Reading notes on “The Interpretation of Financial Statements” by Benjamin Graham and Charles McGorlick

About

Basic accounting books will usually tell you the rules to follow when preparing financial statements. Once you have an idea of accounting, this is a good intro on how to look at them in a critical (i.e. careful) way E.g. a reserve is made for a lawsuit: is that a definite liability or just a possible liability (and if a possibility, do you agree with the amount/likeliness)?

It’s a much shorter/condensed version of the “Security Analysis” by Bejamin Graham and David L. Dodd. Benjamin Graham was one of the mentors of Warren Buffett.

Notes on balance sheets

  • Balance sheets only cover snapshots at certain points in time, not the intervening events.
  • Some financial statements are clearer than others. There might be regulatory requirements to present the financial statements in a particular way. The analyst is free to re-organize the presentation to get a more useful view of the business.
  • The liabilities section combines real liabilities (e.g. borrowings that will have to be repaid) with shareholder “owned” amounts (i.e. capital and profit and loss surplus).
  • Working capital is a good measure of the company’s ability to carry on it’s normal business. Shortage can cause rejection of desirable business, delays in payments (and poor credit rating) or worse bankruptcy.
  • Where cash (and equivalents) are a large amount that requires favourable attention. The cash can find it’s way to the shareholders eventually. The earnings might be better than what it looks because that large amount of cash usually contributes little to the income.
  • Inventory calculation depends on the method used. There are several such methods e.g. FIFO, LIFO. It matters what’s the price evolution of the items in the inventory.
  • Notes payable on the current liabilities show how much the company relies on banks for normal business trading.
  • Fixed assets valuation can be either at cost or fair value (or neither). Also cost can differ from the current fair value. The result is that investors should pay more attention to earnings instead.
  • Depreciation can also be calculated in many ways.
  • “Good will” and other intangible assets can either be overinflated or not be captured in the financial statements. Similarly it’s the earnings that would reflect them.
  • Reserves can be many things: a definite liability, a possible liability (contingency) or a voluntary amount part of the reinvested earnings.
  • Book value is often an arbitrary value. It’s often a measure of what the shareholders have put in the business, not of what they would get.
    • Book value is relevant for banks/investment companies, more than for e.g. an industrial company.
    • Still attention needs to be paid to the book value:
      • Large earnings with little capital might attract competition and thus prove temporary
      • Large amount of capital (per earnings) might be put eventually for better uses.
  • A liquidation value might be of interest, though it has to account that the circumstances that would trigger a liquidation are the ones that would impact asset values as well, often only realising about to cover the losses in liquidating the current assets

Notes on earnings

  • Because of issues on asset valuation, the earning might give a better idea regarding the value of a business.
  • If there have been reasonable normal business conditions for a period of years, the average of the earnings over the period might provide a better view than the last value alone.
    • This is particularly relevant for checking if a bond or preferred share constitute a safe investment. When bonds of varrying seniority are involved, make sure you have a sound method which does not incorrectly calculates more safety for the more junior issues and accounts for tax where needed (e.g. dividents on preferred shares are paid after tax).
  • Pay attention to the maintenance, depreciation and similar factors. There are several methods of calculating depreciation and they might be also be influenced by tax considerations, implicitly included in maintenance, etc. By making insufficient or excessive allowances the net earnings might be over or understated.
  • The trend of earnings is more relevant for shares than for bond valuation, for if a favourable trend continues the share price can advance substantially. Though one has to answer:
    • how likely is the trend to continue
    • how much the trend expectations are already included in the price already.

Ratios

  • Margin: operating income divided by net sales.
    • Net sales is basically the money the company makes from selling things (though it’s not all necesarily directly cash, some might be sold on credit). This does not include “other income” e.g. interest for cash holdings for an industrial company.
    • Operating income is obtained by taking away from the net sales the cost associated, some is usually labeled clearly as “cost of sales”, but also others like depreciation, maintenance etc.
    • Used to determine the operating efficiency
    • E.g. 14% means that for every dollar of sales the company has 14 cents left after paying all the costs associated with the sale.
  • Earnings on invested capital: net income plus fixed charges divided by the sum of bonds, preferred stock, common stock and P&L surplus
    • Fixed charges refers to interest paid on bonds (or equivalent), before taxes. Despite it’s name it does not include building rents.
    • Net income is what the company gets from income after paying the fixed charges and tax, but before paying dividends.
    • It’s a test on how much the company makes on the entire capital employed (bond holders and shareholders).
  • Fixed charge coverage: total income divided by fixed charges
    • Total income includes operating income and other income, just before paying the fixed charges (and before paying tax).
    • Used to determine the ability to pay interest on bonds.
    • At least 7 in average for the last 7 years OR at least 5 for the worst year.
  • Preferred dividend coverage: similar to fixed charge coverage, but accounts for the preferred dividend being paid after tax.
  • Earnings per share: balance for common stock divided by number of shares of common stock outstanding
    • Balance for common stock is income after fixed income charges, tax, preferred dividends, available for dividends or reinvestment.
  • Price earnings ratio: market price of the stock divided by earnings per share
    • Key ratio in determining the attractiveness of a common stock
    • A more suitable figure is the ratio of price to average earnings for a 7 to 10 year period
  • Dividends pay-out ratio: dividends paid by the balance for common stock
    • When low: there is scope for dividend increase. When high: the dividend might be at risk
  • Depreciation as a percentage of cost of plant and depreciation as a percentage of net sales
    • Useful for comparing companies. For the same company increased sales could justify increased depreciation.
  • Inventory turnover: net sales divided by inventory
    • Gives an idea of the inventory soundness
  • Sales per working capital: net sales divided by working capital
    • Working capital is the difference between the current assets and the current liabilities
    • Shows the amount of sales revenues generated by investing one dollar of working capital
  • Number of days average account receivable is outstanding: accounts receivable divided by net daily sales
    • Accounts receivable is the amount owned for sales (not all customers pay cash at the time of sale)
    • Net daily sales is the net sales divided by the number of days in a year
    • E.g. a value of 30 means that it takes about 30 days for customers to actually pay for the sale
  • Capitalization ratios
    • Shows in what ratios the company capital is constituted out of bonds, preferred shares and common shares.
  • Current ratio: current assets divided by current liabilities.
    • The more liquid the current assets, less margin is required. Satisfactory value varies by kind of business. 2 is a standard minimum.
  • Quick assets ratio: current assets less inventories, divided by current liabilities
    • Similar to current ration, but it takes away the inventories to ensure that the cash (and equivalents) and receivables cover current liabilities.

Other

  • The ability to deal in shares successfully relates to the ability to look ahead accurately. Looking backward is necessary, but will not suffice. I guess that qualitative rather than quantitative analysis also comes into play.

Reference

Benjamin Graham and Charles McGorlick: “The Interpretation of Financial Statements” 1955