Book Review: Interpretation of Financial Statements

Whether one is investing, managing a business, or beginning to learn finance, this book is the 101 rapid course in Financial Statements. A must read, have.

Warren Buffett and the Interpretation of Financial Statements: The Search for the Company with a Durable Competitive Advantage by Mary Buffet & David Clark (Scribner; 1st edition, 2008)

The author has written this book with the objective of making Financial Statements understandable to almost anyone. Every component of Balance Sheet, Income Statement, & Cash Flow Statement is dismantled and explained in simple language without any financial jargon. Anybody, who would, in some way, be starting to learn finance or accounting, should read this book first.

Importance of Financial Statements in Investing

The author sets the stage for delving into all the elements of financial statements. She starts by explaining the types of businesses that Buffett would buy in part or a whole. She explains how Buffett took the value investing philosophy advocated by Benjamin Graham and augmented it with his philosophy of durable competitive business advantage. Graham believed in buying interest in business whose stocks are undervalued and selling it when the price is escalated, with less regard to the type of business. Whereas, Buffett looks at businesses that always have, what he calls, a durable competitive advantage.
How does he unearth the hidden treasures? Only with the help of financial statements. Beginners and novice investors or traders just look into the metrics on the quote snapshots, which does not tell much about the financial strength or the competitiveness of a business. Financial Statements are what he turns to to discover the gems. These don’t require reading between the lines, but just understanding the lines.

Income Statement – Where to Get the Bottom-line Measure

The book first elucidates the metrics in the income statement, which is the most important of all the financial statements. It contains the bottom-line metrics, the net income, and all the components that equate to the net income. It is not enough to just look at the most recent statement. Buffett's uses 10 years’ worth of bottom-line numbers to predict the durability of a company for at least the next 10 years.

How to Determine the Strength, Size, Sustainability, and Solvency

The next section details the components of a balance sheet. This provides a different view of a company. It tells about the size of a company, the liabilities, the magnitude of debt it carries, and the shareholder equity.
The third section details the importance of cash flow statement. It explains what to look for in a cash flow statement. It is necessary to look into actual cash coming in and going out as the net income may not be actual income earned, it is just the sales recorded and it may have been sold on credit to the customers.

One Financial Statements Pocket Guide to Definitely Carry for Quick Reference

The last section illustrates how Buffett makes his buy decision, once he has determined that the fundamentals are strong based on financial statements. The price paid for a stock determines the return. Even if the company is a good investment, if the price is not right, Buffett lets it go or awaits an opportunity. He also compares the return on treasury bonds to estimate the right price to pay.
Every term on a financial statement is crisply explained in one or a few pages. This is a great book for those who are averse to reading pages of fluff. If this book is published with small text, it could be the bestselling pocket reference to interpreting financial statements.