greatly — was Fastly, right? And it was about a two billion dollar market cap company, an edge computing there, a leader. Judged by a lot of independent firms and I looked at their numbers. They’re growing. Their sales are getting more efficient. And I said this company could be a 20 billion dollar company or a 100 billion dollar company one day. And I recommended it. I personally hold it and I intend to add more shares over time. So I don’t want these numbers to be intimidating people. We need to have a base understanding, which is what we’re trying to provide. But that’s how I use it as an investor and in the recommendations that I make for 7investing.

So, Simon, do you want to kind of share your your thoughts on it as well?

Simon Erickson: Yeah, absolutely.

I think that the key for all of this is the story that it tells that’s captured within the financial statements. Right.

And so two examples of this. One is Rosetta Stone. The other is Ubiquiti Networks.

And just kind of looking at those. I’ll cut to the chase really quickly that Rosetta Stone sells software for foreign languages. And it wasn’t spending a whole lot of money on R&D. You can’t really change the Spanish language if you’re trying to learn that. And you know, you can’t do that many software updates, they try to get some stuff online where they weren’t spending a whole lot of money on improving the product. Didn’t have a lot of opportunities to improve their products, but they were spending a ton of money on sales, general administrative. They were spending a lot of money on the kiosks to the salespeople to try to get people to buy those products.

And if you look at Rosetta Stone, Austin, the stock has gone nowhere in the last 10 years. That’s not something you want to see. You put the common sense test on this and you say it’s really hard to capture a lot of profits when you’ve got a business that’s organized like.

And the other one is Ubiquiti Networks, a company that I’ve been a shareholder for a long time on. Love this company. They’re building hardware solutions, so these are things like routers, improving wireless Internet. That’s specifically going towards Internet of Things devices. And they’re in recent years in broadband. And it just kind of doing a whole lot of really neat things, that wireless Internet.

But the company figured out that if it didn’t employ a direct sales force, if it just talked to its customers online and ask what their needs were, it could take all of those sales expenses and put them right into R&D. And so there’s a company that plowed money into its R&D line item and was really just a fraction of what its competitors were spending because they didn’t have a direct sales force.

And over the last decade, Ubiquiti was a “10 bagger”. They’re worth 10 times today what it was a decade ago.

So you see kind of the difference between a company that’s spending heavily on marketing in this case versus when it’s spending it heavily on R&D.

You can see storylines like that in every company that’s out there that’s publicly traded. It’s our job as investors to to figure out the moral of those stories, bring those out. And the opportunity that you just talked about with Fastly and all the other ones that were put together for 7investing. And I think that that’s where you can really benefit as an individual investor to take advantage of those opportunities.

Austin Lieberman: Awesome. We’ll take us home, Jim Nantz.

Simon Erickson: Well, thank you for everyone who stuck with this on this on this podcast. We really enjoyed it. This is something we could talk a lot more time on. We’re gonna keep it to that now.

And really, like we said, please leave us a review. Leave us a star rating. If you have questions, We’re @7investing on Twitter.

For my colleague Tony Romo, a.k.a. Austin Lieberman, I’m Simon Erickson. We really appreciate you tuning in. We are here to empower you to invest in your future. We are 7investing.

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