Book Review: Financial Statement Analysis: A Practitioner’s Guide

Financial Statement Analysis: A Practitioner’s Guide is a well-organized and in-depth exploration of the challenges faced by practitioners who rely on financial statements to make investment and lending decisions. In the preface, Martin Fridson and Fernando Alvarez state that their “intention is to familiarize readers who have already acquired basic accounting skills with the complications that arise in applying knowledge derived from textbooks to the real world”.

Throughout the book, Fridson and Alvarez argue that in the “real world” accepting financial reports at face value is both naive and dangerous, and that the best analysis requires “the relentless pursuit of precise financial profiles of entities. analyzed. “

The book is divided into four parts: (1) “Reading between the lines”, (2) “Basic financial statements”, (3) “A closer look at earnings” and (4) “Forecasting and analysis of the security “. The first three parts focus on the limits of financial statements, and the fourth is a study of techniques to be used for forecasting and analysis.

The authors establish the purpose of the book in Chapter 1, aptly titled “The Contradictory Nature of Financial Reporting,” in which they challenge the conventional view that the purpose of financial reporting is. to accurately measure the profitability and financial position of a company. On the contrary, they argue,

the purpose of financial reporting is to obtain cheap capital. . . . Simply put, the lower the interest rate at which a company can borrow or the higher the price at which it can sell shares to new investors, the greater the wealth of its shareholders. From this point of view, the best type of financial statement is not the one that represents the situation of the company in the most complete and fair way, but rather the one that produces the credit score and the multiple price- highest possible profit. If the highest scores and multiples are the result of statements inaccurately measuring profitability and financial condition, the logic of fiduciary duty to shareholders requires management to publish this genre, rather than the one presented as a model in management manuals. accounting.

It is a sober assessment of the profession; Throughout the remainder of the book, Fridson and Alvarez repeatedly demonstrate that financial statements often hide as much information as they reveal. And to complicate matters, the authors show that much of what happens in the industry is perfectly legal, even when it looks like it shouldn’t be.

In Chapter 8, “The Income Statement” (in Part 2), the authors provide additional evidence that financial reports cannot be taken at face value and that manipulation of the income statement is common practice. Companies routinely refer to expenses as “extraordinary, non-recurring or unusual” to give the impression that they are one-time events that should not be part of future net income projections:

A search of the Capital IQ database found that 487 of the companies represented in the Standard & Poor’s 500 Index reported unusual items in at least half of the years 2002 to 2009. Almost half (230) reported items. unusual during the eight years of this period. span.

Obviously, items that recur annually, or even semi-annually, are not extraordinary, non-recurring or unusual. Analysts should be aware of these situations and be prepared to distinguish between truly one-time events and those which are simply designated as such by the issuer of the statement.

In Chapter 9, “Reliability of Disclosure and Audits” (in Part 3), the authors explain the challenges inherent in our current audit system. In theory, publicly traded companies are required to hire highly qualified auditors to validate their financial statements each year. This requirement is intended to assure investors that the financial statements have been prepared in accordance with generally accepted accounting principles.

In practice, however, “a tension necessarily exists between standards of professional excellence (which, admittedly, matter a lot to most accountants) and fear of the consequences of losing a client. Auditors, after all, are paid by the company issuing the statements, and they can’t go any further without losing clients.

Taking a harder line may not produce more full disclosure for investors, but simply means sacrificing the audit contract to another company with a more accommodating policy. Given the gap between theory and practice in financial reporting, users of financial statements need to give themselves an extra layer of protection through careful scrutiny of numbers.

Part 4, “Safety Forecasting and Analysis,” is a little different from the first three. It provides a broad study of the techniques to be used in forecasting and analysis, as well as a discussion of the limitations of each. Fridson and Alvarez recognize that these are the most important functions of an analyst’s job, but they also recognize that it is irreducibly difficult to predict the future. For example, in the conclusion to Chapter 13, “Credit Analysis,” they write: “Ultimately, credit analysts need to equip themselves with all of the tools described in this chapter, but not be complacent. “

One last point to make on Analysis of financial statements is that it’s surprisingly entertaining, especially given the genre. Reference books on accounting, while invaluable for their ideas, are seldom so enjoyable to read. This book is different because the authors seamlessly integrate fascinating real-life examples and informative fictional scenarios into each chapter to illustrate their points. Although mostly unrelated, the story series draws the reader in, creating a unique literary experience that is part a detective story, part a finance textbook.

My only reservation about the recommendation of this book is that sophisticated security analysts may find it too basic. Although I am a CFA charter holder, my background is not in accounting or financial statement analysis, so I found the book to be a treasure trove of interesting ideas. A seasoned analyst, however, will undoubtedly be more familiar with the issues addressed by the authors and therefore might not find the book as valuable. But for anyone with a passing interest in the subject, or for new analysts who are still learning the trade, Analysis of financial statements is an incredible resource.

The opinions expressed in this review are those of the author and do not represent the views of Moody’s Analytics

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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Christopher Shayne, CFA

Christopher Shayne, CFA, is Director of Product Operations for Enterprise Risk Solutions at Moody’s Analytics, San Francisco.

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Marianne R. Winn