Investment Success - It’s All in the Statements Baby!

When talking about a firm’s financial statements such as the balance sheet, income statement, and others, the majority of casual investors and probably even some professional investors think of these statements as being written in a foreign language. For most people when you start talking about EBIT, EBITDA, depreciation and amortization their eyes glaze over and they tune you out. I understand this completely – I am one of those people who would rather go to the dentist then read an entire 10k. Despite my inherent avoidance of these types of statements I still take the time to make sure I am familiar with them for any company I am invested in or plan to invest in. You see investments, like any business or organization is a system that must be actively managed for you to have long term success. That means taking more than just a passive interest in the companies you are planning to sink your money into. I am not saying you should become an expert on all the inner workings of potential investments, but you should be more aware of the workings of a company you are planning to invest into than the average consumer.

There is a reason the SEC requires annual statements – it is the only way for the outside investor to get a small glimpse into the inner workings of a corporation. Do not think of reading the 10k and analyzing financial statements as a chore, instead think of it as an in depth consulting session that you are getting absolutely free of charge.

Understanding a firm’s financial statements can uncover a wealth of information about the company’s future performance and managerial style. Do not underestimate this information, with it you can easily (well maybe saying “easily” is an overstatement) determine how a company compares to its competitors, the inherent risk in its investments, whether or not the firm’s cash flow is sufficient to meet its needs, and a wealth of other information. When you look at a company’s 10k there are four statements you really need to be concerned with; the balance sheet which shows the firm’s assets, liabilities and stock holder’s equity, the income statement which shows you such things as a firm’s net profit or loss, the statement of stock holder’s equity which reconciles any accounts that are listed in the stockholder’s equity section of the balance sheet, and the statement of cash flows which provides information about the firm’s cash inflows and outflows from the company’s activities. Take some time to look up a company’s 10k and make yourself familiar with these different financial statements. Most large corporations make their 10k’s available on their company websites usually listed under a section named something like “investor relations” or “corporate information”. Alternatively you can go to www.sec.gov to search for a firm’s 10k.

When you look at a 10k there are a large number of things you should pay attention to. A couple important ones are to read the auditor’s report. The auditor’s report is written by an independent auditor that is not associated with the company. An unqualified auditor’s report lets the reader know that the financial statements adhere to the Generally Accepted Accounting Practices (GAAP) that are followed in the United States. Basically an unqualified report means that the statements fairly represent the company’s financial position, cash flows, and operations. If the independent auditor finds that the statements have deviated from GAAP they will issue a qualified report. A qualified report does not necessarily mean that there is something duplicitous or unethical occurring with the company, but it is important to learn why GAAP standards were not followed to assure yourself to the best of your ability that there are no hidden problems within the company. When you are looking at financial statements found in the 10k do not ignore the notes sections. The notes section which is found after the four statements will reveal information to you that is not readily available elsewhere in the report and is essential to fully understanding what you are reading in the financial statements. The notes include such things as major acquisitions or divestitures, employee retirement, pension and stock plans, leasing arrangements, any pending legal proceedings, and a myriad of other factors that should not be overlooked.

Remember, when you are evaluating a business as a potential investment you are looking at a complicated beast with a wide range of internal and external factors that leave a tremendous amount of ambiguity in the investment process. Let’s face it, if that ambiguity was not there we would all probably be rich off of our investments by now. The point of the financial statements is to take some of this ambiguity out of the picture. So the next time you are evaluating an investment take a look at the company’s 10k, you will soon learn it is not nearly as complicated as you first thought.