Analyzing Financial Statements and Value Investing

Knowing what to look for in the numbers!

Analyzing financial statements may appear a daunting task. But if you know how to read financial statements, value investing becomes easier!

Companies use financial statements to report on company activities. They have to be released quarterly, including an annual report in some countries such as the United States.

In other countries, more sensible half-yearly and annual reporting is the norm.

I say 'more sensible' since two reports a year rather than four allow companies to get on with the job of running the business rather than being distracted by excessive reporting.

For non-accountants (including me), analyzing financial statements may appear daunting in the first instance.

But like most things in life, if you know what you are looking for you can simplify the process by going straight to the information of greatest interest.


Your Skill Requirements

The first skill is understanding the format of the reports. However, companies generally report using a common format.

While this may vary to some extent from country to country, with the advent of the global economy, international accounting standards are becoming the norm.

Of course, if having advanced accounting skills were a necessity then one would expect that accountants would be over-represented in the wealthiest circles. This is not the case.

Neither do you need mathematical skills above basic arithmetic for analyzing financial statements. And if someone suggests you do, then they are over-representing the situation for purposes about which I would remain wary.

"if calculus were required, I'd have to go back to delivering papers" - Warren Buffett

Financial reports usually have summaries near the front with graphs that inevitably show ever increasing earnings per share and dividend payments.

While looking impressive, the information that is presented can be easily manipulated. This is not often the case, but the desire of company CEOs to present the most favourable impression can be overwhelming.

Earnings per share can be manipulated by undertaking share buybacks.

The question the value investor needs to ask is whether the shares were undervalued at the time of the buybacks, or whether this was an exercise to inflate the earnings per share result.

Dividends can be maintained or increased by borrowing money. Is this a sustainable situation over the longer term?

Investors need to be vigilant to make sure data is not being mis-represented.

So value investors need to look beyond the colourful graphs to make an accurate assessment of the financial health of the company.


Areas Requiring Disclosure

There are three areas that companies must disclose. They include the capital resources, the liquidity and the results of operations.

These areas are covered in the company's financial statements that include ....

• the consolidated statement of income that tells you if the company is making money, and if so, how much they are making
• the balance sheet that provides the value investor with information on the company's liquidity and solvency
• and the statement of cash flows that measures the flow of cash into and out of the company in a specific period of time

Each statement provides a different view of the company. The critical information from each can be combined so value investors can formulate a snapshot in time of the financial health of the company.


To Conclude

The upshot for value investing in relation to analyzing financial statements is to use them to find companies with better than average (and hopefully growing) operating margins, net profit margins, and return on equity.

After that, you need to ask yourself ...

• is the company within your circle of competence; that is, in an area that you know something about?
• does it pass a qualitative analysis test?
• and finally, does the current price represent fair value?

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