For most investors, stocks present the ultimate dilemma— investing in them is at once most profitable and most perilous. According to investment gurus, the surest way to overcome this dilemma is to invest in businesses (companies) rather than in stocks.
That is, invest in the stock of a company only after understanding its business and finances. But how does a nonguru understand the finances of a company without having to suffer obscure pages of its balance sheet? Well, one option is to pick up this book from the Dummies series.
Financial statements are full of jargon—depreciation, amortisation, accrual accounting, LIFO, FIFO, basic or diluted EPS, accounts receivables, and the like. All of which can fox the lay reader.
Enter Reading Financial Reports for Dummies, a pathfinder for such investors. The book starts off with a basic summary of what a financial report contains and the reasons for its importance to various stakeholders — investors, creditors, executives and government agencies.The early chapters explain various types of business entities (sole proprietorship, partnership firms and incorporated companies), their tax liabilities and reporting requirements. It also looks at the distinctive features of private limited and public limited companies.
BASICS FOR STOCK INVESTING
|Ratios: Look at profitability, liquidity and solvency ratios while making investments|
|Financial statements: Statement of cash flows, income statement and balance sheet|
|Accounting basics: Cash and accrual accounting, inventory valuation, depreciation & amortisation|
|MD&A: Read the management, discussion and analysis section of annual report|
|Debt: Be wary of firms having high debt content in their capital structure and overvalued assets|
Some accounting basics like accounting methods, depreciation and double entry accounting, are highlighted. The accounting methods — cash basis and accrual basis—which are related to revenues and expenses are important to an investor.
Any changes in them would make it difficult to track a company’s performance over a given period. Different types of assets (tangible, intangible and long term), liabilities (current and long term), stock (equity and preference), revenues (sales, discounts), expenses (operating and nonoperating) and profits (gross, operating and net) are also explained.
There is a chapter devoted to the various components of an annual report. According to the author, management, discussion and analysis is the most important part of the annual report, as it contains critical information about the company’s operations, capital and liquidity. The other important aspect of the annual report is the auditor’s report, especially if the auditor has any comments about the company’s financials.
Different formats of balance sheets and income statement are explained in a couple of chapters. The formats shown are prescribed by the Securities and Exchange Commission (the American counterpart of the Securities and Exchange Board of India, or Sebi) and may not be the same as prescribed by Indian company laws. However, as most Indian companies are expanding their businesses abroad, it is important to get a sense of these global reporting formats and standards.
Cash is the lifeline of any business. Any shortfall of cash could affect the company’s stock price. Investors need to go through the statement of cash flows. Chapter 8 explains the format and various activities (operating, investing and financial) involved in the statement of cash flows. The operating activities section is important, as it provides information about the cash generated from the company’s core operations.
For investors the notes to the financial statements are vital; they contain vital information about accounting policies, depreciation methods, inventory valuation methods and taxes. Generally, companies in financial or operational trouble try to hide critical information in the notes to financial statements.
The author explains in detail important financial ratios—price to earning (P/E) ratio, dividend payout ratio, return on sales, return on equity, etc. The P/E ratio, for instance, explains how much investors are willing to pay for every one rupee of the company’s earnings. High P/E stocks are considered expensive, as market expectations are higher for such stocks. Investors must also assess the dividend payout ratio carefully, as very high payout ratios could mean that the company does not have any expansion or growth plans in the near future.
Other important aspects to look for are liquidity and solvency. The company should have enough assets to pay off its liabilities. The liquidity of a company can be judged through current and quick ratios. Solvency is determined through debt-equity ratio and interest coverage ratio. Investors must go through solvency ratios if they plan to invest for long term.
The book concludes with 10 indicators of financial and operational troubles. These include lower liquidity, high debt and disappearing profit margins. Investors should stay away from companies exhibiting such indicators. All these indicators are derived from financial statements and one must study these reports before investing in equities.
Reading Financial Reports… acts as a tutori -al for those who are not from accounting or finance backgrounds and who want to invest directly in equities. It serves as a step-by-step guide to stock selection. All the concepts related to financial statements are explained in simple language and with relevant case studies. It’s an informative read for investors, students, brokers and analysts.