How to Not Get Fooled by the Financials - dummies

How to Not Get Fooled by the Financials

By Matt Krantz, Robert R. Johnson

If you’ve ever taken a look at the financial statements generated by companies, they look like they could be etched in stone. Neatly arranged rows and columns of carefully presented numbers calculated down to the exact dollar seem indisputable and accurate.

But if you ask any investment banker or accountant, you’ll find that many of the numbers that are taken as gospel by investors are actually largely up to a bit of interpretation. Sure, there are rules including generally accepted accounting principles, or GAAP, which guide companies on how to record their numbers. But there’s still quite a bit of wiggle room.

If there’s one thing you can learn from the rigors of investment bankers, it’s that blindly accepting financials from the financial statements isn’t a good idea. Looking over the numbers with a skeptical eye for inconsistencies and other quirks before having total faith in the numbers is prudent.

Investment bankers put their reputations on the line when they do a deal. They often line up investors and their cash and trust based on the numbers on the financial statements. And because of that, investment bankers take the time to dig into the financials and look not just at the headline numbers, but also for true evidence of the actual performance of the company.

At the very least, a great exercise for investors is to compare the net income reported on the income statement with the company’s cash flow from operations from the statement of cash flows. The net income is the official, accountant-approved measure of profitability that investors fixate on and companies pay great attention to in order to meet expectations. But the company’s cash flow from operations is a true measure of how many greenbacks are actually coming into the business. When you see net income soaring over cash flow from operations, it’s a good idea to do what investment bankers would: Dig deeper.