Working with financial statements
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One of the most basic and essential skills in stock investing is to work with financial statements and understand the implications of the numbers. In fundamental analysis, the extent of overvaluation or undervaluation of a particular stock is established largely by the analysis of the balance sheet, the income statements and the cash flow statements. However, companies use quite a range of financial reporting policies and standards so you should get acquainted with the general factors that characterize financial statements so that you can make the most of them.
What you should always keep in mind is that in business, the score is measured in terms of dollars and financial statements are a business scorecard. To understand the game therefore, you need to have a working knowledge of how to use financial statements and this is not as complicated or complex as you might have been led to believe. Michael C. Thomsett says in his 1998 book “Mastering Fundamental Analysis”:
“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.”
The financial statements that are essential to your analysis are the balance sheet, the income statement, and the cash flow statement. The other financial statements may contain useful information but are not absolutely necessary for the purpose of analysis. Because these statements reflect the performance of the companies in a real-world business environment, make an effort to learn something about the company and what it produces before starting to crunch numbers. Because different companies operate in different businesses and different environments, you will often see a variety of different accounting presentations though this is more likely to occur with balance sheets rather than income statements which are relatively standardized.
You must also bear in mind that accounting is not a science and many of the numbers that you see are influenced by the judgment of the management. With the best of companies, management is likely to be candid and open about the yardstick they use for the judgment and auditors are likely to require more stringent reporting standards. You should not take the numbers at face value but try and understand a little about the factors would likely to influence the accuracy. In other words all numbers should be taken with a pinch of salt until you establish that they are reliable.
Just numbers by themselves convey only a limited amount of information and it is necessary to use financial ratios to establish meaningful relationships and to analyze trends over a period of time. You should again realize that evaluating these ratios and relationships is an art that you must cultivate because companies operate in different industries and different environments. The obvious trap to avoid is to use a “one size fits all” kind of analytical approach and evaluate each company on its own merits.
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