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Friday, July 29, 2011

Analyzing financial statements for investing? Read this first

1.       Prefer consolidated numbers(including subsidiaries) over standalone numbers. However,  calculate the ratio of Consolidated/Standalone(especially for earnings). If C/S>>1, it may indicate an increased risk of accounting errors/fraud during consolidation. While if C/S<1, either the company is booking losses through subsidiaries via transfer pricing hoping that investors will ignore it, or that the new ventures(SPVs) are not doing well.
2.       Go through atleast 4 consecutive quarterly reports(and the related notes to accounts) to identify any seasonality trend disclosed, company’s reporting pattern etc.  This also holds for conference call transcripts/investor presentations(if any). In some cases(like of Religare Financial Services), one hits gold by finding strategic disclosures etc in earlier reports.
3.       Remember that most ratios stress on operating numbers.  Hence, deduct non operating income(interest/capital gains) and assets(investments, excess cash etc) from the numerator/denominator of the ratios calculated. Nearly everyone does it differently, and you should understand how it is done. For valuations using P/BV, EV/EBITDA etc, these adjustments are quite material/
4.       Whatever be the corporate governance spin etc, the ratios reveal the true picture, and one can check whether they are consistent with the management disclosed policies/spin. For instance, if a FMCG market leader claims to treat its vendors/suppliers fairly, but consistently has net negative working capital(compared to positive working capital of other competitors), then it is probably gouging its competition. Also, if a management attributes increased profits to better performance but a DuPont Analysis shows it to be due to higher leverage, you then know that someone is trying to pull wool over your eyes.  
5.       Preferably read multiple company documents from the same industry, so that you can distinguish the MD&A spin and understand who is bullshitting and who is talking straight. For instance, a real estate company which does not mention risks of inflation/interest rates, is probably not disclosing enough. Also, you get to know/expect a minimum level of proforma disclosures(like realization/sq foot, land bank etc) which you can compare.

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