For Beginners: Linkages between Financial Statements or How to Read a Financial Statement

A reader posts a question

I haven’t started investing yet but can’t wait to do so once I get a job. I am still developing my investment strategy and plan.

I think I am able to do basic valuations and financial modelling. BUT the one thing I can’t get my head around is: Linkages between financial statements.

This is the most important issue that is not being discussed here. I agree with V4Value that learning financial statement analysis would be an excellent idea. Unfortunately, there doesn’t seem to be any good, free online courses such as there are for valuations. I have been able to find this  course which comes close to what I am looking for: http://ocw.mit.edu/courses/sloan-school-of-management/15-535-business-analysis-using-financial-statements-spring-2003/lecture-notes/

But no video lectures! :(

CSInvesting Accounting Sources

Thanks for your dilemma and your excellent link above to the MIT accounting course (free).  Here are two books (of course, in the VALUE VAULT.  Email me at aldridge56@aol.com with VALUE VAULT in the subject line and I will send a key within 48 hours).

Ben Graham’s Classic Book: Interpretation_of_Financial_Statments-1

Tracy’s book on how financial statements link together: How_to_Read_a_Financial_Report

Videos on Accounting

Here is one link for an accounting lecture on common-size financial statements:

http://www.learnerstv.com/video/Free-video-Lecture-1170-Management.htm (Click on videos at the top of the web-page for videos on accounting and many other courses) A great series of videos for a Saturday night date.  Seriously, another supplement to what you learn from books. The next step is to go through a company annual report of a company that interests you.

Short lectures on financial topics or many other subjects: http://www.khanacademy.org/

Good luck!

2 responses to “For Beginners: Linkages between Financial Statements or How to Read a Financial Statement

  1. I found it helpful to first get a good understanding what a balance sheet, cash-flow statement and income statement is trying to show. Also bear in mind that everybody who is reporting something about a company is starting from a certain framework and has certain incentives to show numbers, trends or facts in a certain way. Think about accountants, management, external audit, analysts, regulators, investment bankers, analysts, etc. they all report in a certain biased way starting from they professional and or legal background.

    About cashflow, income statement and balance sheet : after a while you see that it makes sense that you cannot just look at net-income as a profit measure, but that it is helpful to make some adjustment so that you arrive at operational cash-flow. You can then see that some assets that shows up on the asset side of the balance sheet probably went through the investing cash flow section once. Finally you can see that the liabilities side of the balance sheet is linked to the financing cash flow section, where you for example see extra borrowing.

    The next step is to:
    – read a book like financial shenanigans (reading it now) : really good to see how easily companies can shift numbers around without doing anything illegal
    – look at some problem companies (bankrupt of alive ones)
    – study special topics such as financial versus operational leasing etc.
    – make a checklist of accounting issues you want check (inventory trends, R&D, leasing, etc.)
    – …

    Other tips welcome..since I’m still learning here!

  2. As an accountant, I can understand some of the predicament that many non-accountants are facing. Three years to get a professional qualification and another 4 years in auditing and I still get a bit of headache digesting some information on financial statements. So, even though its’ daunting, please don’t get discouraged.

    There’s been a lot of great discussion and tips by everyone here (great community) but I’d like to add my top 3 tips to help in understanding financial statements.

    1. Start with the Familiar
    Basically, I am sure everyone is familiar with some sort of business. You may be an engineer, so you’d be familiar with an engineering business. Or your family may run a stationery shop, so you’d be familiar with that sort of business. After reading the basic books on financial statements, stop and get a copy of financial statements of businesses that you are familiar with.

    Then from there, look at the figures, preferably for the past 3-5 years. You see, what is important to understand is that the financial statements with the notes over a 3-5 year period tells its’ own story. It’s like a novel, except with more figures and some explanatory notes. If you understand the business well enough, you’ll find that financial statements actually make a lot of sense and quantifies what you know in your gut-feeling. Further, the type of financial statement in every industry is sometimes vastly different. Financial statements in a trading business is vastly different from that of an insurance co, for example.

    2. Understand the principles and Hot Areas
    If possible, try to understand the underlying reasons why accountants prepare certain financial statements in a certain way. For instance, an understanding of the principle of deferred taxation would allow you to make the firm judgment call that any deferred tax asset in the Balance Sheet should be ignored. Why? I’d leave you to find out. Further, be aware of certain danger areas such as Contingent Liabilities and Special Purpose Vehicles (SPVs). Yes, it’s difficult reading but knowing these areas are quite crucial in assisting in making a firm judgment call.

    3. Follow the money
    As with all things, cash is KING! So the cash flow statement is the most important part of the financial statements. It doesn’t matter if the company is making HUMUNGOUS profits if its’ cash flow is NEGATIVE. So, a company that is the darling of everyone but is hemorrhaging cash quarterly is a dangerous one. Coincidentally, Enron never prepared cash flow statements on the basis it was too complicated. We all know what happened next.

    Hope what I’m sharing is useful.

    Kind rgds

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