“The Interpretation of Financial Statements” is the classic book by Benjamin Graham. Widely regarded as the founder of value investing, Benjamin Graham’s principles of value investing have impacted scores of individuals from Warren Buffett to Bruce Berkowitz. Written in 1937, “The Interpretation of Financial Statements” guides the reader through the core concepts found in balance sheets, income and expense statements, and financial ratios.
We will look at seven key points of advice and the specific financial ratios found in this essential guide to investing.
- Benjamin Graham is one of the founding father of value investing, and a financial guru to many famous value investors such as Warren Buffett.
- Graham's philosophy was to closely examine a company's financial statements to identify undervalued opportunities.
- Here, we take a look at the specific financial ratios that Graham highlighted as key metrics of value investing.
Working Capital Ratio
Working capital is calculated by subtracting current liabilities from current assets. This ratio indicates the ability of a company to pay its expenses in the near future. This requires particular attention because, as Graham points out, it is useful in determining the strength of a company’s financial position. A healthy working capital number shields the company from being unable to meet demands, fund emergency losses and helps with the prompt payment of bills.
Graham further advises the individual to analyze the working capital over several years to watch its corresponding incline or descending levels.
The current ratio can be calculated by dividing the current liabilities from the current assets. As Graham states, “When a company is in a sound position the current assets well exceed the current liabilities, indicating that the company will have no difficulty in taking care of its current debts as they mature.” Each industry is different in terms of what makes up a decent current ratio.
“Quick assets,” which is cash and receivables, excluding inventory, is generally expected to be higher than current liabilities. A quick asset ratio is calculated by taking the current assets less inventories divided by current liabilities. A quick asset ratio of 1:1 is regarded as a reasonable number.
When looking at intangible assets on a company’s balance sheet, pay particular attention to how a company presents this figure. It should be recognized how high the value of goodwill is presented, or not presented at all. Graham further explains that companies vary dramatically in how they present goodwill on their balance sheet. Often, companies tend to exaggerate the value attached to the goodwill figure. This can be telling. Conservative accounting practices can be revealed by presenting a low goodwill figure.
Essentially, Graham advises the reader to look not at the balance sheet valuation of intangibles, but their contribution to the earning power of the company.
It is noteworthy to watch how companies put together their cash account. The key is, in these cases, to look closely at how the cash account is being represented.
In some cases, companies may liquidate a large portion of the inventory and receivable portion of their assets to store more cash into their cash account. If a company has a significant cash account, this can prove to be very attractive to investors. Why? This excess of cash may be distributed to the stockholders or invested back favorably into the business.
Graham informs the investor that notes payable is the most important item to watch among the current liabilities. Here, notes payable tend to represent bank loans or loans from other companies or individuals. In the case that the notes payable have increased at a faster rate than the sales over the years, it could be a negative sign for the company because it signals an overreliance on borrowings from the bank.
Liquidation Value and Net Current Asset Value
A high percentage of current assets over fixed assets can be a good sign when assessing the liquidation value, or net current asset value of a company. The net current asset value is calculated by taking a firm’s current assets and subtracting its total liabilities and preferred shares.
Why this is important is because fixed assets tend to suffer a greater loss than an easily liquidated cash or its equivalent in the current asset category. Graham reminds the reader: “When a stock is selling at much less than its net current asset value, this fact is always of interest, although it is by no means conclusive proof that the issue is undervalued.”
Margin of Profit
As a crucial part of value investing, the margin of profit (also known as the margin of safety) can be calculated by dividing the operating income by sales. Why the margin of profit is important is because it informs the investor of how efficiently the company is operating. For example, a given ratio of 74% shows that the company has 74 cents left after all operating expenses are paid off for every dollar. Here, you would be buying a $1 company for 74 cents. A strong margin of profit is beneficial and adds a competitive edge to the company.
This is perhaps one of the most essential principles underscoring Graham’s investment principles. It not only helps minimize the downside risk of an investment but has shown to produce higher than average returns, as the market eventually realizes the fair value of the company. Seth Klarman, a legendary value investor, has said, “There are only a few things investors can do to counteract risk: Diversify adequately, hedge when appropriate and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”
The Bottom Line
When analyzing financial statements, the key figures to look for in determining the strength of a company are its earning power, asset value, how the company compares to its industry and the company’s earnings trends over a number of years. The goal of “The Interpretation of Financial Statements” is to show the investor how to assess these factors under the objective of achieving intelligent and reasonable results.