Understanding Financial Statements with Warren BuffettPosted December 1st, 2010
Why is this Topic Important to Wealth Managers? Presents discussion on the basic need to understand financial statement information. Whether it’s a predetermination of an insurable interest in a small business or stock and securities advice, wealth managers who are able to interpret financial information are at an obvious competitive advantage.
Financial statements to a business are like a report card to a student. The business, like the student, goes on for some time working, and at periodic intervals information is shared with interested parties. But ask The Professor (Byrnes), or the company accountant, at any given time what a student’s grade is, or what the current account receivables might be, and all he has to do is look in his grade book, or ledger, respectively. The financial statement, similar to the report card, is a summary of all the information complied and then neatly presented.
The financial statement is like the report card, in that it represents performance described over a period of time. What this report card tells us is important. In fact, this author remembers watching an interview with Warren Buffet where the legendary investor was asked, “how do you decide which companies to invest in?” Mr. Buffet answered, “that’s easy, I invest in companies that are undervalued.” What Mr. Buffet meant by undervalued, as it relates to this discussion, is presented below.
There are four basic financial statements. The balance sheet, the income statement, the statement of cash flows, and statement of owner’s equity. Each statement serves a distinct purpose, but is inter-related with all other information in the other financial statements. For beginners that are first understanding financial statements, the income statement and balance sheet are the most important.
Take a simple example. On the income statement, generally, the company will display its revenues (what it collected) minus its expenses (what it paid out) throughout the year. The difference between the two is generally referred to as net income. This same figure will appear on the balance sheet as a change in retained earnings for that year period. Retained earnings is located in the equity column of the balance sheet and is simply the total of all the undistributed net income from the start of the business to present time.
The balance sheet is referred to as such because, it must balance. The basic equation for the balance sheet is Assets = Liabilities + Owner’s Equity. Therefore, all of the assets in the business will total the sum of all the liabilities plus everything the owners or equity shareholders are entitled to. This makes sense. If the business has assets or cash of 100 and it owes a bank, say 50, the owners are entitled, naturally, to 50 as well.
Now, with just a basic understanding of the income statement and balance sheet we can better understand what Mr. Buffet meant, when applied to publicly traded companies. He states that he invests in companies that are undervalued. He goes on to say in the interview that undervalued means the company is trading for less than its worth. That is an interesting concept.
This is so for two reasons. First, we know how much the marketplace “thinks” the company is worth. This figure is represented in the total capitalization of the company stock, or the total current market value of all stock traded on a single company. Secondly, from our brief study of the balance sheet we know what our owners are entitled to. Therefore, as a basic undervalued scenario, when the total market capitalization of the organization is lower than total assets minus liabilities, there is a potential undervalued investment opportunity.
For more discussion of financial statements see AdvisorFX: Business Financial Statements
Tomorrow’s blogticle will present additional tools for the wealth manager.