- by Richard Loth
What You Need to Know About Financial Statements (2)
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What Financial Statements To
Use
For investment analysis purposes, the financial
statements that are used are the balance sheet, the income statement and the cash flow statement. The
statements of shareholders'
equity and retained earnings, which are seldom presented, contain nice-to-know, but not critical, information, and
are not used by financial analysts. A word of caution: there are those in the general investing public who
tend to focus on just the income statement and the balance sheet, thereby relegating cash flow considerations
to somewhat of a secondary status. That's a mistake; for now, simply make a permanent mental note that the cash
flow statement contains critically important analytical data.
Knowing What's Behind
the Numbers
The numbers in a company's financials reflect real world events.
These numbers and the financial ratios/indicators that are derived from them for investment analysis are
easier to understand if you can visualize the underlying realities of this
essentially quantitative
information. For example, before you start crunching numbers, have an
understanding of what the company does, its products and/or services, and the industry in which it
operates.
The Diversity Of
Financial Reporting
Don't expect financial
statements to fit into a single mold. Many articles and books on financial statement analysis take a
one-size-fits-all approach. The less-experienced investor is going to get lost when he or she encounters a
presentation of accounts that falls outside the mainstream or so-called "typical" company. Simply remember that the
diverse nature of business activities results in a diversity of financial statement presentations. This is
particularly true of the balance sheet; the income and cash flow statements are less susceptible to this
phenomenon.
The Challenge Of Understanding Financial
Jargon
The lack of any appreciable standardization of
financial reporting terminology complicates the understanding of many financial statement account entries. This
circumstance can be confusing for the beginning investor. There's little hope that things will change on this issue
in the foreseeable future, but a good financial dictionary can help considerably.
Accounting Is An Art,
Not A Science
The presentation of a company's financial position, as portrayed in its financial statements, is
influenced by management estimates and judgments. In the best of circumstances, management is scrupulously honest
and candid, while the outside auditors are demanding, strict and uncompromising. Whatever the case, the imprecision
that can be inherently found in the accounting process means that the prudent investor should take an inquiring and
skeptical approach toward financial statement analysis.
Two Key Accounting Conventions
Generally accepted accounting
principles (GAAP) are used to
prepare financial statements. The sum total of these accounting concepts and assumptions is huge. For investors, a
basic understanding of at least two of these conventions - historical cost and accrual accounting - is
particularly important. According to GAAP, assets are valued at their purchase price (historical cost), which may
be significantly different than their current market value. Revenues are recorded when goods or services are
delivered and expenses recorded when incurred. Generally, this flow does not coincide with the actual receipt and
disbursement of cash, which is why the cash flow becomes so important.
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