So what is the secret to making a killing in the stock market? It's to recognise and pick shares of superior companies. But how can one judge whether a company is better than its peers? This is possible only by analysing a company's financial statements and business prospects thoroughly. While this information is easily available in the form of brokerage reports, analysts' recommendations and letters, or views of market experts, it is replete with technical jargon and financial facts, making it difficult to understand. To ease comprehension and derive maximum benefit from these sources, one needs to be well-versed in the basics of accounting theory, financial statements and ratios. A good place to start building your financial vocabulary is the Guide to Analysing Companies. A book by Bob Vause, it is part of a series by The Economist.
The book is divided into two parts, the first half concentrating on different types of financial statements and the latter on financial ratios, which are essential for those who want to learn the applications of fundamental analysis. In the first part, Vause highlights the importance of annual financial statements, dealing with each element listed in these. He also tells investors to be cautious about the companies where the auditor issues a qualified report. He then goes on to explain the basics of accounting and principles, such as going concern, materiality and prudence. Separate chapters have been allocated to the concepts of balance sheet, income statement and cash flow statement. The impact of inflation on asset valuation is explained very well and the dangers of poor asset vaulation are catalogued. For instance, a company with undervalued assets becomes an attractive target for a takeover. The book also offers insights into inventory valuation, asset revaluation and treatment of intangible assets such as goodwill.
The second part of the book chronicles almost all ratios that a financial analyst has in his intellectual armoury. The ratios are divided into four groups: profitability, efficiency, working capital and capital/valuation. All these have been discussed in separate chapters and each ratio is accompanied by a hypothetical numerical example. For instance, interest cover ratio is calculated by considering three hypothetical companies, which have different profits before interest and taxes but same interest costs. The implications of different ratio scenarios have been illustrated well.
One of the biggest advantages of this book is that it highlights the areas where accounting frauds are possible. After the Satyam fiasco, shareholders of listed companies have been concerned about the quality and reliability of financial statements that are presented by managements. In order to show higher profitability, managements try to create false profits by overstating income or understating expenses. Not all such practices are illegal, but they can be misleading. The author pinpoints the areas in a financial statement, such as notes to the financial statement, management, discussion and analysis, that one must check in order to rule out such dubious practices.
The strength of the book is that it has dealt with all the concepts in a simple language doing away with jargon and linguistic finery. But in doing so, it has not lost the flavour of the content, so the readers will find it easy to grasp without losing interest in it. Another plus is that it serves the purpose of both amateur and experienced investors because it covers the concepts as well as applications. So it can be a valuable pick for investors, brokers, analysts as well as students of financial management. The ultimate test of its effectiveness would, of course, be if they manage to make a killing in the stock market.