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Knowing how to work with the numbers in a company's financial statements is an
essential skill for stock investors. The meaningful interpretation and analysis
of balance sheets, income statements and cash flow statements to discern a
company's investment qualities is the basis for smart investment choices.
However, the diversity of financial reporting requires that we first become
familiar with certain general financial statement characteristics before
focusing on individual corporate financials. In this article, we'll show you
what the financial statements have to offer and how to use them to your
advantage.
TUTORIAL: Advanced Financial Statement Analysis
1. Financial Statements Are Scorecards
There are millions of individual investors worldwide, and while a large
percentage of these investors have chosen mutual funds as the vehicle of choice
for their investing activities, a very large percentage of individual investors
are also investing directly in stocks. Prudent investing practices dictate that
we seek out quality companies with strong balance sheets, solid earnings and
positive cash flows.
Whether you're a do-it-yourself or rely on guidance from an investment
professional, learning certain fundamental financial statement analysis skills
can be very useful - it's certainly not just for the experts. Over 30 years
ago, businessman Robert Follet wrote a book entitled "How To Keep Score In
Business" (1987). His principal point was that in business you keep score with
dollars, and the scorecard is a financial statement. He recognized that "a lot
of people don't understand keeping score in business. They get mixed up about
profits, assets, cash flow and return on investment."
The same thing could be said today about a large portion of the investing
public, especially when it comes to identifying investment values in financial
statements. But don't let this intimidate you; it can be done. As Michael C.
Thomsett says in "Mastering Fundamental Analysis" (1998):
"That there is no secret is the biggest secret of Wall Street - and of any
specialized industry. Very little in the financial world is so complex that you
cannot grasp it. The fundamentals - as their name implies - are basic and
relatively uncomplicated. The only factor complicating financial information is
jargon, overly complex statistical analysis and complex formulas that don't
convey information any better than straight talk." (For more information, see
Introduction To Fundamental Analysis and What Are Fundamentals?)
What follows is a brief discussion of 12 common financial statement
characteristics to keep in mind before you start your analytical journey.
2. What Financial Statements to Use
For investment analysis purposes, the financial statements that are used are
the balance sheet, the income statement and the cash flow statement. The
statements of shareholders' equity and retained earnings, which are seldom
presented, contain nice-to-know, but not critical, information, and are not
used by financial analysts. A word of caution: there are those in the general
investing public who tend to focus on just the income statement and the balance
sheet, thereby relegating cash flow considerations to somewhat of a secondary
status. That's a mistake; for now, simply make a permanent mental note that the
cash flow statement contains critically important analytical data. (To learn
more, check out Reading The Balance Sheet, Understanding The Income Statement
and The Essentials Of Cash Flow.)
3. Knowing What's Behind the Numbers
The numbers in a company's financials reflect real world events. These numbers
and the financial ratios/indicators that are derived from them for investment
analysis are easier to understand if you can visualize the underlying realities
of this essentially quantitative information. For example, before you start
crunching numbers, have an understanding of what the company does, its products
and/or services, and the industry in which it operates.
4. The Diversity of Financial Reporting
Don't expect financial statements to fit into a single mold. Many articles and
books on financial statement analysis take a one-size-fits-all approach. The
less-experienced investor is going to get lost when he or she encounters a
presentation of accounts that falls outside the mainstream or so-called
"typical" company. Simply remember that the diverse nature of business
activities results in a diversity of financial statement presentations. This is
particularly true of the balance sheet; the income and cash flow statements are
less susceptible to this phenomenon.
5. The Challenge of Understanding Financial Jargon
The lack of any appreciable standardization of financial reporting terminology
complicates the understanding of many financial statement account entries. This
circumstance can be confusing for the beginning investor. There's little hope
that things will change on this issue in the foreseeable future, but a good
financial dictionary can help considerably.
6. Accounting Is an Art, Not a Science
The presentation of a company's financial position, as portrayed in its
financial statements, is influenced by management estimates and judgments. In
the best of circumstances, management is scrupulously honest and candid, while
the outside auditors are demanding, strict and uncompromising. Whatever the
case, the imprecision that can be inherently found in the accounting process
means that the prudent investor should take an inquiring and skeptical approach
toward financial statement analysis. (For related content, see Don't Forget To
Read The Prospectus! and How To Read Footnotes - Part 2: Evaluating Accounting
Risk.)
7. Two Key Accounting Conventions
Generally accepted accounting principles (GAAP) are used to prepare financial
statements. The sum total of these accounting concepts and assumptions is huge.
For investors, a basic understanding of at least two of these conventions -
historical cost and accrual accounting - is particularly important. According
to GAAP, assets are valued at their purchase price (historical cost), which may
be significantly different than their current market value. Revenues are
recorded when goods or services are delivered and expenses recorded when
incurred. Generally, this flow does not coincide with the actual receipt and
disbursement of cash, which is why the cash flow becomes so important.
8. Non-Financial Statement Information
Information on the state of the economy, industry and competitive
considerations, market forces, technological change, and the quality of
management and the workforce are not directly reflected in a company's
financial statements. Investors need to recognize that financial statement
insights are but one piece, albeit an important one, of the larger investment
information puzzle.
9. Financial Ratios and Indicators
The absolute numbers in financial statements are of little value for investment
analysis, which must transform these numbers into meaningful relationships to
judge a company's financial performance and condition. The resulting ratios and
indicators must be viewed over extended periods to reflect trends. Here again,
beware of the one-size-fits-all syndrome. Evaluative financial metrics can
differ significantly by industry, company size and stage of development.
10. Notes to the Financial Statements
It is difficult for financial statement numbers to provide the disclosure
required by regulatory authorities. Professional analysts universally agree
that a thorough understanding of the notes to financial statements is essential
in order to properly evaluate a company's financial condition and performance.
As noted by auditors on financial statements "the accompanying notes are an
integral part of these financial statements." Take these noted comments
seriously. (For more insight, see Footnotes: Start Reading The Fine Print.)
11. The Auditor's Report
Prudent investors should only consider investing in companies with audited
financial statements, which are a requirement for all publicly traded
companies. Before digging into a company's financials, the first thing to do is
read the auditor's report. A "clean opinion" provides you with a green light to
proceed. Qualifying remarks may be benign or serious; in the case of the
latter, you may not want to proceed.
12. Consolidated Financial Statements
Generally, the word "consolidated" appears in the title of a financial
statement, as in a consolidated balance sheet. Consolidation of a parent
company and its majority-owned (more that 50% ownership or "effective control")
subsidiaries means that the combined activities of separate legal entities are
expressed as one economic unit. The presumption is that a consolidation as one
entity is more meaningful than separate statements for different entities.
Conclusion
The financial statement perspectives provided in this overview are meant to
give readers the big picture. With these considerations in mind, beginning
investors should be better prepared to cope with learning the analytical
details of discerning the investment qualities reflected in a company's
financials.
by Richard Loth
Richard Loth has more than three decades of international experience in banking
(Citibank, Industrial National Bank, and Bank of Montreal), corporate financial
consulting, and non-profit development assistance programs. During the past 12
years, he has been a registered investment adviser and a published author of
books and publications on investing. Currently, he devotes his professional
activities to educational endeavors, writing and lecturing, aimed at helping
individual investors improve their investing know-how (see http://
www.lothinvest.com)