Historical financial statement
(Source: http://en.wikipedia.org/wiki/Financial_statement retrieved 4/7/2014)

 

1 Financial statements are scorecards

Wise investing requires that we seek out good businesses with healthy balance sheets, consistent and reliable earnings and positive cash flows.

 

Most people do not understand how to keep score in business. Talk about profits, assets, cash flow and return on investment confuses them.  The general public does not know how to identify investment values in financial statements.  This should not be intimidating.  Very little in the investment world is so difficult that it cannot be understood with a little study and guidance. The fundamentals are relatively uncomplicated. What complicates financial information is jargon, overly complex statistics and formulas that seem to hide information rather than reveal it.

 

2 The three most important financial statements: balance sheet, income statement and cash flow

When investing, the main financial statements that are needed are the balance sheet, the income statement and the cash flow statement. All three are of equal importance.  Do not make the mistake of treating cash flow as less important.  Financial statements of secondary importance are the statements of shareholders' equity and retained earnings – but these are rarely provided, and while they contain nice-to-know information, none of it essential to investment analysis.

 

3 Know what's behind the numbers

Before beginning to crunch the numbers in the financial analysis of a company, first obtain a thorough understanding of what the company actually does, what products it makes, what services it offers, what markets it serves, and the industry of which it is a part. The numbers in a company's financial statements are only an abstract synopsis and snapshot of the real world operations. These numbers and the financial ratios and indicators that are calculated from them will make more sense if the underlying realities the numbers represent are visualized.

 

4 FIRST: Read the independent auditor's report

The wise investor should only consider investing in companies with financial statements audited by certified and licensed independent/public accounting firms. These are required for all publicly traded corporations.  A "clean opinion" from the auditor lets us know it is worth taking a closer look at the company. Qualifying remarks, however, indicate caution.  If the auditor’s qualifying remarks are several and serious, we should not waste our time analyzing the company’s financial statements, but move on to look for more promising investment prospects instead.

 

5 Financial reports are diverse

Financial statements do not fit into a single mold. Many articles and books on financial statement analysis take a one-size-fits-all approach.  Less-experienced investors are going to get lost when they come across financial statements that do not conform to those of the textbook company. As businesses and their activities are diverse, so too are the look and layout of their financial statements, especially their balance sheets. While this can make it challenging to compare businesses, it does help the investor to examine each business on its own merits.

 

6 Get a GOOD financial dictionary – and then get two or three more!

The world of finance and financial reporting is awash with jargon.  To make matters worse, there is no universal or even national standard for which terms to use and what they mean.  Terminology will vary somewhat from industry to industry, region to region, and even company to company.  Get used to it. And do not be afraid to ask for clarification.  A good financial dictionary can help considerably. When doing business in different regions and industries, try to get a financial dictionary geared to each one. This is especially true when dealing with English financial terms in different English-speaking countries. Never assume that an Englishman, an Australian, and an American mean the same thing by the same term or expression.

 

7 Accounting is NOT an exact science – It’s more of a black art

A company's financial position as presented in its financial statements is always influenced by management estimates and judgments. There is unavoidable imprecision in the accounting process. As every published financial statement must consolidate individual transactions and items into categories, information will necessarily be obscured and confused in the consolidation. That is one reason the investor should always read the footnotes and endnotes (see 11 below).  Even when management is scrupulously honest and candid, and the outside auditors are exacting and uncompromising, the wise investor will be inquisitive and skeptical when analyzing the company’s financial statements.

 

8 Historical cost vs. accrual accounting

Generally Accepted Accounting Principles (GAAP) are used to prepare financial statements. In total, the number of these accounting principles is as vast as their scope – far too vast to attempt even an introduction here.  But for investors wishing to analyze business financial statements, it is especially important to understand at least two of these conventions: historical cost and accrual accounting. According to GAAP, assets are valued at their purchase price (historical cost), which may be significantly different than their current market value. (Look carefully for notations indicating depreciation and appreciation of assets.)  By contrast, revenue is recorded when a good or service is delivered while an expense is recorded when it is incurred. Typically, the timing of these account entries does not coincide with the actual receipt and disbursement of cash, which is why the cash flow becomes so important.

 

9 Vital information NOT FOUND in a financial statement

The information provided by financial statements is just one, though very important, piece of the investment information puzzle.  The investor should acquaint himself with (1) the state of the economy and how it affects the business and its industry, (2) the business’s industry and competition within that industry and with alternative industries, (3) developments in technology, (4) the business’s customer base, (5) its vendors and required materials/resources, (6) the quality of and long-term availability of its labor force, and (7) the quality of management and key personnel, and how dependent the company is on them for its success. None of these are reflected in a company's financial statements.

 

10 Investment tracking over time with financial ratios and indicators

The raw figures in financial statements are of little value when making investment decisions.  The investment analyst must use these numbers to calculate relationships – typically expressed in ratios – at various points in time over the last several years or business cycles. Then from these he may determine meaningful trends over time from which he can assess a business’s past performance, present condition, and future profitability. And as with jargon, evaluative financial measurements (“indicators”) can differ significantly by industry, company size and stage of development.

 

11 Always read the fine print

Always take endnotes and footnotes in financial statements absolutely seriously.  They are a vital and integral part of the report: do NOT fail to read them. Among other things, they help to un-obscure and un-confuse information lost in consolidation, and will also often indicate relevant accounting methods and management estimates and judgments.

 

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 these separate legal entities are expressed as one economic unit. While such consolidations will tell you whether the whole is making or losing money, consolidation may conceal that some entities are performing badly while others are performing well.

 

Conclusion
This overview has hopefully given “the big picture” on financial statements. With this big picture, one can be better prepared as a student in investments to learn the analytics of evaluating a company's financials.

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Language Focus 10.1

Language Focus 1

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Activities

Activity 1