What good are financial statements?
Photo: Anatoly Babiychuck. Source: Dreamstime Stock Photos
Most of us have a vague idea that Apple makes iPhones, that Panera runs restaurants, and that Wal-Mart sells stuff. But how well do they do these things? Reports that Amazon earned 19 cents last quarter or that IBM had sales of $20.8 billion leave us cold. Numbers by themselves don’t tell us very much. Put another way, a text without a context can become a pretext.
Financial statements are intended to tell us what a company has (the balance sheet) and what the firm did with what it has (the income statement). They also disclose what management has done with its cash (the statement of cash flows). We need to know these things because ultimately any investment’s value is determined by how much cash it can generate for its investors, and how predictable (or unpredictable) this cash stream is.
Because we don’t let sports teams make up their own rules as they play, we have certain standards that companies are supposed to go by when they report their earnings. Accounting isn’t “Calvinball.” But electric utilities are different than banks, which differ from defense contractors. So management is allowed a little leeway as they apply the rules. Those choices, however, have to be reflected in the footnotes—usually “Footnote 1.”
In order to make sense of the raw numbers, equity analysts use ratios to compare companies with each other. It’s notable that Apple had a 40% profit margin the last year, but that’s even more remarkable when you see that Microsoft’s margin was only 23%, and that Samsung’s was just 10%. That may be one reason why Apple seems to be taking over the world.
Every year public companies have to hire outside accountants to examine their financial statements and verify that they’ve been playing by the rules. Although the financial news tends to report just one or two numbers each quarter – earnings per share and sales – there are lots and lots (and lots) of supporting statements that go into those. Businesses can be complicated, and disclosing their activities properly takes a lot of time and effort. Last year, GE’s annual financial statement was 247 pages long!
By looking carefully at these supporting ratios, and how they change over time, a careful analyst can sometimes sniff out whether a company’s earnings are real, or whether they’ve been enhanced by questionable accounting practices. Because financials are like a bathing suit: what they reveal is interesting, but what they conceal may be even more interesting.
Douglas R. Tengdin, CFA
Chief Investment Officer