Have you always struggled to read financial statements?
Look no further.
Benjamin Graham and Spencer B. Meredith’s book, “The interpretation of financial statements”, will help you solve this issue. More specifically, the two major parts of financial reports – the income statement and the balance sheet – are explained.
Today I will summarize the 10 most important points that Graham and Meredith make in their book. Graham is truly a guru within the value investing field, and has been an inspiration and teacher for many others, such as Warren Buffet. Let me start out by quoting him:
”Buy your stocks like you select your groceries, not your perfume.”
For those of you who have limited time, the takeaways are summarized here. Later in this post, they will be expanded upon though.
- Size matters.
- Don’t focus on intangibles.
- Some figures in current assets are often overvalued.
- The current ratio is of most importance.
- Look for big cash holdings.
- Among the current liabilities, notes payable are the most important.
- The importance of book value.
- The importance of liquidating value.
- Consider depreciation with caution.
- Focusing only on numbers will yield an average return.
Being able to read financial statements is of greatest importance in investing. The author of the famous book “Rich dad, poor dad”, which I’ve summarized in the post Top 10 takeaways from Rich dad poor dad, is someone who also points this out, and calls it financial literacy.
Obviously, a problem arises when trying to pick the main takeaways from an accounting book, because the main ones are understanding the financial statements and the individual accounts. Explaining every item in the income statement and balance sheet wouldn’t make a good top 10 list though. Instead of listing facts and accounting principles, I will summarize Graham and Meredith’s most important standpoints when it comes to these principles and the interpretation of them. Some points will be made regarding investing in general as well.
Here are the 10 takeaways. As always, the authors thoughts will be in plain text and my eventual comments will be in italic. The name of different accounts in the statements will also be in italic.
1. Size matters.
After all, every large company was a better opportunity years ago, when it was smaller. If you bought H&M, one of Sweden’s highest valued public companies, 30 years ago, in March 1987, the price per share was 2.19 SEK. Today that price is about 240 SEK, at a more than 10,000 % return. It would be surprising, to say the least, if H&M repeats that performance in the upcoming 30 years. It would then be worth the same as Apple, Microsoft, Johnson & Jonson, Exxon Mobile and Amazon together today.
2. Don’t focus on intangibles.
In general, Graham and Meredith thinks that little, if any, weight should be given to the numbers with which intangibles are represented in the balance sheet. It is the income statement that reveals their real value, not the arbitrary figure in the balance sheet.
3. Some figures in current assets are often overvalued.
In current assets, there are a few things to watch out for:
- Installment account receivables, receivables that are paid in a series of payments, are often included to their full amount, even though some of the payments may actually be scheduled for later than one year.
- Inventory is often accounted for in its whole value, even though some of it might not be sold within the next year. Also, some of it might have to be sold at a discount because it’s no longer up to date. Within the clothing industry, for instance, this is common.
4. The current ratio is of most importance.
One of the most frequently used ratios for analyzing the financial position of a company is the relation between current assets and current liabilities. This is obviously strongly correlated with working capital (current assets minus current liabilities), but is a relative number instead of an absolute one. It is called the current ratio. If it is 1 or above, the company shall have no problem to pay its debts during the year. A margin higher than that is usually preferred though. The required margin highly depends on the sector, but Graham recommends 2 or higher.
Inventory should be excluded from the current liabilities if it can’t be expected to be sold the next year. A tip here is to look at the ratio between inventory and revenue to understand if that will be possible or not.
5. Look for big cash holdings.
A big cash holding, which appears under the account cash assets, should be considered as something good (no surprise here). If the company is performing well, even without incorporating that extra cash, it is to be considered very good. Eventually, shareholders will bear the fruit of that cash, either through an extra dividend payment, or through investment in the productivity of the company.
6. Among the current liabilities, notes payable are the most important.
This is usually a bank loan, but can also be a loan to a high net individual for instance. If the figure is exceeded by the cash item, usually it can be ignored. If it is not though, notes payable should be researched further. Check if the numbers have grown faster than the sales for instance. This is typically a sign of weakness.
7. The importance of book value.
The book value, which Graham defines as tangible assets minus liabilities, is not to be considered what shareholders can get from liquidating the company today. There are several reasons for this. The most important two being that the value of the assets are usually valued a bit higher than they should be, and that during a liquidation process it will be hard to get the real market value of the assets. The second reason is due to the fact that the company is in a poor bargaining position.
What the book value should be seen as is rather how much shareholders have put into the company, plus undistributed earnings. The amount is of importance since there is a rough relationship between how much has been invested in the company and how much money it can make. Some companies can produce a large profit from little or nothing, but remember that this will usually be temporary since competitors will probably notice. Also, those large assets, not earning much profit today, can later be made more productive.
8. The importance of liquidating value.
The liquidating value is of importance if the business is performing very poorly. In case this is higher than the total price of the company, a good short-term profit could be made. If the company is also making profits (this is very uncommon for these kinds of stocks today) it could be a good long-term deal. In calculating the liquidation value, start with the book value. As explained in takeaway 7, this value is usually inflated. Two rules of thumb:
- Current assets are usually valued at a fairer price than fixed ones.
- The specific assets must be considered. A railroad company will probably have a harder time to sell its rails, than a bank or an insurance company will have to sell their financial assets. Therefore, the book value must be reduced more for the former to reach a fair liquidating value.
9. Consider depreciation with caution.
In the income statement, one figure that should be considered carefully is depreciation. If the company has a high value of total assets compared to revenues, this is of even more importance. When a company writes down the value of an asset in the balance sheet, the net profit is affected. The greater the assets, the greater the possible negative impact on earnings. There are guidelines and rules regarding how much value an asset loses per annum, but there is also a grey zone. The write down can therefore be inflated because the company wants to avoid taxes, or it can be smaller, because the company wants to show higher earnings. As a rough estimate, Graham want to see a depreciation of about 5 % of net assets per year.
Just remember to do a thorough analysis. If the depreciation is a small number compared to assets, and especially if it is way smaller than earlier years, you can expect this to affect profits negatively in the future. If the opposite is true though, you can expect a positive effect on profits in the future.
10. Focusing only on numbers will yield an average return.
An investor that buys stocks when companies look cheap according to their statements and sell when they look expensive, will probably not make any spectacular profits. On the other hand, the investor will probably avoid big losses. This is why my own analysis consists of two steps. Firstly, I screen through companies which look good based on their statements, and secondly, I screen them based on market trends etc. The first part is quantitative, and the second is qualitative. The second part is way more time consuming, but this is the one that can turn average profits into spectacular ones.
Is there anything missing? What do you think are the top 10 takeaways from “The interpretation of financial statements”? Do you want me to develop on any of the subjects? Let us know in a comment!
If you would like to read the full book, and, besides become an expert on debit and credit, improve the cash position on my balance sheet, buy it here today.
As a conclusion, I will use one of Grahams citations:
“Common stock selection is a difficult art – naturally, since it offers large rewards for success. It requires a skillful mental balance between the facts of the past and the possibilities of the futures”.
For more investment tips delivered in cooperation with a polar bear, stay tuned!