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. Almost 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, the cash flow statement as well as shareholders' equity and retained earnings. 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) or International Financial Reporting Standards (IFRS) are used to prepare financial statements. Both methods are legal in the United States, although GAAP is most commonly used. The main difference between the two is that GAAP is more "rule based," while IFRS is "principle based." Both have different ways of reporting asset values, depreciation, inventory and more. (For related content, see: What are some of the key differences between IFRS and U.S. GAAP?"
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 Annual Report/10-K
Prudent investors should only consider investing in companies with audited financial statements, which are a requirement for all publicly traded companies. Perhaps even before digging into a company's financials, an investor should look at the company's annual report and the 10-K. Much of the annual report is based on the 10-K, but contains less information and is presented in a marketable document intended for an audience of shareholders. The 10-K is reported directly to the SEC and tends to contains more details.
Included in the annual report is the auditor's report which gives an auditor's opinion on how the accounting principles have been applied. 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.
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.