Lesson 6a: The language of businesses
Value Investing 101: introductory course
Introduction
"When in Rome, do as the Romans do," goes a well-known saying. This means that to participate effectively in a society, you must understand its language and customs. The same applies to investing: before entering the world of investments, you need to speak the language of businesses.
And what is the language of businesses? Numbers.
Companies communicate with investors through numbers. If you don’t understand this language, investing becomes a maze—you don’t know where you are or how to find your way out. But here’s the good news: if you can understand your own paycheck, you can also learn to read financial statements.
The basics are not difficult, and certainly not advanced mathematics.
This lesson became too long, so I’ve split it into two parts. Today, we’ll start with the company’s numbers, summarized in three key reports:
The Balance Sheet – shows what a company owns and how it is financed.
The Income Statement – reveals how profitable a company is.
The Cash Flow Statement – illustrates how money flows through the company.
Together, these documents tell the story of how a company performs, how it manages its resources, and whether it is financially healthy. Investors who can read these reports gain a significant advantage in identifying strong and weak companies.
Next week, we’ll dive into the financial ratios that can be derived from these reports.
Let’s analyze each of these financial statements in detail.
1. The Balance Sheet
The balance sheet is a snapshot of a company’s financial position, showing what it owns (assets), what it owes (liabilities), and how much of its value belongs to shareholders (equity).
The fundamental equation of a balance sheet is:
This means that everything a company owns is financed either through debt or the owners' (shareholders’) money.
The balance sheet is traditionally divided into two sections:
Assets (what the company owns)
Liabilities (debt + equity, meaning the sources of financing)
1.1 Assets: What does the company own?
A. Non-Current Assets (Fixed Assets)
Fixed assets are possessions that last longer than a year. They are not sold directly but are essential for keeping the business running.
Examples of fixed assets:
Tangible fixed assets: Land, buildings, machinery, vehicles.
Intangible assets: Patents, trademarks, goodwill (the premium paid for acquisitions).
Financial assets: Shares or bonds in other companies in which the company has invested.
Fixed assets are usually depreciated, meaning their value decreases over time in the company’s accounting records.
B. Current Assets
Current assets are possessions that can be converted into cash within a year.
Examples of current assets:
Cash and bank balances: Cash that is immediately available.
Accounts receivable (debtors): Money that customers still need to pay.
Inventory: Raw materials, work-in-progress, and finished products that are yet to be sold.
Current assets indicate how quickly a company can generate liquidity to cover operational expenses.
1.2 Liabilities: How is the company financed?
A. Liabilities (Debt)
Liabilities represent the company’s obligations—what it must repay to others.
Current liabilities – Debts that must be repaid within one year, such as:
Accounts payable (creditors): Money owed to suppliers.
Short-term loans: Debts due within a year.
Tax liabilities: Taxes and social contributions payable.
Non-current liabilities – Debts that extend beyond one year, such as:
Long-term bank loans.
Issued bonds (debt securities sold to investors).
B. Equity
Equity represents the money that belongs to shareholders. It consists of:
Issued capital: Money invested by shareholders.
Share premiums: Additional amounts paid when shares are issued.
Retained earnings: Profits that are not distributed as dividends but reinvested into the company.
Equity is crucial because it indicates to what extent a company can finance itself without relying on debt.
2. The Income Statement: How Much Profit Does the Company Make?
The income statement shows how much money a company earns, what costs it incurs, and what the final profit is.
The core formula of the income statement:
Key Components of the Income Statement
A. Revenue (Sales/Turnover)
The total income from selling products or services.
B. Cost of Goods Sold (COGS)
All costs directly related to production, such as:
Raw materials
Wages of production employees
Transportation costs
\(\text{Gross Profit} = \text{Revenue} - \text{COGS}\)
C. Operating Expenses
Costs that are not directly tied to production, such as:
Salaries of management and administrative staff
Marketing expenses
Office rent
\(\text{Operating Profit (EBIT)} = \text{Gross Profit} - \text{Operating Expenses}\)
D. Interest and Taxes
The company pays interest on its loans and taxes on its profits.
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Net profit is what ultimately remains for shareholders.
3. The Cash Flow Statement: How Does Money Flow Through the Company?
The cash flow statement may be the most important report, as it shows how much cash a company actually generates.
The Three Sections of the Cash Flow Statement
A. Operating Cash Flow (Cash Flow from Operations)
Shows how much cash the company generates from its core activities.
Important: This differs from the income statement because some revenue has not yet been received, and some expenses have not yet been paid.
B. Investing Cash Flow (Cash Flow from Investing Activities)
Shows cash flows from investments, such as:
Buying or selling machinery
Investing in other businesses
C. Financing Cash Flow (Cash Flow from Financing Activities)
Shows how the company raises or repays money through:
Issuing new shares
Taking on or repaying loans
4. How These Three Reports Are Connected
The balance sheet, income statement, and cash flow statement are interconnected:
The income statement generates net profit, which is then recorded in the balance sheet as retained earnings.
The cash flow statement shows whether the profit actually leads to more cash.
For investors, the cash flow statement is often the most reliable indicator of a company’s financial health.
Next week, we’ll take a closer look at some key financial ratios derived from these three reports.
The Start
