Finding Financial Reality

What good are financial statements?

That may seem like a funny question from a financial analyst. But financial statements can distort, rather than reveal, the nature of a company. Beyond outright fraud, where managers just make things up, there are counterintuitive accounting practices that are misleading, like marking liabilities to market. For example, during the financial crisis, when banks got into trouble and their debt was downgraded, that created an earnings boost, as all those mark-to-market liabilities got cheaper.

Financial statements are a necessary—but not sufficient—component of understanding a company’s economic reality. Most of us know what McDonald’s sells, but did you know that less than a third of their sales come from the US? The fact that so many firms generate so much revenue from non-US sources creates a complex situation where different legal standards, accounting issues, and currency regimes make it difficult for the most scrupulous manager to communicate what’s really happening. Add to this the misaligned incentives that corporations sometimes attach to their financials, and you have a recipe for disaster.

But throwing up our hands and giving up isn’t an option. Financial statements can and should be combined with other sources of information about a company. These include management’s discussion of their results, the conference calls that accompany earnings reports—especially the Q&A sessions—and site visits, to store locations and management headquarters.

In the end, all of these factors help us learn more about a company—what they do, and how things are going. It’s like a jigsaw puzzle: every piece is important, and taken together they paint a picture. We don’t have to like it, but we do need to understand it.

Douglas R. Tengdin, CFA

Chief Investment Officer

Follow me on Twitter @globalmarketupd

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