If you don’t understand financial statements, you don’t understand the language of business. Think about the TV show Shark Tank. Whenever there’s a pitch, the Sharks want to know volumes, sales and margins. You may be a great salesperson, but if you cannot present your numbers, it’s certainly harder to pitch.
Not Rocket Science
Most of us make it through math in elementary and middle school without too much hassle. I was never a math whizz, and my grades were average. But in high school, I was terrible at math. I failed and had to retake all my final math exams (except the first). In Finland, high school math is divided into “long-math” and “short-math”. “Short-math” is basically a nice way of saying “easier than long-math”. Failing short math is embarrassing, since mathematics is tied to our general level of intelligence. It may be taboo, but subconsciously we believe it. No one want’s to be labeled “dumb”.
Business Math is Simple
In business school I remember feeling anxious about the upcoming introduction course to accounting. After all, my memories of math was certainly not pleasant.
Long story short, the final exam was on the three financial statements and I passed with flying colors. The truth is that business math on financial statements is easy and learnable as long as you understand basic subtraction, addition and division. That’s all there is to it. All the numbers are given to you. You start at the top, and work your way down to the bottom.
Terminology Confusion
What confuses many initially in financial lingo is the terminology. The same concept can be said with different words, and may be written differently in financial statements and annual reports in general. Here’s a few that mean exactly the same thing:
- Sales aka. Revenue, gross sales, gross revenue.
- Operating income aka. EBIT (Earnings Before Interest & Tax).
- Income statement aka. P&L statement (proft & loss), statement of operations.
- Debt aka. Leverage, credit agreement.
- Tangible capital. Aka. Tangible equity, tangible assets, physical assets.
Interpreting the Numbers
This is where things go towards of the “art” part of investing (e.g. part art, part science). When you know the numbers, how do you interpret them? Are they good or bad? This is more difficult, since it’s not a one-size-fits-all. You cannot compare the numbers of a capital intensive (aka. expensive to run) business with an asset-light internet company. Both can be great or terrible investments, it all depends on the price you pay. What you really want to look for is consistency. Has the management been able to clearly state, and deliver on their set goals throughout the years? Do they have skin in the game? Can you see that the business has a future many years from now? How dependent and thus vulnerable is the business to technological shifts?
A great business and a great investment are not always the same thing. No matter how wonderful a company, it’s not worth an infinite price. Price is the ultimate factor, since the future is by definition unknowable. You will never have perfect information but if you buy with a margin of safety, you greatly cushion the blow incase you are wrong. If you minimize your losers, the winners will take care of themselves.
Conclusion
Warren Buffett has said that he meets many CEO’s who are terrified of financial statements. The reason is that many have risen through the ranks in sales, and now they have to learn a completely new language. The good news is that like most skills, understanding financial statements is learnable and you should not be discouraged. Yes, it takes work, but so do all things in life that are worthwhile. By understanding the language of business, you will have much more confidence in your investments. I’ve written in more detail on the three financial statements, and they are linked below:
If a short-math failure can learn this, can you?
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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