3. What is a Balance Sheet and Margin of Safety

welcome to the course 1 unit 1 lesson 3

what

is a

balance

sheet

and

margin

of

safety

in this lesson we have four lesson objectives the first is to understand the importance of a

balance

sheet

the second is how the capital of a company is determined the third is to understand

what

goes accompanied by a

margin

of

safety

and the fourth is the value of the business, a comparison of net income and capital, so let's get started, let me warn you that if you are starting this lesson without having seen lesson 2, you will probably feel a little bit a little behind, so I recommend that you go back and watch the course 1 unit 1 lesson 2 a video before we move on to this lesson 3 okay, where we left off in lesson 2 was that we had a small business whose name was Nancy You can see here on the top and she had this little ice cream business and the ice cream business had $100,000 in revenue and as she went through all the different costs, she finally ended up with $20,000 of revenue or net profit and we know that that revenue term in profits It is a very important figure to understand because that is the amount of money left after the entire business model and Nancy had two options: she could keep that money, she could pay it herself or she could put the money back into the business she owned.

We had talked in the previous lesson about how much Nancy's business was worth, so let's say Nancy wants to sell her business, she doesn't want to own it anymore, she wants to sell it and she's asking $200,000 for someone to buy it so that's her market price, every time a person sets that price, that doesn't necessarily mean that she will get $200,000 for the ice cream stand, but that is what she asks for, we realized that every time she makes $20,000 in that income she would have a 10% return if she's asking for $200,000 for the business, but how safe is that investment, that's really the question we need to understand at this point moving forward, so let's go to the balance sheet.

I have to discover that any business, any corporation, has three sheets of paper that have to account for all the things that their business operates. The first is the income statement, the next is the balance sheet, the third is the cash flow statement and I. We have a little bit where they represent each of these documents, so for Nancy's business, she has an income statement. Now, if you look under the income statement, you'll see the little model that we used in lesson two below, because that's what we were doing. we were essentially finding out what their income statement was: it starts at the top of that income statement is total revenue and the final figure at the bottom of that income statement document is net income, so we pretty much already understand the income statement and that is used to find what the company's profits will be.

Now something we haven't talked about is next, which is the balance sheet. If you look in the middle, there is the balance sheet and we can use the balance sheet to determine. The margin of safety that you would get if you bought this business from Nancy, who asks you for $200,000 for her business just so you know the cash flow statement is something that we are not going to cover until the course of the general courses that the website teaches so don't worry about the cash flow statement right now. I really want to focus on two documents, the income statement and the balance sheet.

You absolutely need to know all three documents, that's something that as a stock investor you need to know. I'm going to have to become very familiar with these three documents, so there are only three of them. You need to save those memories, so remember that the income statement, balance sheet, and cash flow statement, if you're taking notes, would do that. Definitely write those three documents, so what we're going to focus on now is the balance sheet and this is used to determine our margin of safety, among other things as well. What is the overall balance? The best way to understand what the balance is.

The key is to ask yourself this question: what would happen if the company went into liquidation right now? Well, now I use the fancy term liquidate, but the only thing that liquidate means is that you're basically going to convert the entire company into cash, which means that you're going to wind it up, you're going to kill it, that's another word for liquidate, is that you're going to kill the business, she was going to liquidate her business, what is it worth now, not ten days from now, not ten days ago, it's right now that's how you have to look at that estimate, so to do that you basically have to? add all your assets, add all your liabilities and then the difference when you subtract the liabilities from the assets is your equity, so Prove that, so here what I did was take a very generic balance sheet for Nancy's business, her business of ice cream, when at the top you can see I have the total assets okay, so I'm going to go over them very quickly, the cash in the account so Nancy has a corporate bank account that is different than her personal bank account and in those bank accounts If you have three thousand dollars on hand your ice cream stand, let's say the ice cream stand is worth ten thousand dollars, let's say the ice cream machine, Let's say you have a really fancy ice cream machine inside, it's worth $5,000 in the supplies you have on hand in right now like a thousand and the land that he bought to put his little ice cream stand on is worth twenty-five thousand dollars, so when we summarize those assets it's forty-four thousand dollars, so now let's look at the total liabilities, so the first thing we see is the salary owed to his employee of two thousand dollars, so he has to pay it.

She still hasn't paid him. The next. It's the ice cream stand itself. Now you'll notice that I listed the ice cream stand in the assets and I also listed the ice cream stand in the liabilities at the top, it's ten thousand dollars, at the bottom it's nine thousand dollars, the reason why that ice cream stand appears twice is because she has not paid for the ice cream stand, so even though the ice cream stand is worth ten thousand dollars, she only paid one thousand, so she only owns one thousand dollars of that ice cream. To put up with the other nine thousand dollars, she blackballed the bank or whoever lent her the money to buy it, so we just learned something about Nancy's ice cream stand here and that is that she doesn't necessarily own the stand itself, she He has a thousand dollars. of that, of the $10,000 from the ice cream stand, then we look at the ice cream machine and we have exactly the same thing: the machine might be worth $5,000, but three thousand dollars of that is still death because Nancy doesn't own the ice cream machine, she asked for a loan to buy it, so she owns two thousand dollars of the five thousand dollars, okay, and then we look at the land, then she would have bought that land because the land is worth twenty-five thousand. dollars what she's listing, but she still owes $23,000 on that land, so she only paid $2,000 for that land, so when we add up all her liabilities we see that Nancy owes $37,000 on this ice cream stand, so when what we have to do It's just we take the assets, we take those total assets, we subtract the total liabilities and we see that Nancy's equity in this business and the equity is just the difference between those two is $7,000, so this sheds a lot of light on the position.

Nancy's ice cream shop. You know she could be making twenty thousand dollars a year, but the only thing that's worth on the books right now is her balance sheet and if you look up on the left, the balance sheet, the equity is only seven thousand dollars. this business, so to get a better idea of ​​a balance sheet, I often encourage people to sit down and try to determine their own capital with a balance sheet, you know, sit down with a blank sheet of paper and write all your assets, you know. write down how much cash a plant has in your bank account write down how much you think your car is worth right now and you have to say how much it's worth now not how much you bought it for how much you think your house is worth and then go to the liabilities and then start listing how much you have in credit card debt, how much is your home loan, how much is your car loan and then you list all those things, then what you do is you just add up your assets subtract your liabilities and see what your personal wealth is and when you do that, you'll actually have a better idea of ​​what a balance sheet really is because you've done it first hand, okay, and one last thing I want to highlight here is look at the balance sheet at the top left. , equity is for the entire business when you value the entire business when we start talking about stocks, a stock, the equivalent terminology for equity is book value, so every time I make a mistake and say Book Value.

I'm actually saying equity, but the book value is per share, that's equity per share. Okay, so now let's see here if Nancy couldn't find a buyer for her. I shout to Stan, how much does it cost? The business is worth, okay, we said if we value it at $200,000, we'll give her or the person who would buy it a 10% return, but if no one is willing to buy it for that, how much is it really worth? If she just wanted to finish this business and she couldn't sell it to anyone, how much would she get? and the answer is her capital, she will get $7,000 for this business. sell it for maybe $200,000, but if you can't find a buyer and you just want to close the business and sell your ice cream machine and pay off your debts and all that, you'll only have $7,000 left at the end of the day, so this difference between the price of market of what a person asks for and the real capital that there is in the company, that difference is the risk, it is the margin of safety and this was the most important thing about Benjamin Graham, who we learned was Warren Buffett's professor at Columbia, his Lo More important was the margin of safety if a company did not have a substantial amount of safety between market price and capital.

I was very hesitant to buy a company, so in this scenario the capital is actually three and a half percent of the market price and you know that's not at all safe because let's say you would buy this business for $200,000 let's say you bought it, there you're running your ice cream stand and you're making that The net income you saw was twenty thousand dollars and as you go along, all of a sudden your employee quits and sales start to decline and all of a sudden you're not making any money anymore and you have to sell the business.

What is the value of the business? well it's worth the capital so there it is, that's all the risk involved in this company, it's the difference between the market price you buy it for and the value of the capital to the company on its balance sheet and as you We can see that the closer the capital is to the market price, the safer the investment will be. As you look at this slide here, I laid out the two things that we've already talked about the income statement, that's what we learned in lesson two and now you look at the balance sheet that we're going to learn in this lesson, so net income on the income statement was $20,000 a year, so if you buy that business for $200,000, you can expect a 10% return on your money, but that's only if the business runs like it's supposed to if everyone customers keep coming if all your employees don't quit or change if your ice cream machines never break or if you know you don't have any problems you don't have any demands, any of those things, okay, that's what the business would be worth, but As we go there and look at the balance sheet, the capital is only $7,000, that is, there is a lot of risk that you have and therefore the margin of safety is really low in this investment, the capital is 3, 5% of market price, so you're looking for something that has equity.

If the capital of the business was $150,000 and its net income was $20,000, you would probably have It's a very easy time, you know, asking $200,000 for the business, but in this case I think it's going to be very difficult for you. finding a buyer for $200,000 when there is only seven thousand dollars of equity in the business. Okay, so I'm going to do it quickly. Go ahead, what I really wanted you to learn from this was to understand what the term equity was and also understand what the margin of safety was, so if you took that away from this lesson, that's what we're really aiming for.

I'm going to give you an idea of ​​what's coming here, so if this confuses you, don't worry, just go to the next lesson, you should be fine, so if you remember from lesson two, I and I want to. If you look at the $20,000 in that income, I told you that the owner has the option to do two things: he can pay himself or he can put that money back into the business and if he pays himself, that's a dividend when you're negotiating. with stock and when you put it back into the business I said it could potentially be retained as profits so when we look at this I put the balance on the right side, let's say Nancy took that $20,000 and was putting it back into the business instead of paying herself , you would actually see your capital.

Hopefully, if she's making wise decisions paying off her debt at this point based on her balance sheet, she would see that she when he would increase by that $20,000 if she makes direct payments to him on her debts, so that's what would like to see. Did her earning power increase a lot, maybe a little, because she could have made some smart investments? suchMaybe a new machine or whatever, but overall he'll probably still be making about $20,000 a year, but what did change is that his capital would probably have gone from seven thousand and seven thousand dollars to twenty-seven thousand dollars if he had put it all in. there for a period of one year, so what would she have done?

It would have reduced her risk. She would have increased her margin of safety because her capital would have increased in the business. Her net income would probably still be generally close to. the same thing, so it's something to consider and if you didn't get it, that's okay, you'll get a lot more as we go along, so it's something to think about as we're looking at this scenario very early on. From now on we can already start to see how some of these things will play out, so the four things that we learned in this lesson we learned about how to understand the importance of a balance sheet and we understood how to determine the capital of a company that We understand the company's margin of safety and we understand the business value of comparing net income to equity, so I hope you learned a lot and I'll see you in the next lesson.