Accounting is for investors what concrete is for builders, the stuff that puts everything together. Accounting in business is the systematic development and analysis of information about the economic affairs of an organization. This information can be used in a whole variety of ways. It can be used to help make decisions, plan future decisions and operations as well as appraise the organization’s performance. It is the most basic of financial tools investors have at their disposal.

If you are an investor or are planning to be one it is a good idea to learn the basics of accounting, especially the branch of financial accounting. This article will analyze one of the three basic financial statements that investors can use to weigh up a company and make educated decisions on its future. The three financial statements that will be analyzed in this hubpage are: the balance sheet, the income statement and the statement of cash flows.

The Balance Sheet
The balance sheet describes the resources a company has under its control at a specific moment in time indicating where the resources came from. Your basic balance sheet has three sections a) the assets, valuable rights the company owns, 2) the liabilities, what the company owes to outside lenders that have provided funds and 3) the owner’s equity, which means the funds the company owners provided. Check here for an example balance sheet

These three sections of the balance sheet must always be related in this basic form: total assets equals total liabilities plus total owners’ equities. Or what is the same: total assets minus total liabilities equals total owners’ equity. What all that means is that the owner’s equity is always equal to the net assets or assets minus liabilities.

Balance sheets are generally divided by current assets and noncurrent assets. Current assets include cash, amounts to be received by customers, inventories and other assets that can be converted into cash easily. Noncurrent assets may include fixed assets and long term investments that are not as easily liquidized.

Liabilities are similarly divided into current and noncurrent liabilities. The day to day or year to year expenses like wages, amounts payable to suppliers and tax are included in the current liabilities while long term liabilities like long term bonds, company pensions and amounts payable to company holders are labeled as noncurrent.

With respect to owners’ equity there is a difference between American and continental European accounting practices. In America Equity is divided into pain-in capital and retained earnings. Paid-in capital refers to money paid to the company in exchange for stocks or shares in the company. Retained earnings are the difference between the amount earned by the company and the dividends paid to the owners.

In Europe and other parts of the world owners’ equity is classified between equity that cannot be distributed except by liquidizing all or part of the company (capital and legal reserves) and the amounts that are not restricted (free reserves and undistributed profits).

As you can see the balance sheet is a powerful business tool that can give you a very useful snapshot of a company’s financial health. However the balance sheet only tells part of the story. When you are looking at a company you don’t want to know what it has but how it is using its assets to make a profit. A great tool to dig that kind of information is the income sheet, the subject of our next blog.

Income Statements
In order to make good business decisions it is important to understand the current health of a business. You need to know the assets and liabilities of the company and what equity it has. Your best tool to analyze the health of a company at any given moment is the company’s balance sheet. However that is only part of the story. What you really want to know when you buy or invest in a company is to know where the company is going. It is no good buying into a great company that is being run into the ground.

How can you predict the direction a company is going in? Obviously this is not an exact science or every accountant would be a millionaire but a great tool in order to predict the profitability of a company is its income statement.

Financial statements, like the income statement are a financial tool that provides us with data that allows us to make educated business decisions. The last section explained how balance sheets work, we will now deal with income statement.

So how does an income statement work?
Well companies use assets to produce goods and services. Success depends on whether the business uses its assets wisely to produce goods and services.
Success is generally measured in the amount of profit it earns, the growth or decline of its stock assets. Another term we must understand is Net income. This is the accountant’s term for the amount for the amount of profit in a set period of time.

The income statement of a company shows how the net income for a set period was derived or how the company made the profit. For example a typical income statement would have a first line that shows the net sales revenues for a period. These are the assets obtained from clients in exchange for the goods or services.

The second line might summarize revenues (income) from other sources not directly related to the business. This information is not as important for an investor because it does not provide as much useful information about how the business is run.

The next part of an income statement shows the expenses incurred in the period being analyzed. In other words the assets consumed while revenues were being earned. Expenses can then be divided in any number of categories to show what the assets were used for.

The final part of the income statement has the net income that summarizes all the gains and losses in the period. This includes the results of the company’s normal day by day activities and any other events. The net income shows if there is the net income is positive (a profit) or negative or as it is also called, a net loss.
Check this example Income Statement

Income statements are usually accompanied by a statement that shows the change in profit or retained earnings from one year to another. As a summary and in order to use some of the jargon we have learnt in this article: Net income increases, retained earnings; net loss or the distribution of cash dividends (payouts) reduces it.

If you can read an income statement you can learn how a company got where they are. How profitable they are and how good they are at making money from the assets they have.
Making good investments is a skilled job that requires experience and a solid understanding of business management. Whether you choose to invest through a broker or do it yourself it is important to be able to work your way round financial company statements if only to ask your broker the right questions.

Cash flow
Barring a magic ball, Accounting is the best tool an investor has to help him decide where to put his money. Many of us view accounting as a quasi-mystical activity only geniuses can even get close to. It is true that investing is a skilled activity that should not be played with unless you have plenty of money to lose. However this does not mean we can’t get enough of an understanding of accounting to get a feel of the health and trajectory of a company.

In this hubpage we have already checked out two basic company statements you are sure to encounter if you venture in world of accounting or investment, balance sheets and income statements.

These statements helped you understand how well a company is doing, its assets and liabilities and how they got to be in that position, what they invested in and how much of a return they made from their investments.

However these statements only give a partial view of a company’s situation. That is why companies also prepare a third financial statement, the statement of cash flows. Cash flows result from the combining of three major groups of activities:

1) Operating activities,

2) Investing activities and

3) Financial activities.

Combining these three areas into a meaningful statement is a great way of evaluating the desirability of an investment. Check this Cash Flow Example

Why are cash flow statements useful?
They provide information income statements and balance sheets cannot provide. To start with not all revenues in a company is collected in cash. Cash a company perceives from operations is not the same as the net income (revenues minus expenses) that income statements record.

Cash from operating activities on the other hand reflect actual cash, collected not only the accounts receivable. This makes accounting more flexible and in a way more realistic. For instance expenses can be recorded without an actual cash payment.

Take this situation. Cash is received from the issuance of bonds and was paid to shareowners as dividends. This is an important operation that is simply not recorded in an income statement but is the bread and butter of a cash flow statement.

The purpose of the statement of cash flow is to provide valuable information on management’s use of financial resources available to it and to help the users of the statements to evaluate the company’s liquidity, its ability to pay its bills as and when they come.

Now you have a basic understanding of the three basic company statements, balance sheets, income statements and cash flow statements you can begin to understand how investors use accounting to make smart investments.

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