For most investors we have to depend on financial statements issued by companies, although over the years we have seen many companies falter even when reporting massive profits in prior years.
Veteran Investor, Warren Buffet of Berkshire Hathaway has more to say on this topic. In this year’s letter to shareholders, Mr. Buffet stated “never trust the financial statements of companies, and don’t just focus on profit figures….research and focus on broader financial figures”, as reported by The Daily Telegraph March 7, 2011, Vol.1, No 2274.
So, can we rely on financial statements? Yes and No!
As Investors, we should understand that companies cannot give us a more detail picture of the company and this is mainly due to competitive reasons and revealing their strengths and weaknesses.
If that is the case, then we should then ask if the financial statements issued can be used to assist us in making a reasonable decision about the company?
The figures in financial statements are mainly collated to show how much profits are made by the company.
To arrive at a profit, companies have to abide by rules set by the taxation department of countries as to what can be claimed as expenses, to arrive at a profit.
In essence, it is a document that shows at the end of the day what taxes are to be paid from profits. This suits the requirement of taxation departments.
Profit figures are also used to show various ratios like price earnings, dividend growth and yield. These are the main figures investment brokers tend to use.
It is difficult to establish that this profit route is a good indicator of the viability of the company. Especially when we consider that it is the unilateral rules of taxation authorities that ascertain what should be included in the calculation of profits and net assets.
An investment analysis should be conducted on each aspect of the financial data that is allowed to be given to us.
Analysis of other financial information such as assets, inventory turnover, and liabilities should be conducted.
One of the more pertinent information is in the Notes to Financial Statements. This gives us more information on the composition of each financial data.
The Notes also provide us with historical information and the structure and policies that had an effect on the financial data.
However, we should still keep in mind that the financial statements are mainly written up to show taxable income.
So, as Investors, what can we do to assess companies?
One of the main areas is assessing the financial viability of the company. An investment analysis needs to be carried out in this area to appreciate any viability of the company.
By knowing this, we can at least have an idea of how vulnerable the company may be in different market conditions, so that you can invest wisely, and according to your risk levels.
Financial viability studies and work are mainly conducted by investment analysts. Some of the reports are contracted to the broking community.
Trusting Financial Statements have its limitation, and looking further into the figures and having an understanding of the ” how” and the “why” these figures are given will provide us with a clearer insight into the company.
Relying on bottom line figures such as Profits and figures on face value as stated in Financial Statements is not a good option.
The current perception that annual reports, broker reports etc are a good indicator of a company cannot be taken wholeheartedly without a further breakdown of that information.
By conducting an investment analysis of all publically available information, will further strengthen your decision making skills.