Investing Caffeine

Financial Statements: Monetary X-Rays for Decision Makers

January 29, 2010 at 1:30 am 1 comment

Virtually everyone has been to a doctor’s office or hospital, and at some point gotten an x-ray. Typically, multiple x-rays are taken to give the doctor adequate data for determining a patient’s health and well-being. For example, a dentist will take numerous views in searching for disease and cavities, above and below the surface of the mouth. When it comes to financial markets, the same diagnostic principles apply to securities analysis. But rather than x-rays, we have financial statements. The income statement, balance sheet, and cash flow statement provide analysts multiple angles for making a proper company diagnosis. Each financial statement provides the user a unique perspective, and together, the statements paint a more complete picture into the financial condition of a company. In the coming weeks (and months), I will take a deeper dive into the world of financial statement analysis.

Financial Statement Reporting

What is the purpose of financial statement analysis?

“The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.”    -Howard Schilit (author of Financial Shenanigans) 

Sounds simple and pure in its aim, but as we will find out, there can be more to financial statements than meets the eye (see also EPS Tricks of the Trade). In order to profit (and protect oneself), financial statement users need to read between the lines.

The Bookkeeper Police

Policing the integrity of the financial bookkeeping process are the FASB (Financial Accounting Standards Board) – the entity behind the creation of GAAP (Generally Accepted Accounting Principles) – and the SEC (Securities and Exchange Commission). Unfortunately the goals of management (maximize wealth and shareholder value) do not always align with the objectives of financial statement users (accuracy and transparency). As we found out from the case of Bernie Madoff, investors cannot always rely on the SEC for law enforcement. A deep-rooted foundation in financial statement analysis mixed in with some common sense may protect you from some major financial pitfalls.

Why are Financial Statements so Important?

Transparency of Capital Markets: Our capitalistic society is based on the trust and transparency of available financial information, so key decision makers can make informed decisions. In many emerging markets, standards are more lax and well-versed decisions are more difficult to make. Ultimately, if you believe in free markets, money migrates to where it is treated best.  Reliable and transparent financial systems build investor confidence and make our system work. When companies like AIG and Enron have complex derivatives and opaque off balance sheet structures that are not clearly disclosed, then investors and key decision makers are at a disadvantage. The companies generally suffer as well, since investors afford lower valuations for complex organizations.

Investment Bankers / Sell Side Research:  Investment bankers rely heavily on financial statements when determining the suitability of corporate marriage. A company cannot be bought or sold without determining an agreed-upon valuation. Financial statements help bankers establish an appropriate price for transactions.

Competitors: We live in a dog eat dog world. Assessing the strength and effectiveness of various competitor initiatives can lead to better decision making. For example, one can simply compare the revenue growth rates of two companies to determine who is gaining market share. In tough times like now, an analyst can look at items such as debt load on the balance sheet or cash generation on the cash flow statement to determine how a company is positioned to weather a potential cash crunch.

Employment/Compensation: Astute financial analysis by job seekers can lead to tremendous insights into a company’s financial condition. The process can also trigger shrewd questions to bounce back at the interviewers. Executives can also look at financial and proxy statements to uncover compensation practices of a company.

Fraud/Inaccuracies: The SEC and other regulatory agencies need tools to hunt down the bad guys and notify those stretching the letter of the law. The SEC and FASB are supposed to act as the industry financial cops. Our trust in these institutions took a deep hit when these organizations failed to catch the corrupt actions of Bernie Madoff, despite the multiple times outsiders waved red flags to the SEC.

IRS/Tax Collection: Uncle Sam wants to collect his revenue, especially in these times of large and expanding deficits. Verifying and auditing the correctness of a company’s tax liabilities can ensure correct tax revenues are accumulated.

Bankers/Creditors: Banks are becoming even more tight-fisted these days, and in order to provide loans to borrowers, financial statements become a key component of the loan equation.

Internal Finance Staff & Consultants: Chief Financial Officers and corporate finance department professionals need financial statements to steer strategy in the right direction. Many companies develop a six sigma type of approach whereby margin and cash flow improvements are targeted. In that vein, internal and external benchmarking can highlight areas of strengths and weaknesses.

For many, financial statement analysis is not the sexiest endeavor. However, I think when properly applied, the process engenders clearer and more confident decision-making. A doctor feels much the same way upon reviewing a set of accurate x-rays and making an informed patient diagnosis. Do yourself a favor and don’t ignore the financial statement components. With appropriate financial analysis, I am confident you can make healthy investment decisions too.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in AIG or other securities mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

Entry filed under: Accounting, Education. Tags: analysis, balance sheet, cash flow statement, FASB, financial statements, GAAP, income statement, transparency.