Value Investors Tribe

Understanding business of any kind requires understanding its financials which requires understanding accounting basics. In this series of blogs focused on accounting basics, we will try to understand accounting principles required to decode financials of a business. In the previous blogs we understood the basics of income statement and from this section, we explore the balance sheet.

This is part 5 of decoding balance sheets and as customary, we’ll discuss five line items of the balance sheet, continued from part 4. Five line items from the balance sheet are explained below:

• Shareholders’ Equity: When we subtract total liabilities from total assets, we get shareholders’ equity, this is also termed as net worth of the business. This is basically total amount of money, from inception of the business that shareholders have put in the business for it to function. When we divide shareholders’ equity by total shares outstanding, we get book value. For instance, if a business has shareholders’ equity of $100 and there are 50 shares outstanding, the book value of the business is $2 ($100/50) per share.
• Common Stock: When a business raises funds by selling their equity or by offering a stake in the businesses, the units that are sold (to investors) are called common stocks. Common stock owners have right to elect a board of directors which hires a CEO to run the company. Also, if board of directors decide to pay dividends, common stock holders receive them.
• Preferred Stock: Preferred stock is similar to common stock however the preferred stock owners do not have right to vote for board of directors. However, preferred stock owners have a right to a fixed or adjustable dividend paid before common shareholders. Also, in case of bankruptcy, preferred shareholders are prioritized to avoid their loss of capital.
• Retained Earnings: When a business earns profit, it basically can distribute it to shareholders as dividends, it can use the profit to buy back shares of its own company or it can reinvest the profit in the business for future growth.  This portion of the profit which is ploughed back into the business is accounted for under Retained Earnings; it is a cumulative figure similar to shareholders’ equity.
• Treasury Stock: When a company buys back its shares, it can either retire those shares which in turn reduces total shares outstanding permanently or it can retain those shares for reissuance sometime again in the future. When company retains these shares for reissuance, they are counted for under Treasury Stock.

Action Items:

• Dig through the balance sheet of your favorite company and see what these line items look like.
• Dig through the balance sheet of the businesses we analyzed and see if you see a pattern in it!
• Do you see any correlation between numbers in income statement and balance sheet?