Basic Finance 101 - Balance Sheet, Cash Flow and Operations

Level 1 - NGMI

Welcome Avatar! We covered the income statement in part 1. Here, we’ll explain the “complex” financial terms used in balance sheet and cash flow statements. The reality is that if you’ve ever run a business this becomes intuitive. If you haven’t, a lot of the wording and calculations appear to be complex (they are not).

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Balance Sheet

Of all the statements the balance sheet is the easiest to understand. It is simply a snapshot of the “net worth” of the company. When you view companies as an extension of a single individual they become a lot more intuitive. Therefore we’ll use a balance sheet and apply it to a rich individual! Then when we go to cash flows it will be quite easy to follow step by step.

Cash, Debt, Equipment, Inventories, credit card payments etc. These are standard items for an individual to have. If we look at your personal finances we can calculate your net worth on the current day with reasonable accuracy (unless ultra rich where too many assumptions are made).

Cash: All the cash in your checking accounts, savings accounts, brokerage accounts, under the mattress etc. Easy to calculate add that up and that’s the cash on your “balance sheet”

Short-Term Investments: Anything liquid you can sell right now in your stock account, coinbase account, etc. Also include anything fast liquid you can sell such as gold bars (we don’t own any but some people do).

Long-term Investments: Anything illiquid that you can sell in about 12-24 months. This would include homes/apartments, some RSUs that unlock at a later time and collectables like expensive watches.

“Inventories”: While you’re not technically a business we will go ahead and assume you are with a simple tweak. We’ll assume that you’re trying to flip the latest christmas good (say a Nintendo system). You own 20 of them and these represent inventory on your “balance sheet”

Property, Plant and Equipment: For an individual we’d just throw in your car. This is what should depreciate over time.

Accounts Receivable = Money Owed to You: You already sold 10-15 systems but five of them have not paid yet due to timing of cash hitting your account. Five Nintendo systems times selling price is your accounts receivable (money owed).

Accounts Payable: While you have 20 Nintendo Systems in inventory, the money hasn’t been paid in cash yet due to timing once again and you owe money for 3 Nintendo systems bought at retail price.

Debt: Some of these purchases you made with a credit card (at retail), so you have a revolving credit balance of a couple of thousand dollars. You have to pay off the debt for your daily purchases and the purchase of inventory within 30 days to avoid interest payments.

Taxes Payable/Receivable: At any point in time you might owe some more taxes than currently paid out or you may be *owed* taxes as you’ve overpaid for the quarter. This is similar to you getting your monthly paychecks and not knowing if you owe taxes come April of the next year.

Wrapping it Up: At the end your assets minus your liabilities = your net worth. Said in the complicated finance way, because your net worth + liabilities = Assets, that is why Assets = Liabilities + Shareholders Equity. The only reason the finance industry shows it as Assets = Liabilities + Shareholders equity is because you can check if they match (meaning 0 imbalance). Intuitively Assets - Liabilities = Share Holders Equity is more logical from a value perspective.

Autist Note: We didn’t include much complication from real estate. That said consider the paid off portion equity, the total amount as an Asset, and consider it to be long-term debt that balances it out. Take 1 year worth of payments and put that into short term debt. Therefore if you own $100,000 of the home that’s in equity, $500,000 in assets, $20,000 in short term debt and $380,000 in long-term debt (as an example for a $500,000 place). Asset = $500K which is balanced by $400K debt and $100K equity

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Leverage: Before moving on, the most important item to look for on the balance sheet is really the debt vs. cash balances (yes this is a general statement with exceptions). You can appear to be rich by levering up (borrowing money) with a minimal cash balance. This works until the debt comes due and you can’t pay leading to bankruptcy.

For those with a Wall Street background you already know what enterprise value is. For those that don’y you’ll now understand what it means!

Enterprise Value = Equity Value - Cash + Debt. This calculation gives you a rough idea of how levered up a company is. If you have more debt than cash that tells you what the market is really valuing the company at.

Final note, back in 2008-2009, there were companies that traded at NEGATIVE enterprise values. This means public companies were worth less than the cash on their balance sheet (assumes they will lose money forever and never make it back). This can be applied to crypto as well, you can find projects with a positive treasury that is higher than the market cap (insane but it happens).

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Cash Flow Statement

Image Source and More Detailed Explanation Here

While Wall Street focuses a lot on metrics like EBITDA, for any biz owner this metric is flawed. It doesn’t tell you if the firm is generating any actual positive cash flows (profits) which is what really matters for the firm. No one cares about hypothetical income, they only care about money that goes into their bank account at the end of the month/quarter/year.

Once again a lot of phrases from accounting come in here to make it appear complicated. We’ll simplify using the same old strategy as the balance sheet.

Quarter 1 - Net Income: For simplicity you should look at a quarter. From the income statement, you can see how much money was brought in over the past three months. After that you have to figure out if the firm had bills to pay just like a single individual. So. We’ll use basic examples once again to make it easy to follow.

Accounts Receivable: From the prior example, if you make say $60,000 a month that would be your net income. However. After that you might have credit cards to pay off and maybe some people who owed you money come back and pay it. The last part “people who owe you money” is really what matters in accounts receivable.

If people pay you back for say $1,000 they owe you, this means Accounts Receivables go down. This means your cash flow goes up. If you sold three Nintendos and have a $1,000 check hit your bank account that’s a $1,000 increase to your account but the bill is officially paid off so receivables go down.

Accounts Payable: Same concept in reverse. If you buy something and haven’t paid yet, as you pay the balance off the number goes *down* which means the cash flow goes *down too*. If you acquire some goods but haven’t paid yet, the payable balance goes up as does the cash flow (since you haven’t paid it off with cash yet).

Capital Expenditures: After you figure out all the receivables you’ve collected (or haven’t) and payables you’ve paid off (or haven’t) you’ll end up at “cash flow from operations”. At this point all you have to do is adjust for capital expenditures. This would be a car in a person example, or for companies equipment like machinery (that depreciates over time).

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Short Cutting: As a short cut way to look at companies, just look at the annual Cash Flow from Operations and the Annual Capital Expenditures. This will give you the rough amount of money that the firm is generating per year. This number is the best estimate for how much money is hitting the bank account.

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Quick Rip on Three Statements for Any Company

We get a ton of questions about how to look at stocks, new markets, etc. Since this is a free post, one the goals is to actually avoid big blow ups. Avoiding disasters like LUNA, COIN, GBTC and others will help you outperform the market without significant research. If you can look at say 500 companies and figure out 100 are definitely awful, you’ll outperform by default (just don’t buy the garbage). Here are questions to ask and you have to answer a *resounding yes* to all of them. If they are all *resounding Nos* you cannot invest in them under any circumstances.

1. Will this company grow faster than 8% per year (inflation)?

2. Will this company easily make money (CFO-CAPEX) in the next couple of years - at minimum?

3. Will the firm maintain or grow market share despite increased competition?

4. Is this firm able to service debt without missing a beat?

5. Can you explain how the business makes its money in three sentences or less?

6. Can you explain the competitive advantage in less than three sentences?

7. Do you trust the people running the Company?

8. Would you invest in this and forget about it for at least 5-10 years (enough time for a step function improvement)?

9. Can you explain the changes in the income statement, balance sheet and cash flow items easily to someone who is familiar with financial statements?

10. Does the Company have a share count that is growing by a minimal amount to prevent dilution?

Generally speaking, most of these take less than 5-10 minutes to filter for. Many people are unaware that the price of a stock (or crypto like Bitocin) but the market cap is actually higher! This is because a flat price is good if there are new shares/tokens. It means there is just enough demand to offset that dilution. (We will cover nuances like this in the third part of basic finance).

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Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are *opinions* written by an anonymous group of Ex-Wall Street Tech Bankers and software engineers who moved into affiliate marketing and e-commerce. We may or may not be homeless and set for life. We’re an advisor for Synapse Protocol and on the JPEG team.