Reading a Financial Statement - Part 2

Reading a Financial Statement - Part 2

In part 1 of this series, I described three of the more important data points when reading a financial statement. That article can be found here. Part 2, this article, will focus more on the subtle aspects of reading a financial statement - the Management's Discussion and Analysis, and the Footnotes. These data items are much more qualitative than quantitative. They are decidedly more subjective than the data items described in part 1. But they are no less important. In fact, many believe these to be even more important (and telling) than the quantitative measures described in part 1.

Reading a Financial Statement

Management's Discussion and Analysis

One trick I like to do to see if the company I am tracking (or investing with) is to read what the managers' plans were from a previous annual report. Then, I can see if they accomplished the objective spelled out in that past report. Do a year-by-year comparison and see how well management did. Also, we're in a tough economic period right now so look for managers that are making excuses as opposed to those who have a plan on getting their companies back on track.

Footnotes

When reading a financial statement, this is very often overlooked and that is both a shame and dangerous.  This is where you can find out whether companies are playing accounting tricks, etc.  Management always tends to throw in a whole bunch of caveats such as how aggressive they were in reporting revenue or that the increase in sales was a direct result of currency conversion, etc.  You should never overlook reading through the footnotes.  Unfortunately it's a tough read so it can take some practice on getting used to them.  But reading a financial statement does take a bit of experience.

Insider Transactions

There won't be much about insider transaction when reading a financial statement, but I feel a mention of this aspect is necessary.  I never buy stock in any company without first checking this critical information.  It can be easily found in Yahoo's finance page.  Now thorough analysis of insider transactions are well beyond the scope of these two parts.  But you can get a feel for whether management stands by their own company by how much they have invested and also what has been going on recently.  You will hear the following said often when dealing with insider transactions.  There are many reasons why management will sell its stock, including divorces, kids going to college, upgrading a house, repairs, etc.  But there is only one reason for purchases.  Namely, management believes that something good is going to happen at their company and they are backing up that claim financially.

Conclusion

There are plenty of resources on the web to get started in gaining an understanding when reading a financial statement. Using the guidelines described in both part 1 and this article, you will have a better feel on reading a financial statement. Of course, before embarking on any financial endeavor, it's always wise to consult a financial adviser.

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