Introduction to Accounting
To become an informed and successful investor, developing accounting skills is essential. Choosing stocks and companies that have potential for future success requires thorough analysis and a deep understanding of financial dynamics. The skills acquired through accounting are invaluable for this purpose and, when applied correctly, can result in returns exceeding 1000%.
The Accountant’s Role
Accounting, as a profession, involves analyzing company performance and all financial transactions within specified time periods, typically on an annual or quarterly basis. Accountants monitor transactions and company operations in real-time, following a standardized process for documentation. While the information they review can offer insights into a company’s future, it’s important to note that accountants are not able to predict the future. Instead, they assess assets and operations to evaluate the current state of affairs.
The Process of Analysis
When accountants conduct their analysis on a company, they essentially inquire about various aspects and utilize the expected responses to structure their analysis. The initial “question” posed by accountants revolves around the company’s assets. In this stage, accountants review all the assets owned by the company, estimate their values, document purchase dates, track their growth over time, and evaluate whether the investment in each asset has yielded a net gain or net loss for the company.
Subsequently, accountants delve into examining the company’s liabilities to external parties. This encompasses assessing all contractual agreements and obligations held by the business towards other organizations, as well as scrutinizing its financial borrowings or bank loans.
Lastly, accountants determine the company’s profitability by assessing various metrics such as expenses, revenue, cash flow, and other relevant factors. This evaluation allows them to gauge the amount of money the business generates.
By posing these questions and utilizing the information obtained, accountants can gain valuable insights into a company’s financial status and performance.
Major Accounting Statements
After conducting thorough research on a company and analyzing important public financial documents such as 10-K forms, accountants organize the gathered information into three primary statements: the balance sheet, income statement, and cash flow statement.
The balance sheet provides a summary of what the company owes and owns at the specific point of documentation, as well as any changes since the last reporting period. It also estimates the value of the total equity held by the company. The income statement presents the company’s earnings, detailing values such as net revenue, all expenses incurred, and ultimately the resulting profit or loss. The cash flow statement outlines the inflows and outflows of cash within the business, including cash earnings from operations, investments, and financing activities. It provides a comprehensive view of the company’s net cash flow. These three statements play a crucial role in providing a comprehensive snapshot of a company’s financial position, performance, and liquidity. They are essential tools used by accountants to evaluate and assess the financial health and operations of a business.
The balance sheet is structured into two columns: assets and liabilities. Within the assets column, there are four main categories under which a company’s assets fall: fixed assets, current assets, financial assets, and intangible assets. Fixed assets encompass the long-lived physical assets owned by a company, such as land, buildings, factories, or hardware. These assets have a durable nature and typically remain unchanged for an extended period. Current assets, on the other hand, are short-lived physical assets that include readily available cash, short-term investments, inventory, or other cash equivalents. Current assets are more dynamic and subject to frequent changes compared to fixed assets. Financial assets pertain to a company’s investments in other companies or banks. Common examples of financial assets include stocks, bonds, mutual funds, and bank deposits. Intangible assets are non-physical assets owned by a company. They are less common and usually consist of factors such as brand recognition, patents, domain names, licensing agreements, and company goodwill.
Moving to the liabilities column, a company’s liabilities can be categorized into four sections: current liabilities, debt, other liabilities, and equity. Current liabilities represent the company’s short-term obligations, including short-term debt, accounts payable (money owed to suppliers), outstanding wages, income and sales taxes owed, and pre-sold goods and services. Debt refers to what a company owes to another party, typically in the form of a bank loan. Long-term debt specifically refers to debt with a longer repayment period. Other liabilities encompass any remaining obligations that do not fall under current liabilities. This section generally has a lesser impact on the total liability of a company. The equity section represents the shareholders’ equity, which reflects the ownership that shareholders have in the company. It represents the value that public stockholders possess by purchasing the company’s stock. By organizing assets and liabilities into these categories, the balance sheet provides a comprehensive overview of a company’s financial position at a specific point in time.
The income statement, which is the second main statement created by accountants, begins with the company’s raw revenue and ultimately calculates the net income. Accountants initiate the process by estimating the revenue generated through sales. Next, they deduct the cost of goods sold (COGS), which represents the production expenses associated with sales, from the revenue to obtain the gross profit or production profitability. Subsequently, they subtract other operating expenses, which are administrative expenses not directly tied to the goods sold, from the gross profit to determine the operating profit, reflecting the overall profitability of the business.
Accountants also take into account financial expenses, representing the company’s debt, to ultimately calculate the taxable income. This taxable income is then reduced by the applicable taxes to arrive at the net income. The net income is subsequently utilized by equity investors for their own analysis. By following this process, accountants provide a comprehensive view of the company’s revenue, expenses, profitability, and net income, allowing equity investors to assess the financial performance of the company.
The final statement, the cash flow statement, is generally considered the most reliable source of information about a company, as it is less susceptible to manipulation or alteration. Accountants begin by calculating the net cash flow from operations (after taxes) and interest expenses, which reflects the cash generated from the company’s operations. Next, they include the cash flow from investing activities, which encompasses the sale and purchase of real assets (capital spending), as well as the disposal or acquisition of assets and other firms. Finally, they incorporate the cash flow from financing activities, which accounts for the net cash flow from issuing or repurchasing equity and dividend payments.
By summing these components, the accountant arrives at the net cash flow after investing and financing, which represents the net change in the company’s cash balance. The cash flow statement provides a transparent view of the company’s cash inflows and outflows, allowing stakeholders to assess its ability to generate and manage cash. It serves as a valuable tool for evaluating the financial health and liquidity of the company.
But how are these three statements connected to each other? We can describe how these statements are connected through this chart:
As depicted in the chart, different factors impacting company assets have an effect on both the income statement and the balance sheet. Similarly, the operational, investment, and financial activities undertaken by a company result in changes to both the balance sheet and the statement of cash flows. Additionally, the net income or loss recorded by a company during the specified reporting period naturally impacts all three statements, as net income is a crucial determinant for values reflected in each of them. Beyond the numbers, every action taken by a company, whether in the realm of politics, product development, or industry dominance, has a significant influence on all three statements, as these actions inevitably have an impact on the corresponding financial figures.
Accounting is a highly formalized and rule-based process, which is crucial for facilitating comparisons among different companies across various sectors. The standardization of accounting practices is particularly important in enabling such comparisons. Without standardized accounting, the ability to compare financial information between companies would be compromised. The fundamental principles of accounting are established to ensure that earnings, asset values, and cash flows are measured consistently across different accountants.
However, the question of how accounting standards fare internationally arises. Globally, there are two primary sets of accounting standards: Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). GAAP was developed by the Financial Accounting Standards Board (FASB) and is applicable to accounting reporting in the United States. On the other hand, IFRS, also developed by the FASB, is intended for use by globally dominant companies.
In instances of conflict between the two standards, IFRS typically takes precedence over GAAP. Each of these standards provides highly specific guidelines to ensure comparability among accounting statements. The objective is to ensure that financial information prepared using GAAP or IFRS can be effectively compared to that of other companies or jurisdictions. The international adoption of standardized accounting principles, such as IFRS, aims to enhance transparency, consistency, and comparability in financial reporting across borders. It facilitates meaningful analysis and decision-making for global investors, stakeholders, and regulators.
Accounting indeed serves as the foundation for corporate financial analysis and valuation across various industries. Gaining a comprehensive understanding of how accountants think and operate is essential for individuals seeking to excel in this field. Accountants possess a dynamic nature as they navigate the ever-evolving landscape of companies.
By honing our knowledge of accounting principles, we can make well-informed investment decisions and identify the most promising emerging companies. Accounting expertise allows us to delve deeper into financial statements, interpret data accurately, and identify key indicators of a company’s financial health and performance. This level of insight empowers us to seek out the crème de la crème of emerging companies with strong potential for growth and profitability.
By integrating accounting knowledge into our investment analysis, we enhance our ability to evaluate companies from a financial perspective. This strategic approach enables us to identify valuable investment opportunities and make informed decisions based on a thorough understanding of a company’s financial position.