Lesson 4 - Deciding on the company: What the books tell… Accounting

Shares are pieces of ownership of a company. Therefore, if a company performs well and makes a lot of profit, people will pay more to own a portion and share in the profits, than for a company that does not perform well.

But lets start at the beginning. Assuming a certain company is profitable, you can make money in two ways by becoming a shareholder in this a company:

Firstly, a company’s directors may elect to declare a dividend. When a company makes profits, it is up to the directors how to use that money. They can decide to use it to re-invest or expand the company’s operations, or pay out the cash to the shareholders. The cash payment to shareholders is called a dividend. Normally, the directors would declare a dividend, but also use a portion of the profit to re-invest or acquire extra businesses.

So the first way to make money as a shareholder is to get paid a dividend. The dividend is not fixed, but in good companies and economic climate, the dividend is bigger year after year, as the company expands and makes more profits than the year before. Looking at the dividend history of a company and comparing it with the economic trends over the same 5- or 10 year period, you can often see whether this company took the knocks with the economy, or whether management was able to earn good income despite the economy

You can also compare dividend history with a chart of the performance of the All Share Index or a Top 40 index: A company that was able to grow profits and dividends constantly despite dips in the performance of the All Share Index testifies of good management with the ability to perform even in tough times. This may be seen as a forecast to their future ability to deal with market shocks as well.

The second way to make money is to get an increase in the price you paid for your shares. You might have paid $100 for a share in Pete’s business, based on the expectation that Pete will pay a dividend of $50. However, Pete’s business grew, and his business pays a dividend of $75. People are now more eager to get shares in his business because it’s performing better and paying out more cash to shareholders. Based on this the price would likely rise, to around $150 per share. You however only “make” this money once you sell your share. And once you sold it, it stops working for you for those dividends.

When you invest, you have to decide for which of these reasons you are investing: Dividend payouts, or share value increases. Depending on which one of these you can probably classified as either an investor, or a trader.

A trader buys shares, and sells them at a higher price. He makes his money in selecting a share that will be favored by the market in the coming months. He buys at a low price and waits for the shares to increase in value, and sells them again. When he sells he loses his “portion” of the company, but he doesn’t care, because he’s making money on selling his portion of the company. The trader is usually a short-term investor that enters en exists an investment within a few weeks, maybe a month or so.

The investor invests in the company: He wants that portion of the company that makes profit and pays his dividend. Therefore he evaluates what the share price is and when it is good enough compared to the income he’ll generate from the dividends he expects, he buys. He does not necessarily plan to sell his share of the company if the price increases. He’ll rather keep his share in the company so as to receive future dividends. He will however detect changes in the economic climate that might stir him to exit his investment and move it elsewhere. He will make sure that if this becomes an option that he will still sell out of his share at the highest possible price, therefore profiting not only from the dividends he received over years, but also from the increase in share value that resulted from good financial performance.

Therefore and investor and a trader have two different approaches to buying shares: The trader invests based on a technical analysis of the economy and expected share price movements. The investor buys shares based on the economy and the company’s inherent profitability potential.

When starting it might be wiser to start investing like an investor rather than a trader. Trading is an activity that requires in-depth local- and global market knowledge, a good understanding of worldwide economics, and a continuous familiarity with current market and economic indicators. Often, the business news headlines today determine tomorrows share prices. Share prices are determined on a day-to-day basis by investor sentiment. On the longer term share prices are determined by the company’s performance and future performance expectation. However, dividends are slower to adapt to market movements and economic climate changes.

However, this tutorial will teach you skills required to be either a trader or an investor. Again I refer you to the Rich Dad Poor Dad books authored by Robert Kiyosaki. If you follow his principles of working towards a passive income (earn money for which you don’t work), you’ll invest looking for dividends. (Someone else runs the company - you just share profits). If you were to be a trader, you are actually working for your money.

Lets start with an investor;s viewpoint, and explain how to analyze a company in order to determine if you want to be a shareholder.

For this analysis we will approach the company from two different angles: Firstly, looking at their “books” and secondly looking at ratio’s within the figures.

Someone with good accounting skills might want to skip the section on “company books” and move on towards interpreting the books with ratio’s and figures. The following section covers the basics necessary to understand a company’s financial statements.

Accrual basis accounting:
It’s important to understand accrual basis accounting before proceeding. Accrual basis accounting recognizes that an incurred cost to purchase an item used in business, should be spread over a period of use of that item. The period of use usually correlates to an average expectd period of use within the business.

For example: Pete buys a huge fax machine worth $2000. The fax machine should last him two years (24 months). He wants to factor the cost of the fax machine into the bills he sends his clients. Therefore he splits the cost of the fax machine into 24 months. ($2000 / 24 = $83.33 per month).

So, on his books, he shows the cost of the fax machine as $83.00 per month. Although he incurred a one time expense, the expense gets spread over the time period over which it would need to be factored into the costs of his services or goods.

Each month Pete sends 100 faxes. The cost per fax would be $83/100, which equals $0.83. Now he knows to charge 83 cents back to the clients if he sends a fax.

A different example: Joanne sells 10 home made cakes per week to and old age home at $10 each (Total $100). However, she buys her supplies once a month only, and it costs her $180

In calculating her weekly profits and losses, she would suffer a great loss in the same week as she buys her supplies ($100 income – $180 expenses = -$80.). This is an inaccurate reflection: She hasn’t used all the supplies to bake the 10 cakes in week one. However the full cost was attributed to week one’s books.

So, she will make a loss of $80 in week one, and only start being profitable in week two. So the calculation is ($200 – $180 = $20) if she uses cash basis accounting on a weekly basis.

However, if she splits her costs into 4 weeks and allocate it proportionately, the costs would more truly reflect what portion of the supplies are really used to produce her goods each month.

So, a total cost of $180 spread over 4 weeks, equals $45. This equals $4.50 per cake. Her weekly income ($100) minus the cost ($45) equals $55. This is a more true reflection of her business.

This type of matching expenses proportionally to a time period or lifespan, is also used to determine the cost of goods. Pete now knows the costs of a fax. This is valuable to determine the cost of goods sold, which is an indication of operational effectiveness. For example, Joanne’s Cost of Goods Sold (COGS) is $45. If she manages to produce 11 cakes at the same price, the COGS would be lower – $45/11 = $4.10 each.

Let’s continue to look at how company book keepers records the financial status of the company:

A company’s books are an indication of a company’s financial strengths or weaknesses at a certain moment in time. There are three indicators or “books” we can use to analyze a company’s financial status:

1. The Balance statement
2. The Income statement
3. The Cashflow statement

The next few chapters will cover how investors look at these books. Do not despair – you don’t need to be an accountant to be an investor. We will show you why…

Practical Section

Use the Internet to go to the websites of the companies you are using as samples. Try to find the company's financial statements. They are usually under a link such as "Investor relations" or "shareholder data"

Such results are often published a few months after the company’s financial year-end. The financial year-end does not necessarily run from January to December. A financial year can stretch over any period of 12 months

On these financial results, see if you can identify the Income statement, balance sheet, and cash-flow statement. Notice how they are organized and get an overview of what lines make up totals. Don't worry about understanding these components yet... that's coming up next.

So let's move on to || Lesson 5