Introduction to Accounting for Stock Investors
Stocks represent ownership in companies. Before you invest in individual stocks, you want to understand the companies whose stock you’re considering and find out about their operations. Accounting is the language of business, and believe it or not, you’re already familiar with the most important accounting concepts! Just look at the following three essential principles:
Assets minus liabilities equals net worth. In other words, take what you own (your assets), subtract what you owe (your liabilities), and the rest is yours (your net worth)! Your own personal finances work the same way as Microsoft’s (except yours have fewer zeros at the end).
A company’s balance sheet shows you its net worth at a specific point in time (such as December 31). The net worth of a company is the bottom line of its asset and liability picture, and it tells you whether the company is solvent (has the ability to pay its debts without going out of business). The net worth of a successful company grows regularly.
To see whether your company is successful, compare its net worth with the net worth from the same point a year earlier. A firm that has a $4 million net worth on December 31, 2011, and a $5 million net worth on December 31, 2012, is doing well; its net worth has gone up 25 percent ($1 million) in one year.
Income minus expenses equals net income. In other words, take what you make (your income), subtract what you spend (your expenses), and the remainder is your net income (or net profit or net earnings — your gain).
A company’s profitability is the whole point of investing in its stock. As it profits, the business becomes more valuable, and in turn, its stock price becomes more valuable. To discover a firm’s net income, look at its income statement. Try to determine whether the company uses its gains wisely, either by reinvesting them for continued growth or by paying down debt.
Do a comparative financial analysis. That’s a mouthful, but it’s just a fancy way of saying how a company is doing now compared with something else (like a prior period or a similar company).
If you know that the company you’re looking at had a net income of $50,000 for the year, you may ask, “Is that good or bad?” Obviously, making a net profit is good, but you also need to know whether it’s good compared to something else.
If the company had a net profit of $40,000 the year before, you know that the company’s profitability is improving. But if a similar company had a net profit of $100,000 the year before and in the current year is making $50,000, then you may want to either avoid the company making the lesser profit or see what (if anything) went wrong with the company making less.
Accounting can be this simple. If you understand these three basic points, you’re ahead of the curve (in stock investing as well as in your personal finances).