6 Things You Need to Know About Investing in Stocks

INVESTMENT SPOTLIGHT

Based on the results of the last two polls on this site, most of our readers are more interested in learning about investments in general and investing in stocks in particular. The mystique that surrounds stock investing in the country is primarily a by-product of viral hearsay or irresponsible braggadocio: almost all of us know someone (who knows someone who knows someone...) who always tells stories of making a killing in the stock market; the problem is that you will never hear the same person tell you about the times when he actually lost money.

Is it possible to make money in the stock market? The short answer to that is, “YES.” The caveat is that it’s also entirely possible that we’ll lose a portion or all of our investment in the stock market. If you have the stomach for such a risk, then maybe stocks are for you. But before we go into specific stock investing strategies, we need to be familiar with the basics first.

1. There are two kinds of stocks. Common stock represents ownership of a corporation and is thus funded directly by the firm’s owners or investors; common stockholders enjoy the right to vote on important corporate decisions (like the membership of the board of directors) and are entitled to a portion of the firm's assets and earnings after financial obligations to creditors have been satisfied. Preferred stock is an alternative source of long-term capital for the firm; preferred stockholders cannot vote, but receive fixed dividends that are paid before common dividends. Since most investors are more familiar with (and interested in) common stock, this post discusses this type of stock exclusively; so all throughout this post, whenever you see the term “stock,” it means “common stock.”

2. Investors earn from investing in stocks in two ways. First, investors can get a portion of the firm's earnings in the form of cash dividends, but only after interest payments to creditors, taxes, and all other financial obligations have been paid. Companies are not obliged to pay any dividends, even if it is awash with cash; dividend payments are not guaranteed, even for companies that have historically paid a certain level of dividends. Typically, firms in “high growth”, R&D intensive industries would choose to reinvest earnings back to the firm than pay out dividends. Meralco (MER), which operates as a virtual monopoly and which is in the “cash cow” stage of its life cycle, has just announced a 3.15 pesos dividend per share last week. Second, investors earn by selling stocks at a price that is higher than the price at which the shares were bought; the difference or spread between these two prices is called capital gain.

3. Investors can buy and sell stocks in stock markets. Stock markets like the Philippine Stock Exchange or PSE gather market participants and facilitate stock transactions. Market participants include listed companies, or firms whose shares of stock are publicly traded or “listed” in the stock exchange; trading participants or brokers who act as intermediaries between sellers and buyers of stock; and investors, which include institutional investors like banks, insurance companies, and various funds (like mutual funds and UITFs), and individual investors like you and me.

4. You can buy either primary or secondary shares of stocks. Primary shares are those that are sold for the first time through an initial public offering or IPO; a firm that wants to have access to capital provided by the investing public goes through an IPO and is subsequently listed in the stock exchange. Secondary shares are those that are already owned by investors and are traded daily in stock exchanges.

5. Choose a broker. Stock brokers facilitate buy and sell transactions for investors, for a fee. You can choose from among 150 local and 34 foreign trading participants in the PSE. Nowadays, as more and more investors become more tech-savvy, online brokers are becoming more and more popular to individual investors. In a future post, I will discuss the key benefits and disadvantages of traditional and online stock brokers.

6. The performance of the stock market as a whole is reflected by the stock market index. For the PSE, the most quoted index is the PSE index or PSEi, which is the weighted average stock price of the 30 most “important” and highly-traded stocks in the exchange. The PSEi is a number that tells us how well the stock market, in terms of the prices of the component stocks, is performing: the higher the index is, the higher the prices or the components are, the better the stock market is doing. At the height of the financial crisis one year ago, the PSEi was at around 1,800; now it hovers at around 3,200. That’s an overall market growth of around 78% in one year, which means if you invested 100,000 pesos in a portfolio of stocks which mirrors the PSEi (like equity UITFs) set link here, you would have around 178,000 pesos today.

But maybe the more important and relevant question to ask is: Does a relatively high PSEi (such as 3,200 today) mean you should start investing in stocks? Well, it depends. Remember, the idea is to buy at low prices and sell at higher prices; buying stocks when stock prices are relatively high only makes sense if you have reason to believe that stock prices will get even higher in the future. Another very important decision you should make is which stocks to invest in. Does it make more sense to invest in “small cap” stocks or “blue chip” stocks? Individual stocks or index portfolios? In next week’s post, we’ll look at possible answers to these questions and several investing strategies that you can use in your first foray into stock investing.

The Time Value of Money: Making Better Purchasing Decisions

PERSONAL FINANCE 101

Say you’re looking for a brand new netbook for your blogwork. You already have a specific brand and model in mind, and you start to shop around for the best deal you can find. You come across a store which offers the netbook that you want at a retail price of 18,000 pesos and a “0% interest” credit card offer of 1,500 pesos per month for 12 months. Being some sort of a math whiz back in the day, you make a few, quick mental computations and verify that, indeed, 1,500 pesos per month for 12 months totals 18,000 and the offer is a gee-nyu-wine 0% deal. But before you whip out your plastic, you suddenly recall something you recently read in the country’s fastest growing personal finance blog and ask the sales clerk what the cash price of the netbook is (that is, how much you can buy it for if you paid in full with cash and not with your credit card). Without batting an eyelash, the clerk tells you that the cash price is 16,364 pesos. Assuming that you actually have 16,364 to spend, you are now faced with a payment quandary: should you buy the netbook for 16,364 pesos cash up front, or pay for it with 12 monthly installments of 1,500 each? If we ignore the time value of money, then the “less expensive” cash upfront choice is the clear winner. But we know that the time value of money is real, and that paying in installments has a cost (definitely not “0%” as the offer asserts). The question is, what is that cost, and is paying that cost worth it? At first glance, it seems that the cost is simply 10%, which is difference between 16,364 and 18,000 divided by 16,364, but because the installments are made monthly, it is not as simple as that.

Now unless you brought your trusty financial calculator with you, you will need Excel to compute for the implied cost (in percentage terms per month). The internal rate of return(IRR) function of Excel can help you find the implied interest rate between the two financing options. In the image below, we see that since we are looking at the cost of choosing the installment option, the 1,500 installments should be treated as cash outflows or negative cash flows; the 16,364 in month 0 is positive because by choosing the installment option we are not paying 16,364 and the amount should be treated as a cash inflow or positive cash flow.

Using Excel's IRR function gives us an IRR of 1.50% per month; this means that choosing the installment option will cost us 1.50% per month, or that, essentially, we will be borrowing at an interest rate 1.50% per month or 18% per year (in Annual Percentage Rate terms; how this animal differs from others in the interest rate jungle will be the topic of another post). So does this mean we should choose the installment option over cash up front, or is it the other way around? Well, it depends on borrowing interest rates (or investment rates of return) that are available to you. For example, if you can borrow from someone at 12% per year, then paying for the netbook in installments at 18% per year would cost you more; it means you’ll be better off borrowing 16,364 at 12% and buying the item in cash. It also follows that if have 16,364 now and you can only earn 12% per year on any investment, the better option would be to use your money to buy the netbook now than invest the amount. Following the same line of thinking, if your only available debt choices have interest rates that are greater than 1.5% per month (like credit card debt), or that you can invest money at a rate of return that’s higher than 18% per year, you should invest whatever money you have now and pay for the netbook in installments.

With this example, we see how we can use the time value of money to make better purchasing decisions. Borrowing at a lower rate, like 12%, and choosing the cash up front payment option over the 18% installment option, you’ll be able to save 6% in one year or around 982 pesos on a 16,364 peso purchase. Now that may not seem much, but if we scale our purchase to, say, a 50-inch LED TV which costs 200,000 pesos or something even more expensive, the impact of making the right decision becomes significantly more substantial.

The time value of money concept is a powerful tool that we should always use in making important purchasing decisions. Next week, we’ll take a look at how we can use it to choose among a number of available investment alternatives.

33 Ways of Boosting Your Savings (Part 3 of 3 Because In the End, All Good Things Must Come to an End)

33 ways to save more money just in time for someone's special 33rd. Here's 23 to 33 on the list:

23. Pay with cash (for select goods). For basic expenses like gas and groceries, it’s always better to use your credit card because of the freebies you can get, as I mentioned in Item #8 of this list. But for some major purchases like gadgets, appliances, and other consumer electronics and durables, paying with cash is almost always the cheaper option. The “cash price” of these goods would be 5 to 10% lower than the sticker price, which is based on the default assumption that you’ll pay using your credit card.

24. Try to live as near as possible to your place of work. You don’t necessarily have to spend more if you get a pad that’s near your place of work. If you are working in Makati, for example, you’ll find decent and affordable apartments and condos for rent along Estrella or Boni Avenue; if you’re based in Ortigas, there are good-value residences in the Amang Rodriguez area in Pasig City. Whatever additional expenses you’ll incur by by living near your place of work you will recoup with savings on gas, transportation fare, and time. Not only that, you’ll also be less exhausted when you get to work in the morning and when you get back home at night.

25. Regularly clean your electric fan and air conditioner. Clean electric fans and air cons provide better ventilation and cooler air even on lower settings, even in exceptionally hot and humid days. Plus you get the bonus of having a cleaner and more pleasant-looking (and not so icky) living space.

26. Scrap your landline phone. When was the last time you actually needed to use one when you were home? Nowadays you can even text your fast food delivery order. Easy 700 pesos per month or 8,400 pesos per year.

27. Use your work HMO for free medical checkups. Yeah, I know how we all love to play doctor from time to time and just google possible reasons for why we feel a bit doozy. But it does not ever make sense to scrimp when it comes to your health, especially when there’s no reason to. If you’re already working, then most probably you have health insurance, which comes with unlimited medical checkups. Use this benefit whenever you feel a little off-kilt and you’ll save at least 500 pesos per visit.

28. Get a part-time job. If you can watch Chuck marathons or play Call of Duty: Modern Warfare 2 till the wee hours of the morning, it means you have excess free time, precious free time you can use to beef up your disposable income. Try writing for a fee for search engine optimization firms or any writing gig you can find posted on craigslist. If you have a repository of ample knowledge and confidence (and a bottomless well of patience), you might want to try being a part-time tutor. No matter what “racket” you decide to pursue, the key is to be productive and try to maximize the use of your time, especially when you’re still (relatively) young and single.

29. Get free e-books online. Works by Shakespeare, Dumas, Doyle, Dickens and other classical authors are all available online, legally for free, at Project Gutenberg. You don’t even have to have a Kindle or an iPad to enjoy these masterpieces; if you abhor reading from your computer, free e-book applications for most modern cellular phones and smartphones like the iPhone abound online.

30. Always fly no-frills. Just always show up for your flight on time, and you’ll get around 10% cheaper air fares. Who needs crappy airplane breakfast, anyway? The difference in food aside, carrier P is more expensive than carrier C not because it offers better service or because it has a safer flight record: it’s primarily because P is highly unionized. This means at the same level of output, P’s labor costs are several times higher than C’s, at that extra cost is passed on to unwitting consumers, i.e. us.

31. Invest in yourself. It’s something Warren Buffet is often quoted as saying. Getting an MBA is no assurance that you’ll instantly get promoted, but at the very least, you’ll learn things about business that no amount of experience can teach you. And believe you me, it will open doors you don’t even know existed. If you’re too lazy to study for another two years, you can instead try to get a professional certification (e.g CFA, CIA or SCJP) or a professional license to be a Real Estate Broker or a Financial Planner; anything that will set you apart from the other rats in the race.

32. Stop smoking. One, you’ll live longer. Two, you’ll save around 8,000 pesos per year. Need I say more?

33. Don’t celebrate your birthday. But if you can do all of the 32 tips I mentioned above, you can save as much as 140,000 pesos per year (excluding one-time savings), so there’s no real reason to be a penny-pincher on your birthday. Celebrating your birthday may cost you several thousands of pesos, but sharing your blessings with those who have helped you along in the past year and spending happy moments with your friends and loved ones is something you can never put a price tag on. So please ignore this last tip. Splurge and celebrate the most important day of your life. Just don’t forget to invite me when you do. ;)

33 Ways of Boosting Your Savings (Part 2 of 3 Because Once You Pop You Can't Stop)

33 ways to save more money just in time for someone's special 33rd. Here's 12 to 22 on the list:

12. Plan your trips to the grocery. You'll enjoy the benefits of economies of scale in terms of effort and gas usage. Not only that, you also increase your chances of getting a free movie ticket from Citibank.

13. Withdraw money only from your bank’s ATM. It's bad enough that we earn dismal returns on our savings accounts because of terribly low interest rates per annum (often lower than one percent); that we have to pay a fee every time we withdraw from another bank's ATM even when it's part of the same ATM network as our own bank is what breaks the camel's back. To avoid paying 10 pesos every time you withdraw 200 pesos (that's 5% of your money down the drain), just put all of your savings in a bank with the most number of ATMs around the country; I think we all know which bank I'm talking about.

14. Negotiate that your credit card’s annual membership fee be waived. Just ask, and I assure you, your credit card company shall deliver. In my case with Citibank, I was just asked to sign up for their mobile service (which wouldn't cost me any money) in “return” for waiving my annual fee, so who was I to refuse? This will save you at least 1,200 pesos a year.

15. Buy a netbook instead of a regular laptop (and don’t even think of buying a MacBook, with all due respect to Mr. Alyson Yap and all the Mac fans out there). The latest netbook models will cost you anywhere from 15,000 to 20,000 pesos, at least 50% of the price of most regular Windows-based laptops and 33% of the price of the cheapest MacBook in the market today. 10-inch netbooks are not only inexpensive, lightweight, and portable, you'll also find that they are more than adequate for most of your day-to-day computing needs. A big, heavy, and clunky regular laptop should be out of the question for first-time laptop buyers, and while a MacBook may a sexy, secure, and powerful machine, its steep learning curve on top of its equally steep price makes it a not-so-attractive alternative to the frugal laptop buyer.

16. Use a prepaid cellphone line. No industry illustrates how intense competition among market players benefit end users better than the local telecommunications industry. The market is rife with unlimited text and call promos, and now you can even get 150 text messages to all networks for only 15 pesos! So if you're an average user, there's no real reason to get an 800-peso per month plan that you'll just be forced consume just to not let it go to waste. With a prepaid cellphone service, you can easily get away with 500 pesos per month and save 3,600 pesos per year.

17. Use open source software. The reputation of Linux as an operating system for the exclusive use of geeks has now been completely eroded, thanks to the growing popularity and steadily increasing user-friendliness of distributions like Ubuntu and Linux Mint. Using Linux is the closest you'll ever get to a “free lunch”: you get all the benefits of a virtually virus-free system at zero cost. Plus, there's a host of open source software (like Open Office and GIMP) that can easily take the place of most commercial software (like MS Office and Adobe Photoshop) for both your personal and professional needs.

18. Eat more salads or sandwiches. Eating salads is the most inexpensive and hassle-free way of eating healthily. A bag of lettuce only costs 58 pesos and can last you 3 to 4 meals; add fresh tomato slices, some pineapple bits or cucumber slices, just about any kind of meat or seafood, a splash or two of dressing or a dash of salt and pepper, and you're done. No cooking necessary. Tuna or ham on wheat bread can be similarly healthy and hassle-free, although I prefer my sandwiches toasted. All this healthy, yummy goodness at a fraction of the cost of eating out. And it can even be cheaper than some home-cooked rice and viand combos.

19. Research any major purchase (3,000 pesos and up) before going to the store. Every good decision requires equally good information. When you start earning your own money, you'll realize how important it is to be more discerning in making big-ticket purchases; oftentimes, the best way to do it is to look for (trustworthy) reviews about your alternatives online before even setting foot in a mall. Once you know what brand and model you really want to buy, then visit a few stores to see if any one store sells the item you want at a significantly lower price than all the other stores: it does happen from time to time. Doing research for major purchases will help avoid "impulse buys" that we more often than not regret as soon as our money (or credit card) leaves our hands.

20. Stop your newspaper and magazine subscription and read news online. The global print industry is dying, as what happens to all business models that are becoming obsolete; in the next few years, most printed content will be converted to digital formats or migrated to online venues. Paying 18 pesos per day (or 6,570 pesos per year) for a newspaper subscription and/or 2,500 pesos per year for a magazine subscription just does not make sense when you can (legally) get the same content and information online for free.

21. Junk your gym membership (yes, the one you don’t even use that often). Doing push-ups for strength training and running for cardio won't cost you anything. You can easily download a training program which uses a couple of dumbbells and an exercise ball for free. So why pay for gym membership, which costs anywhere from 12,000 to 24,000 per year, especially when you don't go to the gym regularly anyway.

22. Brew your own coffee. If you're into real coffee (not that sweet, blended ice beverage kind nor the instant 3-in-1 kind), then the best way to enjoy it is by brewing your own using a French press (even Starbucks says so in one of its flyers). A decent coffee press from Bodum will cost you around 800 pesos; ground coffee will cost you around 300 pesos for a 400 gram pack which will last you around two months at one cup a day (you can get even better and cheaper beans from Baguio). That's a bargain compared to a tall serving of brewed coffee or cafe americano which will cost you around 100 pesos at your neighborhood cafe; drinking home-brewed coffee can thus lead to savings of as much as 33,000 pesos per year.

Part 3 in 3 days. I love patterns.

33 Ways of Boosting Your Savings (Part 1 of 3 Because All 33 in Just One Post is Just Too Darn Long, Just Like This Title)

33 fool-proof ways of cutting back on expenses and saving more money. Here's 1 to 11 on the list:

1. Cut back on going out for drinks. It's okay to occasionally go out with friends and loved ones to catch up on things or celebrate special events. By occasionally I mean twice a week, at most. Going out more frequently than that is a sure fire way of being broke at the end of every month. If you cut back on your going-out spending by 500 pesos per week, you'll save 26,000 pesos per year.

2. Use your free dental benefits. If your office health plan covers dental services, then you're most probably entitled to two cleaning sessions per year and one or two “pasta” treatments. The cleaning treatments alone will save you anywhere from 1,200 to 1,600 pesos per year (conventional wisdom teaches us to visit our dentist twice a year), and that doesn't even count the benefits of having sparkly-white smiles all year long.

3. Walk to wherever you’re going whenever possible. I know how painful it can be to walk even short distances under the stifling heat of the sun, but whenever you can do try to just walk to wherever it is you're going. You'll not only save a few bucks on gas or transportation fare, you'll also get a few minutes of exercise to boot.

4. If it’s not possible to walk, use public transportation whenever possible. If you're just traveling alone and you're not carrying any heavy stuff, then try to use public transportation like the MRT/LRT lines, FX shuttle services, and (as a last resort) buses as often as you can. While the savings on gas may not be very significant, avoiding the frustration and stress brought about by the ghastly traffic along major metro thoroughfares is priceless. What some people from the north do when going to Makati is park their car at Trinoma (flat rate 45 pesos per day) and just take the MRT to Ayala or thereabouts.

5. Stop using cable. TV is called an idiot box for a reason. Stop being an idiot, get rid of your cable subscription, and save at least 9,360 pesos per year (or 2,500 pesos one time if you're into that illegal cable thing).

6. Learn to love reading for entertainment. Get a nice, second hand Stephen King book from Book Sale for 150 pesos and it will give you anywhere from 24 to 120 hours of pure entertainment pleasure, depending on how fast you read and how imaginative you are. You'll save on movie tickets (around 160 pesos for around one and a half hours, and sometimes the movie is not even that entertaining) and electricity (for your TV, DVD player, PC, or gaming console) and you'll even improve your vocabulary and writing skills.

7. Eat at home more often. I'm not even talking about your once a week dinner dates with your special someone; what you need to get rid of is your almost-daily fill of Chickenjoy or Cheeseburger Meals. A 2-piece Chickenjoy meal now costs around the same as one kilogram of dressed chicken. Buy a pack of breading mix and gravy (or ketchup, if you're into that) and deep fry your home-made version of Chickenjoy for at least one-third of the cost. But often, it's not even about how much you'll save, but how you can make sure that you get the best nutrition you can get for your money.

8. Take advantage of credit card freebies. Don't forget those free Chickenjoy meals from BPI credit, Greenwich pizza from Metrobank credit, and movie passes from Citibank. But as Anica commented in one post before, don't make the mistake of buying stuff you don't need just to rack up the required amount. And don't forget to redeem your points for free meals or extra flier miles.

9. Get free language lessons online. Free basic lessons for common languages are available from BBC – Languages. When I was looking for free Cantonese lessons online, I came across these two wonderful sites: chinese-lessons.com and learnchineseez.com.

10. Stop drinking soda. One less soda can a day will lead to around 9,000 pesos per year in savings and a lower chance of getting fat.

11. Buy a second-hand car instead of a new one. A brand new car loses around 10% of its value as soon as it rolls off the showroom floor. A decent second-hand Toyota Vios or Honda City that's less than five years old with less than 100,000 km on the odometer will probably set you back anywhere from 400,000 to 500,000 pesos or around 40% off the brand new sticker price and still be eligible for bank financing.

Part 2 in 2 days. See you then! :)

The Time Value of Money: A Peso Today is Worth More Than a Peso Tomorrow

PERSONAL FINANCE 101

from Abtruse Goose

A peso today is worth more than a peso tomorrow. The time value of money, perhaps, is the most important lesson students of finance learn inside the classroom; unfortunately, it’s also something most of us everyday Juans tend to ignore, both consciously and unwittingly, in making day-to-day financial decisions.

Intuitively, we all know that it’s better to receive 1,000 pesos today than, say, one year from now. A lot of things can happen in that one year, things that can affect (often negatively) the value of our money. Perhaps the most obvious (and predictable) thing than can happen is for the prices of most goods and services to rise, thereby reducing the purchasing power of our 1,000; we all know what inflation is all about, and we all know that it is a fact of life. So, simply because prices of most things tend to increase over time, and 1,000 pesos, most probably, will be able to buy more gasoline or chicken or beer today than one year from now, a peso today is worth more than a peso tomorrow.

What else would make money more valuable today than if received at a later time? What can I do with my 1,000 pesos that will make it more valuable than 1,000 received one year from now? Well, I can always deposit my money in a bank account that pays 1% interest per year (this is the second worst thing you can do with your money; the worst thing, of course, is to let your money rot under your bed or in a piggy bank); after a year, I’ll have 1,010 pesos, just a tad better than if I received 1,000 at the end of that year. What this means is that by receiving money at a later date, I’ll be foregoing the opportunity to earn interest if I receive and invest the amount today, making a peso today worth more than a peso tomorrow.

How should all of this affect how we make financial decisions? Well, at the very least, we should try to get payments we expect to receive at the earliest possible date and take advantage of the extra time by either spending the money now and avail of lower prices, or by investing the sum today to earn returns in the future. Of course it also works the other way around: we also should try to delay making payments or cash outflows as much as we can, but without incurring very expensive penalties or consequences (excessively delaying payments to a friend or relative from whom you’ve borrowed money may irreparably ruin your relationship to him or her, and we all know that paying beyond the due date of your credit card bill will result very expensive penalty charges).

Finally, if you’re willing to do relatively simple time value of money math (I say relatively simple because it does not involve any calculus and it can be done with most calculators and spreadsheet apps), the concept can also help you make better purchasing and investment decisions. Next week, we’ll take a look at how we can use this simple concept to choose between different payment options and save significant amounts of cash.

Gokongwei’s Cebu Pacific to Go Public

IN THE NEWS from Inquirer.net

Cebu Pacific announced on Monday, March 8, its plans to raise about P12 billion by offering 125.25 million new common stock to the public through an initial public offering (IPO). The firm has set a maximum price of 95 pesos per share for the offer. The issue is planned to finance the firm's very aggressive fleet expansion project slated for the next five years.

The move comes amid the very strong performance of the local stock market in the past few days, making the timing of the issue perfect for Cebu Pacific. But the recent news about how the company badly treated a special child passenger and his family, and the very recent complaint about the carrier's late passenger policy may possibly negatively affect investors' sentiments for the firm.

Given Cebu Pacific's gains in market share and profitability in the past year, the current strong performance of the stock market, and the recent string of not-so-flattering news about the company, I'm very interested in how the issue will pan out for Cebu Pacific. History and theory also gives us conflicting views of how investors may react to the offer: on the one hand, past IPOs have often experienced extraordinarily high gains in the first few days of trading; on the other hand, one well-known financial theory states that raising money through new equity may send negative signals about the company's prospects (for example, it may mean that the firm is not confident that it can shoulder future interest and principal payments if it borrows the money it needs, or that the company's stock is overpriced, or both) which may pull down the stock price.

I'll guess we'll just have to wait and see to find out.

Know Your Financial Statements: The Income Statement and the Statement of Cash Flows

PERSONAL FINANCE 101

In the last post, we learned how the balance sheet presents important information about the firm’s investing and financing activities. The next major financial statement, the income statement, presents the status of the firm’s operations for a specified period of time. Below we see Narra’s latest income statement:


The firm’s net income shows how much money the firm makes in the specified period, net of all expenses; if the firm spends more than the sales it generates, then it incurs a net loss. Looking at Narra’s latest income statement, the 721,000 pesos net income it earned is a sign that it has done well in 2009. Revenues (or sales) measure inflows of assets like cash or accounts receivable (unpaid purchases of customers), while expenses (or costs) measure outflows of such assets. The basic income statement formula is shown here:

REVENUES – EXPENSES = NET INCOME

Intuitively, the goal of any business should be to maximize net income, either by maximizing revenues or minimizing expenses, or by doing both. We have to be careful, though, and remember that net income includes noncash items like accounts receivable and depreciation (used to account for the periodic usage of fixed assets), and therefore is often an unreliable measure of how much cash the firm is able to generate (and spend!).

The statement of cash flows reports the cash inflows and outflows from the firm’s various business activities for a period of time. In Narra’s latest statement of cash flows below, we see that cash flows (cash outflows are in parentheses) are grouped into the firm’s three main business activities: operating, investing, and financing activities.


From Narra’s latest statement of cash flows above, we see that we have to make some adjustments to net income before we can derive how much cash the business was able to generate. Depreciation, a noncash expense deducted from revenues in the income statement, needs to be added back. Also, noncash inflows like accounts receivable and inventories need to be removed. The resulting figure is the cash generated by the company’s operations, often called cash from operations or CFO.

Investing cash flows include purchases (or sales) of noncurrent assets like machinery, vehicles, land, factories, or office buildings.

Financing cash flows include debt repayments and availments, and cash dividend issues.

The cash flows from the three activities are added to determine the net cash inflow or outflow for the period. From Narra’s statement of cash flows, we see that in 2009 the firm generated a net cash increase of 451,000 pesos.

To summarize, let’s take a look at how the three financial statements are related to each other: the balance sheet shows the results of the firm’s investing and financing activities and the income statement details its operating performance; the statement of cash flows ties everything together by presenting the cash generated or used by these three activities. Therefore in making important financial decisions, the statement of cash flows provides the most important, relevant, and complete information; successful investors and entrepreneurs know that a firm’s value is derived not from the worth of the company’s assets in the balance sheet, or from sales or accounting profit, but from how much cash the firm can generate in the future. Nevertheless, all three financial statements are very important in understanding how promising (or unattractive) a company’s prospects are. So if you want to know how well your business is doing, or if a stock you’re pining for is a good buy, or if a potential supplier is as reliable as it purports to be, spend a few moments reading the firm’s financial statements; just like googling a girl’s name before going out on a date with her, you’ll see that the extra trouble will be well worth it.

Know Your Financial Statements: The Balance Sheet

PERSONAL FINANCE 101

Financial statements present meaningful information about a firm’s business activities (investing, financing, or operating activities) to the firm’s stakeholders (owners, lenders, regulators, employees). If you want to be a successful investor or entrepreneur, you should know how to interpret the numbers found in these financial statements and how you can use the information to make better business decisions.

One of the most important financial statements is the balance sheet, which presents a snapshot of the investing and financing activities of a firm at a moment in time. It shows a list of assets that the firm owns, and the sources of capital used to finance these assets.

The balance sheet of Narra.com, an online seller of custom furniture, is presented below (click here to enlarge):

On the left-hand side of Narra’s balance sheet, we see a list of the firm’s assets—resources with the ability or potential to provide future benefits to the firm. Assets are often listed based on liquidity, or the ease by which these assets can be converted to cash: liquid assets like cash, accounts receivable (unpaid bills of customers), and inventories are referred to as current assets (assets that can be converted to cash within one year); illiquid assets like heavy machinery, equipment, land, and production facilities are referred to as fixed or noncurrent assets (assets that cannot be easily converted to cash).

The right-hand side of the balance sheet shows where the money used to buy the firm’s assets comes from. Liabilities are funds that come from the firm’s suppliers, creditors, and other stakeholders like the government and the firm’s employees. Narra’s liabilities include the firms’ unpaid bills to suppliers or accounts payable, and short- and long-term debt. Like assets, liabilities are also often classified as current (obligations that the firm must repay within the year) or noncurrent (long-term debt).

A portion of the capital used to finance the firm’s assets come from the owners of the firm themselves. The owners’ stake in the firm is called shareholders’ or owners’ equity, and is found on the right side of the balance sheet below the liabilities. Shareholder’s equity includes funds contributed by the owners since the firm’s inception (common stock) and accumulated funds generated by the company’s operations that was reinvested into the firm (retained earnings).

Take a look at the bottom portion of Narra’s balance sheet. What do you notice? That’s right: total assets equal total liabilities and shareholder’s equity!

ASSETS = LIABILITIES + SHAREHOLDER’S EQUITY

What makes this relationship true? It’s because the value of the firm’s assets should always equal the value of funds used to purchase these assets! (When you hear accounting students complain about how hard it is to balance the balance sheet, it just means they’re having trouble equating the two sides of this relationship :D)

The balance sheet also tell us how much the company is worth, on paper (because actual buyers may think otherwise): Narra’s balance sheet shows us that the book or historical value of its assets, or the firm as a whole, is 2 million pesos, and that the company’s creditors have supplied 900,000 pesos of that amount (Total Liabilities). The company’s owners are entitled to whatever remains after satisfying the claim of creditors; in this example, owners only have a claim on 1.1 million pesos of the firms’ assets, basically because they supplied only that much capital to the company (Total Shareholder’s Equity).

To summarize, the balance sheet provides very useful information about the current size of the company in terms of its assets, the firm’s overall liquidity, and how the firm uses available sources of financing like liabilities and owners’ equity. Looking at several years worth of balance sheets will provide even more meaningful and useful information, like the rate at which the company grows and trends regarding the company’s liquidity and financing position.

Knowing the balance sheet and the different kinds of information that it provides is very important in investing and entrepreneurial success; it helps us better understand a firm we want to invest in or one that we already own. The next step is to know how to use this information to make more informed decisions that would create more value for the business and more wealth for ourselves.