How you can use financial statements

You now know about financial statements, the accounting process, important financial accounting topics such as revenue recognition and leases, and financial ratio analysis. But here are some cautions. First, financial statement analysis can't do anything if the underlying financial statement data are not reliable. If you're doing an important analysis, make sure that the data come from a reliable source. If the data come from a person you can trust, good. If you're not sure about the source, it's a good idea to have the numbers checked by an outside party, an auditor. For example, a friend of mine asked me to help him analyze the financial accounting numbers for a business he was thinking of buying. It didn't take me long to realize that the financial numbers for this family business were hopelessly mixed in with personal family expenses, such as groceries, gas, utilities, and so forth. It was impossible to figure out how much money this business was actually generating. Without reliable data it was extremely risky to try to evaluate the business. My friend decided not to buy the business. With unreliable numbers, not even the most sophisticated financial analysis can tell you anything. Now, we also talked a bit about business valuation using the PE ratio, which combines market information with the net income number from a company's income statement. So here is the big question that's in your mind right now. Can we as individual investors use our understanding of financial statements to identify winning and losing stocks? And the answer is, no. Let me repeat that, no. Now what was that answer, no, no, no! Now, why can't we clever people pick winning and losing stocks? We know about financial statements, we know about the PE ratio, why can't we beat the market? Simply stated, the market is too fast. The market response to new information, fast, 15 minutes or less. The smart people in New York are constantly using supercomputers to do data analysis to find mispriced, publicly traded stocks. If you want to invest in the stock market, our recommendation is to make long-term investments in diversified portfolios, such as an index fund. That's a topic for another time. To repeat, the market reacts to information just too fast. So that if you don't have some sort of special industry expertise, you aren't going to be able to use your financial accounting skills fast enough. So why even learn about financial accounting? Because the total number of publicly traded companies in the United States is just 4,000. There is an active market for information for these 4,000 companies and these are the ones for which your financial accounting skills aren't going to help you pick winners and losers. But there are 15 million total companies in the United States. The vast majority of them are small businesses. And for these 15 million companies, the financial statement understanding and simple financial statement analysis techniques we've discussed here are usually the only rational basis for evaluating the health and the value of the company. Now if you're making a major decision, don't rely solely on your understanding of financial statements. Spend a little money, hire a professional business advisor. Be prudent, be cautious, and do your best to base your financial statement analysis on reliable data.