Finance
by Martin Fridson and Fernando Alvarez
Should you believe the accounts?
Companies prepare their own financial statements, and they have reasons to look good, such as a higher share price or cheaper borrowing. Martin Fridson and Fernando Alvarez write for the analysts, lenders and investors who have to read those statements without being taken in.
Hear a sample · read by Laura
The book opens by calling financial reporting adversarial, a contest between two sides. Companies want to show fast growth and low risk. The people reading the statements want the truth. Within the rules, and sometimes beyond them, companies choose the version that flatters.
Investors see bumpy profits as risky, so companies prefer a steady, rising line. Fridson and Alvarez show how reserves and timing choices can smooth results that were really uneven. A calm line from a choppy business is a reason to dig.
The statement of cash flows is the check on reported profit. If profit keeps rising while cash from operations stalls, something in the income statement needs a closer look. The cash pattern also shows a company's stage of life, since young firms use up cash and mature ones produce it.
Earnings before interest, tax, depreciation and amortisation became a favourite of lenders and deal-makers. The authors point out what it ignores, such as the money a business must keep spending to replace worn-out equipment and fund its growth. It's a rough gauge of cash, and a flattering one.
Shareholders care about the upside. A lender's best outcome is simply being repaid, so credit analysis looks at the downside. It checks whether earnings comfortably cover interest and other fixed charges, and how much debt the company carries against what it earns.
Motive
Companies prepare their accounts partly to raise money cheaply, so expect them to show themselves in the best light.
Balance sheet
A balance sheet mostly shows what things cost, which can be far from what they're worth today.
Smoothing
Managers like steady, predictable earnings, and they have plenty of legal ways to smooth them out.
Cash
The cash flow statement is harder to bend, so check whether profits turn into real cash.
Footnotes
The notes at the back often hold the story that the headline numbers leave out.
One thing to try
Open the annual report of a company you know and put three years of net income beside three years of cash from operations. If profit climbs while cash lags, read the notes on receivables and inventory to find out why.
Knotd has the key ideas from 250+ non-fiction books, each in a few minutes, in plain words. Financial Statement Analysis comes with a Name That Idea round to make it stick.
Get the whole book on KnotdOpen in the appShould you believe the accounts? Companies prepare their own financial statements, and they have reasons to look good, such as a higher share price or cheaper borrowing. Martin Fridson and Fernando Alvarez write for the analysts, lenders and investors who have to read those statements without being taken in.
Reporting is adversarial; Suspiciously smooth; The cash check; What EBITDA leaves out; How a lender reads.
Open the annual report of a company you know and put three years of net income beside three years of cash from operations. If profit climbs while cash lags, read the notes on receivables and inventory to find out why.
Yes. Knotd has the key ideas from Financial Statement Analysis in a few minutes, in plain words, plus a Name That Idea round to test them. It's one of 250+ non-fiction books in the app.
