What good are financial statements?
Photo: James DeMers. Source: Pixabay
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 companies got into trouble their debt was downgraded. This created an earnings boost, as their liabilities got cheaper when they were marked to the market.
Financial statements are a necessary—but not sufficient—component of understanding a company’s economic reality. Most people know what McDonald’s sells, did you know that two-thirds of their sales come from outside the US? The fact that so many companies generate so much revenue from non-US sources creates a complex situation where different legal standards, accounting issues, and tax laws 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 financial performance, and you have a recipe for trouble.
But throwing up our hands and giving up isn’t an option. Financial statements have to be combined with other sources of information about a company. These include management’s discussion of their results, the quarterly conference calls that accompany earnings reports—especially the Q&A sessions—and site visits, to store locations, production facilities, and company headquarters.
Photo: Vassia Atanassova. Source: Wikimedia
In the end, all of these factors help us learn more about a company—what they do, and how things are going. Analysis is like putting together a jigsaw puzzle: every piece is important, and taken together they have a story to tell. But if you just look at one measure or a small segment, you won’t see the full picture.
We don’t have to like our sometimes-obscure accounting rules, but we do need to understand them.
Douglas R. Tengdin, CFA
Chief Investment Officer