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The Basics of Stock Investing
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In THE NEXT three chapters, my goal is to help you understand how financial statements fit together and how you can use them to identify solid companies. First, we'll look at how the three main financial statements fit together by describing what's in them and by following a dollar through a business. Then, we'll build a hot dog stand to see how the operations of a very simple business are represented in financial statements.

In Chapter J, we'll tour all three statements In detail by looking at the books of a real, complicated company. (Note to readers with some accounting background: You can skip to Chapter 6 —Analyzing a Company—unless you want a review of the basics.) In Chapter n, we'll apply our newfound ac­counting knowledge to the analytical process by looking at two real-world companies.

As an investor, you're mainly going to be interested in the balance sheet, the income statement, and the statement of cash flows. These three tables are your windows into corporate performance, and they're the place to start when you're analyzing a company.

All three of these statements can be found in the three major types of financial filings: an annual report, a IO-K filing, and a IO-Q filing. You're probably familiar with annual reports—those glossy booklets with smiling employees that firms mail out every year—but to really understand a firm, you'll need to look up io-Ks and io-Qs. These are dense, detailed sets of financial information that companies file with the Securities and Exchange Commission (SEC) every year (the io-k) and every quarter (the io-q). You can access these reports at http://www.sec.gov/edgar.shtml or http://www.freeedgar.com. The latter is a bit easier to use.

Think of the three statements like this: The balance sheet is like a company's credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities) at a specific point in time. It tells you how strong the framework and foundation of the business is.

The income statement, meanwhile, tells how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company's financial health at a precise mo­ment, the income statement records revenues and expenses over a set period, such as a fiscal year.

Finally, there's the statement of cash flows, which records all the cash that comes into a company and all of the cash that goes out. The statement of cash flows ties the income statement and balance sheet together.

Right now, you're probably wondering why we need an income statement and a cash flow statement—after all, if a company makes money, it makes money, right? The difference lies In a confusing concept called accrual accounting. Here's how it works. Companies record sales (or revenue) when a service or a good is provided to the buyer, regardless of when the buyer pays. As long as the company is reasonably certain that the buyer will eventually pay the bill, the company can post the sale to its income statement.

The cash flow statement, on the other hand, is concerned only with when cash is received and when it goes out the door. I'll go over the cash flow statement in detail later in this chapter, but here's a quick example.

Let's say that Colgate sells a few cases of toothpaste to Joe's Corner Store for $1,000 on February 15 but gives Joe 60 days to pay because he's a regular customer and has a good track record of paying his bills on time. March 31 rolls aroundj Joe hasn't paid yet, and Colgate closes its books for the quarter.

Colgate shows $1,000 in sales on its income statement because it shipped the toothpaste to Joe—according to the income statement, the sale is complete, regardless of whether Colgate has received payment. But because Joe hasn't ponied up the grand yet, Colgate will post an entry on its balance sheet to show that Joe owes Colgate $I,OOO. (The entry goes into the accounts receivable line—more on this later in the chapter.)

As you can see, a company can show rip-roaring sales growth without re­ceiving a cent of cash. In fact, if Colgate produces and sells toothpaste faster than its customers pay for the toothpaste, sales growth "would look fantastic even though cash is flowing out the door—which is why we need a statement of cash flows.

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