On 29 June 2009, Bernard Madoff pleaded guilty to defauding investors and was sentenced to 150 years in prison. The 71 year-old swindler is due to be released in 2159.

Madoff’s $65 billion investment fraud has been referred to as a gigantic Ponzi scheme “dating at least as far back as the 1980s” (The Economist).

A Ponzi scheme is any kind of fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any profits earned. The scheme is named after Charles Ponzi who used the technique in 1920 to attract so much money that his operation became infamous throughout America.

Given the enormity of Madoff’s investment fraud, perhaps we should start referring to this kind of fraudulent operation as a “Madoff scheme”.

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Warren Buffett‘s 2006 letter to shareholders makes for very interesting reading.

One of the sentiments that Buffett expresses in the very first page of his letter is one of gratitude to the managers who have run his companies over the last 42 (now 44) years. Buffett indicates that he and Charlie Munger, Berkshire’s vice chairman, run a company that has turned out to be a very big business; one with 217,000 employees and annual revenues approaching $100 billion.

We certainly didn’t plan it that way. Charlie began as a lawyer, and I thought of myself as a security analyst. Sitting in those seats, we both grew skeptical about the ability of big entities of any type to function well. Size seems to make many organizations slow-thinking, resistant to change and smug. In Churchill’s words: “We shape our buildings, and afterwards our buildings shape us.” Here’s a telling fact: Of the ten non-oil companies having the largest market capitalization in 1965 – titans such as General Motors, Sears, DuPont and Eastman Kodak – only one made the 2006 list.

Instead of taking personal credit for Berkshire’s successes, Buffett pays tribute to the managers who have successfully led his companies over the years, and says he knows that he wouldn’t have enjoyed many of the duties that come with their positions – meetings, speeches, foreign travel, the charity circuit and governmental relations.

Buffett claims to have taken the easy route.

My only tasks are to cheer [my managers] on, sculpt and harden our corporate culture, and make major capital-allocation decisions.

If Buffett has taken the easy route, then it is a path that no-one else has cared or managed to follow. From 1964 to 2007, Buffett and his team have managed to grow the net worth of Berkshire Hathaway by 400,863%, no small feat.

Whether or not Buffett has taken the ‘easy’ route, one thing is clear, he hasn’t lost his sense of humour. Buffett says that he has allowed each of his trusted managers to run their own show over the years. Having a self-effacing sense of humour and, not wanting to miss an opportunity, he quips:

For me, Ronald Reagan had it right: “It’s probably true that hard work never killed anyone – but why take the chance?”

To live in a world full of people as lazy as Buffett, if only we should be so lucky.

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Understanding financial statements is very important if you are looking to invest, become a consultant, work as a CEO or in upper management, or want to start and run your own business. Understanding financial statements will allow you to assess a company’s current financial strength, and determine its profitability and creditworthiness. This article provides an overview of the four key financial statements that you need to understand.

There are four basic financial statements that you need to understand in order to evaluate a company, including the:

1. Balance Sheet;
2. Profit and Loss Statement;
3. Cashflow Statement; and
4. Statement of Retained Earnings (Owner’s Equity).

1. Balance Sheet

The Balance Sheet presents the financial position of a company at a given point in time. It is made up of three parts: Assets, Liabilities and Equity.

Assets are the economic resources that a company uses to operate its business: e.g. cash, inventories, and equipment.

Liabilities represent the debts of the company, the claims that creditors have on the company’s resources.

Equity represents the net worth of a company, and equals Assets minus Liabilities. Equity holders are the owners of the business.

It is important to notice that Equity is defined as a residual amount. As a rule, companies do not promise to pay back Equity holders. An Equity holder’s investment is more risky than a loan given by a bank because their investment is not guaranteed. In the event of insolvency, bank loans and other debts are repaid before Equity; Equity holders receive the residual amount after all the debts of the company have been paid.

2. Profit and Loss Statement

The Profit and Loss Statement measures the success of a company’s operations; it provides investors and creditors with information to determine the profitability and creditworthiness of the enterprise.

The Profit and Loss Statement presents the results of operations of a business over a specified period of time (e.g. one year, one quarter, one month); it is comprised of Revenues, Expenses, and Net Profit (Loss).

Revenue is the income that is generated from trading, i.e. when the company sells goods or services. Although, it might also come from other sources, for example, selling off a piece of the business or a piece of equipment. It is important to note that, revenue is recorded when the sale is made as opposed to when the cash is received.

Expenses are the costs incurred by a business over a specified period of time to generate the revenues earned during the same period. It is important to distinguish Assets from Expenses. A purchase is considered an asset if it provides future economic benefit to the company, while expenses only relate to the current period. For example, monthly salaries paid to employees for services that have already been provided are expenses. On the other hand, the purchase of a piece of manufacturing equipment would normally be classified as an asset.

Net Profit (Loss) is equal to the revenue a company earns minus its expenses during a specified period of time.

3. Cashflow Statement

The Profit and Loss Statement does not provide information about the actual receipt and use of cash generated during a company’s operations.

The Cashflow Statement presents a detailed summary of all of the cash inflows and outflows over a specified period of time; it is divided into three sections based on three types of activity:

1. Cash flows from operating activities: includes the cash effects of transactions involved in calculating net profit (loss).

2. Cash flows from investing activities: involves items classified as assets in the Balance Sheet; it includes the purchase and sale of equipment and investments.

3. Cash flows from financing activities: involves items classified as liabilities and equity in the Balance Sheet; it includes the payment of dividends as well as the issuing and payment of debt or equity.

4. Statement of Retained Earnings (Owner’s Equity)

The Statement of Retained Earnings shows the retained earnings at the beginning and end of the accounting period. It breaks down changes affecting retained earnings such as profits or losses from operations, dividends paid, and any other items charged or credited to retained earnings.

The Statement of Retained Earnings uses the net income information from the Profit and Loss Statement and provides information to the Balance Sheet. Retained earnings are part of the Balance Sheet under Owner’s Equity.

The general equation for calculating Retained Earnings can be expressed as following:

Retained Earnings (year end) = Retained Earnings (beginning of the year) + Net Income – Dividends Paid

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What is an asset?

The question, “What is an asset?” seems like an absurdly simple question. But if you understand the answer to that simple question, and act on it, you have started down the path that leads to riches. Few people become rich, so clearly then, few people understand the answer to this question. Let’s have a closer look.

The Oxford English Dictionarydefines an asset as “a useful or valuable thing or person; [or as] property owned by a person or company.” This is the strict dictionary definition of the word ‘asset’. However, if I use this definition of ‘asset’ when deciding how to spend my money then I am likely to make mistakes. That is, I am likely to make decisions that I would not have made had I really understood what an asset is.

Using the Oxford dictionary definition of ‘asset’, I could be mistaken for thinking that my Mercedes that I have parked out the front is an asset. I own it, it is very useful and it is definitely valuable. This satisfies the dictionary definition of an asset. In addition, the bank will usually be willing to count my Mercedes as an asset when I ask for a personal loan.

In Rich Dad Poor Dad, Robert Kiyosaki makes the insightful point that, “what defines an asset is not words but numbers”. Let’s consider the numbers relating to my Mercedes. Every month I have a series of expenses that I incur because I own my Mercedes. My expenses might include: fuel $400, on-road maintenance costs $50, and insurance $200. So, every month my Mercedes costs me $650 in expenses. This doesn’t sound much like an asset.

According to Robert Kiyosaki, an asset is “something that puts money in my pocket every month.” By this definition, my Mercedes is not an asset but a liability. It costs me $650 each and every month, and that’s not including depreciation.

But, what about my house, is that an asset? The conventional wisdom is that you’re house is an asset, and the bank will certainly let you count it as an asset when you ask to borrow money. Let’s apply Kiyosaki’s definition to see whether a house is an asset. Every month you might have to pay: property taxes $200, loans $3000, utilities $200, and maintenance $100. In this example, your house costs you $3,500 each and every month. This doesn’t sound much like an asset.

It is true that, unlike my Mercedes, houses usually appreciate in value. However, there are three problems with this:

1. Property does not always appreciate in value. The recent sub-prime mortgage crisis in the United States has taught us all that lesson, if we didn’t know it already;
2. Tying up all of your money in your house comes at a high opportunity cost. So, while the value of your house may be rising and you are managing to pay off your mortgage, you may be unable to take advantage of great opportunities that are presented to you. “I would, but I have to make mortgage payments”;
3. Your home does not put money in your pocket every month. The only time that you can obtain money from your house is when you sell it. For one reason or another, people are often reluctant to sell their homes. This fact remains true even when people are in tight financial circumstances.

The kind of assets that I’m talking about come in various forms, five examples include:

1. Businesses that do not require your presence. If you need to be there to run the business it is a job and not a business;
2. Stocks;
3. Bonds;
4. Income-generating real estate; and
5. Royalties from intellectual property such as books or music.

Once you understand the difference between assets and liabilities, it is a good idea to concentrate your efforts on only buying income-generating assets. This is the path to wealth and riches.

What does it mean to be wealthy?

If the main game is to become wealthy, it would pay to stop for a second and consider what it would mean to be wealthy.

I am inclined to accept the definition of wealth that Kiyosaki puts forward, borrowed from Buckminster Fuller.

Wealth is a person’s ability to survive so many number of days forward into the future if they were to stop working today. So, I have become wealthy when my income each month, which is generated from my assets, fully covers my monthly expenses. If I want to increase my monthly expenses, I must increase my cash flow obtained from my assets in order to maintain my wealth.

To say that someone is wealthy, then, is to say nothing about whether that person is rich. I can be wealthy without being rich.

How much income do I need each month, generated from my assets, before I can consider myself rich? The answer to that question is up to you. The definition of ‘rich’ is in the eye of the beholder.

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I recently watched a talk given by Warren Buffett to a group of MBA students at the University of Florida, College of Business. In the speech, Buffett gives his perspective on investing, in which he outlines the need to understand the underlying economics of the businesses that you invest in, and the need to stick to disciplined principles of business evaluation without being swayed by passing investment fads.  If you like this article and want to view a YouTube excerpt from Buffett’s speech, visit the James Cox finance blog.

Warren Buffett is an American investor born in 1930 in Omaha, Nebraska. Buffett is regarded as one of the world’s greatest stock market investors, and is the largest shareholder and CEO of Berkshire Hathaway. He has an estimated net worth of around $US62 billion and was ranked by Forbes as the richest man in the world in 2008. Buffett is noted for his adherence to the value investing philosophy and it is arguable that Buffett’s most influential mentor was Benjamin Graham. Graham was an influential economist and professional investor and is considered the first proponent of value investing.

I have summarised 15 of the most interesting and insightful points made by Buffett in his speech about successful long term investing, as follows:

1. Return on equity is key

Return on equity is fundamental. In general, there is no point to investing, just because of the availability of cheap financing, if a business has a low return on equity. It’s hard to earn much as an investor when the business you’re in doesn’t earn very much money. Buffett elaborates that when he started out as an investor he would sometimes purchase very ordinary stocks at prices way below the value of working capital. This is what Buffett calls the ‘Cigar Butt’ approach to investing. You look around for a cigar butt (i.e. really cheap company), you find one that is old and soggy. You get one free puff out of it, and then you throw it away and try to find another one. If you’re looking for a free puff then this approach to investing works, but these are very low return businesses. By investing in a wonderful business with a high return on equity then, even if you initially pay a little too much, you’ll do well if you stay in for a long time.

2. Ownership of a stock is partownership of a business

Ownership of a stock is part ownership of a business.  With that in mind, the investors should not pay attention to the day to day stock fluctuations.

3. Invest in businesses that you understand

As Buffer jokes, this significantly narrows down the number of companies that he has to look at. You need to look for a simple business which is easy to understand, and which has honest and able management. Buffett says that this lets him understand where a company is going to be in ten years time. If he can’t see where the company will be in ten years, he won’t buy it. Buffett says that “investing is putting out money now, to be sure of getting more money back later at an appropriate rate. To do that you need to understand the business.” Buffett says that he wouldn’t invest money in a new internet business because he doesn’t understand that business and couldn’t say where it would be in ten years time. In his early years he would conduct extensive industry research. For example, by asking every CEO in an industry “if you could buy the stock of one other company in the industry, which one would it be and why?”

4. Invest within your circle of competence

The nice thing about investing is you don’t need to learn anything very new. Buffett says that he learnt about Wrigley’s chewing gum 40 years ago, and still understands that industry today. As a result, you will develop a pool of knowledge about different industries that builds up over time. Interestingly, Buffett says that most of his deals get completed in a matter of hours. If you don’t know enough about a business instantly, you won’t know enough in a month or two.

5. Invest based on solid reasoning

If someone told you about a company at a cocktail party or the charts look good, that’s not good enough. Paying a little too much for a wonderful business, you’ll do well if you stay in for a long time. You buy a lousy business for a good price; you stay in for a long time you’ll get a lousy result. If you’re right about the business, you’ll make a lot of money.

6. Invest for the long term

Buffett recommends buying businesses that you would be happy to own forever. It may happen that you have to sell for one reason or another, but you should, at the time you buy, want to be buying a company that you’ll own forever.

7. Strong businesses need a durable competitive advantage

A strong business needs a durable competitive advantage. Buffett says that although he wants to understand the businesses he goes into, he doesn’t want a business that is easy. You want a business with a moat around it with a duke defending the castle. That moat might be low cost operations, quality of products, service, patents, real estate location, or share of mind (Buffett explains that thirty years ago, Kodak’s moat was as wide as Coke’s moat. Kodak had share of mind, forget about share of market. They had something in everybody’s mind that said, “Kodak is the best”).

8. Feel strongly about the products

You want a business that has products that are not price dependant. Disney and Coca-Cola have developed a favourable impression in the mind of consumers that allows these companies to charge more for their products and sell more of them than other companies in the same industry.

9. Don’t borrow money that you don’t need

Buffett says that he never borrows money. He loves his job and was doing the same thing when he had $10,000 and when making $1,000 was a big deal. He recommends taking a job that if you were independently wealthy you would take. “If you think you’re going to be a lot happier if you have 2X instead of X, then you’re probably making a mistake.”

10. You only have to get rich once

Risking what you have and need to get what you don’t have and don’t need is foolish. Buffett gives the example of Long Term Capital Management. This hedge fund was run by smart people, with extensive experience and with their own money invested. To make money they didn’t have and didn’t need, they risked money they did have and did need. Buffett says, “if you risk something that is important to you for something that is unimportant to you, that decision just doesn’t make sense.”

11. Be patient, think carefully and avoid over stimulation

Buffett says that, in his opinion, the best way to think about investments is to sit in a room and just think. The problem with being in a market environment is that you get the feeling that you have to do something everyday, you get over stimulated. You want to be away from any environment that stimulates activity. Get one good idea a year, and ride it to its full potential.

12. Professional investors should not diversify

Buffett believes that if you are not a professional investor, which is ninety nine percent of people, then you should extensively diversify your investments and not trade. However, once you decide that you are going to bring an intensity to the game and start evaluating businesses and bring the effort, intensity and time involved to get that job done, then Buffett believes that diversification is a terrible mistake. In his opinion, if you really know businesses then you shouldn’t own more than 6 of them. “Very few people have got rich on their seventh best idea.”

13. Business size is not the important consideration

When investing, business size is not the important consideration. Small, medium and large cap stocks can all represent good investment opportunities. It doesn’t matter about the size of the business; it’s the certainty of the returns that counts. The relevant questions are:

1. Can we understand the business?
2. Do we like the people running it?
3. Does it sell for a price that is attractive?

14. Only worry about what is important and knowable

Anything that is unimportant or unknowable, you should forget about it. Buffett outlines that market predictions do not affect his investment decisions. “I have no idea where the market is going to go.”

15. Make investment mistakes

Buffett says that the mistakes that he has actively made have been far less costly than his mistakes of omission. He reflected that the times where he understood a business, saw an opportunity and sat on his hands and did nothing have cost him tens of billions of dollars.

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