The secret to becoming wildly wealthy is mastering the science and art of managing and investing money wisely.
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Master the Fundamentals of Investing for Beginners—Fast!
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One Hour Investor will give you a lifetime of financial knowledge in just one hour, as well as the confidence to put that knowledge to work.
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How to Analyze Stocks
When it comes to analyzing stock investments, there are two major schools of thought: fundamental analysis and technical analysis. While both categories have their pros and cons, the truth is that they work best together, not separately.
Let’s look at fundamental analysis first. Fundamental analysis involves analyzing a company’s financial statements as well as its competitors, industry, and the general economic environment. The goal of fundamental analysis is to assess how well a company is doing financially, and how likely they are to continue to grow and increase their profits.
Every company has three financial statements: a balance sheet, an income statement, and a statement of cash flows. Since this is a book on investing and not accounting, we won’t go into too much detail about the content in those statements. But let’s acquire a basic understanding of what they are, because only then will the field of investing start to make sense.
A balance sheet is a type of financial statement that lists a company’s assets and liabilities at a given point in time. In case you didn’t know, an asset is something a company owns that can be used to generate profits.
A liability is something that is owed by a company, such as when a company is required to pay back a loan or when a vendor sends a company a shipment of product and sends an invoice for the amount owed to pay for it. When you need to know the size of a company’s assets, which indicate its financial health, there’s a simple equation for that: Assets = Liabilities + Owner’s Equity.
Owner’s equity is defined as the owner’s financial investment in the business. From that, we subtract any withdrawals he or she takes, then add the net income (or, if the company is doing poorly, subtract the net loss) since the start of the business. But when you purchase stock in a company, you own a small piece of the company. Therefore, when dealing with a publicly traded company, owner’s equity is better defined as shareholders’ equity. Just like liabilities, owner’s equity is a claim on a company’s assets.
Let’s look at the equation again. Imagine that Company ABC has $1,000,000 in assets. Now assume that they have $300,000 in liabilities and $700,000 in owner’s equity. If you add $300,000 and $700,000, what do you get? $1,000,000. Remember, both sides of this equation must always balance because: Assets = Liabilities + Owner’s Equity. And in this case, $1,000,000 = $300,000 + $700,000.
The next type of major financial statement is the income statement. It is released quarterly (every three months) and is often compared with income statements from previous quarters or years to determine how well a company is doing. It is also known as a profit and loss (P&L) statement because it involves calculating all sources of revenue (money received from the company’s sales) and subtracting the expenses (such as employees’ wages and rent) to find the company’s profit.
At the bottom of an income statement is the company’s net income (net profit), which is the company’s earnings after interest, taxes, depreciation, and amortization. Remember, the higher a company’s net income, the better.
Statement of Cash Flows
Finally, we come to the statement of cash flows, also known as the cash flow statement or CFS. A company’s CFS keeps track of the cash that goes in and out of the company. There are three cash flow categories within a CFS: Operations, Investing, and Financing.
Cash flow from Operations refers to cash the company receives from their business operations. This is the same number indicated by net income on the income statement. Cash flow from Operations deals with money earned by the company through their normal business activities such as selling their products. They do not include things like investing in new factories because while the factories may be used to manufacture the company’s products, the factories themselves are not being sold by the company to their customers.
Cash flow from Investing involves the company’s use of cash to invest in the company itself. So the money spent to build those factories? They would fall under this category. And since money is being spent, this would be a cash outflow because money is leaving the company. But Cash flow from Investing can also lead to a positive cash inflow. If a publicly traded company sells shares of stock to investors, the money they receive is a positive cash flow. They can then use that money to invest in the company further.
Cash flow from Financing is the final category. This involves cash used for any of the company’s financing activities. Going back to the factory example, let’s pretend that instead of paying cash outright for the factory, the company decides to borrow the money. If they borrow $500,000 to build the factory, they now owe that $500,000 to their creditor (the person or bank loaning them money). So, if they had to pay back this debt to the tune of $10,000 a month, then $10,000 would be subtracted from the company’s cash on hand every month.
The important thing to remember: the higher a company’s positive cash flow, the better. Here’s an example. Let’s say that your monthly net income (after taxes) is $2,000. Your rent is $800, you have no credit card debt, and all your bills add up to $500. So you have $2,000 in cash and pay out a total of $1,300 ($800 + $500) in expenses. That leaves you with $700 in the bank every month. That means you have a positive cash flow of $700.
Now pretend that you still net $2,000 a month but you pay $1,200 in rent, $700 in bills, and you pay off $200 in credit card debt every month. So you owe $2,100 in rent, bills and credit card debt ($1,200 + $700 + $200) but only have $2,000 to pay it off. That leaves you with -$100 (negative $100) in the bank every month. That means you have a negative cash flow of $100.
Which financial situation is better? Obviously, it’s the first one. When a person runs out of cash, they might have to declare bankruptcy. Likewise, when a company runs out of cash, it might have to declare bankruptcy. However, unlike people, when a company declares bankruptcy, that company will often cease to exist. That’s why having a positive cash flow is so important for a company because companies that don’t manage their cash flow well go out of business.
Keep in mind that it is possible for companies to show huge profits on their income statement and still go bankrupt (Enron is a great example). And, just like with Enron, it’s possible for companies to “cook their books” by lying about how much money they’re actually earning or how much cash they actually have. Although this kind of financial fraud is rare, it does happen, and it’s another reason why you should diversify your investments.
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