I wonder if people buying these houses, for ever-rising prices, are same people who couldn't get enough Amazon.com stock at $100 or Lucent shares for $75? Having been burned in stock market, I guess they decided to re-invest what was left in their homes. Are we in a housing bubble? I don't know, but I suspect that we are, at least in some areas of country.

Don't misunderstand me, now. I own a home, and I think home ownership is one of great freedoms we enjoy in this country. I get nervous about people who are pulling all equity out of their homes with new mortgages. I suspect that most of these people are spending equity, not investing it. What they're left with is a larger mortgage, and a bunch of worthless Chinese made goods.

The current low-interest rate environment is a once-in-a-lifetime chance to lock in a cheap 30-year mortgage on your home. If you refinance balance of your current mortgage, you've won. If you refinance, and max out on your equity, you're probably hurting yourself. You might say that by refinancing equity in your home, you're just cashing in on your home's rise in value. Well, not exactly.

What you're really doing is collateralizing portion of house that you own to get a cash loan, with intention of paying back loan at a later date. You've really transferred ownership of equity in your house to your lender, not cashed it out. If you want to cash out your equity, you have to sell your house, plain and simple.

For those who are buying new homes, low interest environment is a double-edged sword. On one hand, you can get a tremendous rate on a 30-year mortgage, likes of which you see once in a lifetime. On other hand, because we live in a world where monthly payment is all that matters, lower interest rate mean higher home prices. The monthly payment stays same, but now you've got a much higher mortgage balance, which could turn around to bite you in future.

The dangers of refinancing equity out of your home are readily apparent, but why shouldn't you buy a home in current environment?

That’s where deceptive part of description comes in. The items on income statement are easily manipulated by, say, less-than-honest management, and don’t necessarily represent true situation at a company. Even totally honest companies can have income statements that don’t represent economic reality. Cash flows define economic reality, revenue and expenses define accounting reality.

You see, difference between your household budget and a company’s income statement is their relationships to actual cash flows. Your household budget will generally match your cash inflows and outflows. Not so with an income statement. Income statements can vary significantly from company’s cash flow, meaning that a company in economic trouble can show a very “good” income statement up until day it goes bankrupt.

Generally speaking, though, income statement is a good place to start when evaluating a company. In my forthcoming e-book, Fundamentals of Financial Statement Analysis, I lay out process for evaluating health of a company through financial statements. I’m shooting for publication in beginning of 2004, but in meantime, here are some tips and strategies for evaluating an income statement.

1. Create a Common Size Statement

What’s a common size statement, you ask? It’s income statement, only with each line item represented as a percentage of sales. This is easy to do with a spreadsheet on your computer, but you can do it on paper just as well. Net Sales is always 100% at top, and each of expenses is divided by total sales to arrive at a percentage. For example, if a company has $100 in sales and $50 in cost of goods sold, common size statement will look like this:

Sales 100% Cost of Goods Sold 50% Gross Profit 50%

The importance of common size statement can’t be overstated. It gives you calculation of all your profit margins, from gross to net, and shows how much each cost item takes away from your profits.

2. Create a Year-to-Year Comparison Statement

The next step is to make a year-to-year comparison statement. You can’t evaluate financial statements for just a single year; they have to be compared to previous years. The only formula you need to know for these calculations is:

(current year / previous year) – 1 = % change

Again, a spreadsheet makes this process so much easier, but it can be done by hand. I like to have five years of data, which yields four years of comparison data. This way you aren’t just looking at an exceptionally good or bad year for analysis. Plus, you can get a reasonable estimate of future growth when you do your discounted cash flow analysis. (I’ll have more on Discounted Cash Flow in future.)

3. Read Management Discussion and Analysis