10-K Diver @10kdiver:
1/
Get a cup of coffee.
In this thread, I'll show you how to read and understand a company's Balance Sheet.
As investors, we should be able to judge businesses by looking at their financial statements.
And the Balance Sheet, of course, is 1 of 3 key financial statements:
10-K Diver @10kdiver:
2/
Imagine that Alice and Bob are neighbors.
Alice owns and operates a "candles" business.
She makes candles in her loft, which she's converted into a lab of sorts.
She then takes the candles to a local home goods store, which sells them and pays her at the end of each month.
10-K Diver @10kdiver:
3/
Suppose it costs Alice $10 to make a candle. This is the cost of the candle's glass case, wax, wick, etc.
And suppose the home goods store pays Alice $15/candle, and sells 1460 of her candles every month.
Then, Alice would make ~$87.6K/year. Here's her Income Statement:
10-K Diver @10kdiver:
4/
Let's now turn to Bob, Alice's neighbor.
Bob owns and runs a "burrito" business.
Each morning, he makes 120 burritos. He takes these burritos to a busy street corner at lunch time, and sells them.
On the way back home, he buys groceries to make the next day's burritos.
10-K Diver @10kdiver:
5/
Suppose it costs Bob $4 to make a burrito. This is the cost of the tortilla, the rice, the beans, etc.
And suppose Bob sells his burritos for $6 apiece.
Then, Bob would also make $87.6K/year.
Here's *his* Income Statement:
10-K Diver @10kdiver:
6/
Of course, these models are *highly* simplified.
Both Alice and Bob probably have several other costs -- insurance, permits, taxes, etc.
But to learn key concepts, it's useful to study such "bare bones" examples -- stripped of all extraneous details.
So, stick with me!
10-K Diver @10kdiver:
7/
Here's a question.
Whose business is "better": Alice's or Bob's?
As we've seen above, both businesses have *exactly* the same annual Revenues ($262.8K), Costs ($175.2K), Profits ($87.6K), and Margins (~33.33%).
So, economically speaking, aren't these businesses identical?
10-K Diver @10kdiver:
8/
The answer is NO.
Why?
Because, even though these businesses produce identical *earnings* for their owners each year, they require different amounts of *capital* to do so.
That is, these businesses have identical Income Statements. But very different *Balance Sheets*.
10-K Diver @10kdiver:
9/
For example, Alice's business requires her to invest $10/candle * 1460 candles = $14.6K of capital into it at the outset.
Once she *puts in* this $14.6K to make her candles, she gets to *take out* $7.3K/month ($87.6K/year) from the business ($5 profit/candle * 1460 candles).
10-K Diver @10kdiver:
10/
What about Bob?
Well, following the same logic, Bob only needs to *put in* $480 of capital ($4/burrito * 120 burritos).
And once he does that, he gets to *take out* $240 *daily* ($2 profit/burrito * 120 burritos) -- which adds up to $87.6K over a year.
10-K Diver @10kdiver:
11/
Clearly, Bob's is the "better" business.
First, it requires *less* capital ($480 vs Alice's $14.6K) to produce the *same* annual earnings ($87.6K).
Second, it *turns* this capital *daily* vs Alice's *monthly* -- allowing Bob to take out $240/day vs Alice's $7.3K/month.
10-K Diver @10kdiver:
12/
That's why it's important to study ALL the financial statements of a business -- not just its Income Statement.
In particular, studying the *Assets* side of the *Balance Sheet* tells us how much capital a business needs to conduct its operations.
10-K Diver @10kdiver:
13/
Here's the *Assets* side of Alice's balance sheet, as her business cycles through various states.
As we can see, the Assets on this Balance Sheet NEVER drop below $14.6K -- the *minimum* amount of capital this business needs to function.
10-K Diver @10kdiver:
14/
Compare that to the Assets on Bob's Balance Sheet, and we immediately see that Bob's business requires only $480 to function -- very modest compared to Alice's $14.6K.
High quality businesses require only a small amount of *assets* per dollar of *earnings* produced.
10-K Diver @10kdiver:
15/
Alice's and Bob's businesses are both "simple". They only need "working capital" assets -- cash, receivables, and inventory.
In addition to these, real world businesses typically also need fixed assets (eg, property, plant, and equipment), goodwill, intangibles, etc.
10-K Diver @10kdiver:
16/
For example, here are the Assets listed on Home Depot's and Starbucks's Balance Sheets (which I took from their latest 10-Qs).
These Asset sections have more line items. But the fundamental principles are still the same as Alice's and Bob's simple businesses.
10-K Diver @10kdiver:
17/
So, that's the *Assets* side of the Balance Sheet. It tells us how much capital a business needs (and has) to function.
Every Balance Sheet also has a *Liabilities* side. This tells us *where* all this capital in the business *comes from*.
10-K Diver @10kdiver:
18/
There are 3 main "sources" of capital in a business: Equity, Debt, and Float.
Equity is capital *put up* by the business's owners.
Debt is capital *borrowed* by the business -- on which it typically pays interest.
10-K Diver @10kdiver:
19/
And Float is capital that various parties (eg, suppliers, customers, employees, the government, etc.) have provided to the business -- typically for free.
For example, a supplier may sell raw materials to the business on credit. A customer may pre-pay for an order. Etc.
10-K Diver @10kdiver:
20/
So, that's what the Liabilities side of the Balance Sheet does. It breaks down the capital in the business by *source* -- into Equity, Debt, and Float.
For example, here's how the Liabilities listed on Home Depot's and Starbucks's Balance Sheets break down:
10-K Diver @10kdiver:
21/
And because the *Assets* and the *Liabilities* sides of the Balance Sheet are just two different ways of slicing and dicing the *same* capital, they both have to add up to the same total.
In other words, the Balance Sheet has to "balance". Duh!
10-K Diver @10kdiver:
22/
So, why should we study the Liabilities side?
After all, $1 of capital is $1 of capital, right? Why do we care whether it's Equity, Debt, or Float?
The answer is: businesses can boost returns for their owners by deploying someone else's capital for the owners' benefit.
10-K Diver @10kdiver:
23/
For example, suppose Alice made a deal with her suppliers that she'd pay them *after* she herself got paid by the home goods store.
Then, she wouldn't need to put up $14.6K of her own money. She could put up $0, and still take out $87.6K per year!
10-K Diver @10kdiver:
24/
That's the power of Float.
It's essentially *free money* that can transform ordinary businesses into extraordinary ones.
No wonder Warren Buffett is such a big fan!
From his 2009 letter:
10-K Diver @10kdiver:
25/
And it's not just Float that provides this kind of "leverage".
The other non-Equity source of capital -- Debt -- can do so too. But Debt can also increase risk and make a business fragile -- usually to a larger extent than Float.
For more: twitter.com/10kdiver/statu…
10-K Diver @10kdiver:
1/
Get a cup of coffee.
In this thread, I'll walk you through the basics of leverage -- in our personal lives and in the companies we invest in.