Three Tools to Add to Your Investing Tool Kit

How to improve your investing decisions (guaranteed)... Three tools to add to your investing tool kit... Why great products don't always make for great stocks... Look at your personal finances like an investor...

Sometimes, I (Austin Root) struggle to follow even simple instructions...

The first time Porter asked me to write the Digest, he gave me one straightforward piece of advice...

This is important: The secret to writing a good daily letter to our readers is to focus on one idea. Whatever you write about, just tell them – simply and directly – one thing that will help them make better decisions.

I took this advice to heart when I wrote my first Digest in May (which you can read here). But this time, it seemed... harder.

I know what I want to show you. It's a simple set of skills I first learned in business school... and used constantly during my time managing investments for a variety of Wall Street firms. These skills are guaranteed to help you make better investing decisions. Best of all, they're easy to learn and available to anyone with an Internet connection.

But few individual investors know about them, let alone realize how they can improve their investing decisions.

My problem was, every time I started laying out these skills, my ideas took me in too many different directions. Until I thought about my grandfather...

'You gotta have the right tools'...

When I was a kid, I used to spend hours helping my grandfather with "home-maintenance projects." During these tasks, he often said that half the solution to any job was having the right tools.

Imagine trying to hook up the plumbing for a bathroom sink. You can spend an hour scraping your knuckles and cursing if you try to do it with a simple set of pliers. But break out a plumber's wrench, with its long neck and angled head, and you can hook up those pipes in a matter of minutes.

That's exactly how I feel about investing as well. To consistently make great investment decisions over the long term, you need to have the right tools. And to me, one of the most valuable tools in any investor tool kit is a basic understanding of corporate financial statements.

Now, before I get started, chances are good that you're probably thinking, "Why do I need to get into the weeds and look at the financial statements? I buy the stocks of companies that produce products or services that I understand, use, and love, like Apple (AAPL), Alphabet (GOOGL), and Amazon (AMZN)."

You're right... Putting your money into companies that make products ingrained in our daily lives is an excellent first step in identifying great investments. But it isn't always foolproof...

Sometimes, great products don't translate into great stocks...

My family is a loyal user of Tide laundry detergent and Campbell's chicken noodle soup, both the leading products and brands in their categories. But the stocks for both parent companies – Procter & Gamble (PG) and Campbell Soup (CPB), respectively – have been lousy performers... Both stocks are down since the beginning of 2015, while the S&P 500 has soared more than 40%.

When you look at the financial statements of these companies, the reasons for the underperformance become clear. Procter & Gamble's profits and free cash flow have declined, and Campbell Soup's balance sheet is loaded with more debt each year, with little to show for it. Understanding financial statements may have helped you avoid these stocks.

So what are the key tools?

Let's first start with the balance sheet...

Among the three main financial statements, this one gives a snapshot of a company at a specific period of time. It shows what a company owns (the assets), what it owes (the liabilities), and the difference between those two numbers (the net equity). All else equal, you'd want to invest in a company with a larger asset base, fewer liabilities, and, therefore, a greater net equity value.

The balance sheet is sometimes called the "stock" statement, in that it takes stock of what a company owns and owes at a moment in time. The other two statements – the income statement and the statement of cash flows – are often called the "flow" statements. They measure items generated over a specified period of time. For example, an annual report will show the flows generated over the course of a year.

In general, the income statement measures how well a company is performing...

It tells you how much total business a company generated (its revenues) and subtracts from this what the company spent (its expenses). The net result is its profits, or net income. Again, all else equal, you'd prefer to invest in a company with higher revenues, lower expenses, and, therefore, higher profits (and a higher profit margin).

However, many investors miss one key nuance about the income statement. Many of its line items are smoothed out (or shown on an "accrual" basis), rather than shown on a true cash basis. This is done, in part, to account for large, lumpy items that may not occur every period but represent an ongoing part of the business.

For instance, consider a software company that sells its customers three-year licenses to its software. It receives the cash up front, but provides services (and incurs expenses) over the course of those next three years. If the company recorded all the revenues in year one, this would overstate ongoing profits in that year, and then understate profits in years two and three. Instead, the income statement books the revenues in the period in which it's earned, not when the cash is received.

Smoothing this and other lumpy items out allows us to meaningfully compare a company's performance from period to period. That's important, because investors want to see not only how well a company performed this year, but also how that compares with previous years. This comparison provides rate-of-change information that can be as important – or more important – than the absolute number itself.

Let's take a look at tech companies Xerox (XRX) and Nvidia (NVDA). Both companies booked roughly $10 billion in revenues last year. But Nvidia's market capitalization is more than 20 times larger than that of Xerox. Much of that is due to Nvidia's 40%-plus revenue growth, versus Xerox's 5% revenue decline last year.

This smoothing effect is also what makes the statement of cash flows important...

Many investors overlook this third statement, but longtime Stansberry Research readers know we consider it "mission critical." That's because the cash flow statement shows how much actual cash a company generated.

Of course, this might make numbers jump around from year to year, if a company spends a lot one year on a new factory and nothing on such capital expenditures the next year, for example. But at the end of the day, we want to know about the cash. And the more cash a business generates over time, the more valuable the company is.

Another reason the statement of cash flows is so important is because it provides the quickest and best way to determine a company's free cash flow ("FCF"). Many analysts and editors at Stansberry rely on FCF to evaluate whether a company's stock is attractive. Free cash flow is what's left after the company pays for all expenses and outlays. That makes it a great measure of the excess cash a company generates that can be used to enrich shareholders through dividends and buybacks, or to invest in incremental growth.

When you want to calculate a company's FCF, go to the statement of cash flows. Take the "net cash from operating activities" and subtract the capital expenditures. Again, the higher this number (and the higher FCF as a percent of revenues), the better, all else equal.

The next time you think about investing in a company, take a hard look at its financial statements...

Print out this "cheat sheet" summary of the three financial statements to have at your side as you go through the numbers.

It won't happen overnight, but a better understanding of these financial statements will be a valuable addition to your investing tool kit. You'll have a better perspective on how a business operates. You'll be better at avoiding "good products, bad financial statements" scenarios.

This deeper level of understanding should help you ultimately make better investment decisions, particularly in times of heightened market fear or greed.

I almost forgot to share the other major benefit to understanding financial statements...

This, by the way, is why I said earlier that I struggle with the simple instruction of keeping the Digest to just one idea... But it's important to share. In fact, for many of you, I bet this second benefit is actually more valuable than the first. To get this benefit, all you need to do is start thinking of your own life in terms of financial statements.

Just like the ones used by businesses, personal financial statements equip you with better information about your overall well-being. At a basic level, this will help you with budgeting and managing large purchases (like a car or house), and will even provide a more accurate assessment of your overall financial condition. Taking them a step further, you can use these financial statements not only to measure your finances, but to actually improve them.

For instance, once you've laid out your personal balance sheet, you can begin to optimize it. Pay down high-cost debt. Increase your investments in assets that generate better rates of return.

Or you could use your personal income statement or statement of cash flows to better analyze how much of your income goes toward various types of expenses... And then adjust your spending levels accordingly.

That doesn't mean you need to cut out all fun and frivolous expenses, or eliminate all large assets that tend not to hold their value (like cars or boats). By all means, enjoy your wealth and the fruits of your labor. But I am saying it's time you become aware of how your personal financial statements stack up. You may find some ways to improve your finances that have no impact on your daily life... And take it from me, finding and eliminating those expenses is a great joy in and of itself.

Familiarize yourself with financial statements. I'm confident doing so will provide you with invaluable tools to help make you a more informed, better investor, and improve your personal financial operations. These are two keys to improving your net worth over the long run.