Book Review: How to Read a Financial Report
The first section, Components and Connections in Financial Statements, is the crux of the book. Rather than working through each statement independently, the author works through different operating assets/liabilities and “connects” them to their driver from the Income Statement or Balance Sheet; accounts receivables with sales revenue, inventory with COGS, inventory with accounts payable, operating expenses with accounts payable and prepaid expenses, etc. After explaining the connections between the Income Statement and Balance Sheet, the author tackles the Statement of Cash Flows and, again, connects the different operating assets/liabilities in the statement to their drivers from the Balance Sheet.
The second section, Financial Statement Analysis, explains a few basic ratios, the impact of growth on cash flows, and profit analysis for business managers. By far the most important topic in this section is the impact of growth on cash flows. The author walks the reader through three scenarios; no growth/no decay, growth, and decay. It may come as a surprise that cash flow from operations are negatively influenced in most cases of growth. This is because the operating assets of the business increase, therefore consuming business capital (cash), and lowering cash flows for the year. The author sums this up with an eloquent quote; “There’s no such thing as a free lunch for growth when it comes to cash flows.” The opposite is true for decay, the business needs less capital tied up in operating assets and therefore cash flow from operations is positively influenced by a decay of the business.
The third section, Reliability of Financial Statements, discusses various accounting topics, but the main point is that in general financial statements accurately reflect conditions of the business. Although the author comes out and declares most statements to be accurate, he advises the reader to be a skeptic of all financial statements and briefly discusses how management “massages the numbers” and “cooks the books”.
While the book is very general and does not get into the “weeds” of different accounting issues, it does the job it was designed to do very well. It connects the three financial statements, and that is something most books simply don’t do. Looking at financial statements and seeing connections that most others don’t is akin to seeing the “DNA” of a business rather than simply observing the business from afar.
The book made me question and ultimately change a few notions I had. First, I mainly focused on free cash flow and didn’t give earnings too much thought. That was a mistake. Earnings drive cash flow and the two metrics report on different aspects of the business. Second, I didn’t give all three financial statements nearly enough attention before. Each statement tells the reader something different, and equally important about the business. No one statement should be held with more regard over another, a business must do all three (earn a profit, manage its financial condition, and manage its cash flows) to be successful over an extended period of time.
I highly recommend this book. I’ve read numerous accounting books and taken numerous accounting classes and this book is the best I’ve been exposed to.