Financial Statement Foundations
Know your numbers
Financial statement analysis is my secret sauce for finding value when evaluating investments, acquisitions, and businesses. Last week, I described a basic framework to prep your financials for analysis and I’d recommend starting there.
“If you don’t understand the accounting, you don’t understand the business.”
— Charlie Munger
When investing, I’m looking for cheap and stable cash flows. When operating, I’m looking for what’s going right and what’s going wrong. I’m underwriting both using the 3 financial statements.
Income statement tells me how the business model and profit model are working on an accrual basis.
Cash flow tells me where money is coming from and going to (i.e. how it’s getting allocated).
Balance sheet tells me how efficient things are running.
There are many tools and metrics we can apply here, but before that we need good financials to make good decisions (both as an operator and investor). Good financials and good analysis are joined at the hip.
For now — The best way to get better at dissecting financials is to start looking at them regularly. Use your business, a target business, competing businesses, search for public companies in your industry (or any industry). Treat this like reps in a workout. (I’m hosting a case study on the 29th.)
Profit and cash flow...
Starting with the basics of SMB/investing financial literacy — profit vs. cash flow is the foundation. You don’t need to be an expert on accrual accounting to read financials. Profit vs. cash flow gets you 80% there and the balance sheet fills in the gaps.
Profit = money left after covering expenses — i.e. what a business makes
Cash flow = money coming in minus money going out
So what’s the difference?
They run on 2 separate cycles with separate drivers… profit happens as revenue and expenses are recorded (on paper) while cash flow is all about timing (when it hits the bank account). The key is to know drivers of each. It’s like clocking in for work on Monday while getting a paycheck on Friday. Your P&L shows Monday earnings but no cash flow.
A brief list of things that drive profit and cash flow differences:
Profit drivers — sales volume, pricing, product mix, margins (all of ‘em), cost structure, financing
Cash flow drivers — collections timing (A/R), billpay timing (A/P), inventory management, depreciable assets (capex), debt service, funding, accruals and other stuff not yet paid
You need both cash and profit for long-run value creation. There is no “best” financial statement, they all work together. Profit without cash = dead business walking. Cash without profit = dead business walking (usually).
The balance sheet...
The “bodies are buried on the balance sheet” as they say… translation: business problems typically reveal themselves on the balance sheet (debt, working capital, lack of equity, mis recorded items, etc.).
Taking a step back — the balance sheet exists to serve its master, the income statement. We buy assets to create sales (and earnings). Assets are funded by liabilities (vendors or lenders) and/or equity (owners/shareholders).
If you’re lucky enough to have profit, then you can buy more assets (or pay down liabilities or send money back to owners).
If you’re staring at a profitable business but the cash isn’t piling up, chances are it’s sitting somewhere on the balance sheet. A few places I like to look:
Retained earnings — tells me whether a business has been profitable for a while
Debt / leverage — measure of risk, solvency, etc.
Working capital — efficiency, too much and cash runs dry, too little and sales run dry
Fixed assets — indicates whether the business needs a lot of physical “stuff” to operate
The “other” stuff — intangibles, leases, deferred liabilities, etc. — this grab bag could have its own post
Plenty more to look at on the balance sheet but will cover ratios and metrics another day. Just remember, it’s easy to skip over the balance sheet or simply look at debt… don’t make that mistake.