Reading financial statements

The commonest professional error in reading accounts is not computing a ratio wrongly. It is reading the wrong line into a ratio that is then computed perfectly. Two people can pull debt to equity for the same company on the same day and disagree by half, because they disagreed about what counts as debt and neither of them said so.

This course is about the documents rather than the ratios. It ends with a reader able to find any figure in an annual report, say which statement it came from, and say what the figure excludes.

The sequence, and why it is a sequence

Lessons one to five are the four statements and their joins. The income statement covers a period and says whether revenue exceeded the costs of earning it. The balance sheet covers a single day. The cash flow statement covers the same period as the income statement and says where the money went. The fourth statement, the one nobody reads, records every change in ownership that never passed through profit.

Lesson five exists because of a fact stated in lesson one: net income is not the only thing that moves equity, so the first three statements do not close on each other. That is not a flaw in the accounts. It is the reason there are four.

Lesson six takes the last line of the income statement apart. Lesson seven covers the two disclosures that decompose the company, segments and the non-GAAP reconciliation, both of which sit in the same item of the annual report and both of which are routinely skipped.

Lessons eight to ten are about the filings: what is in a 10-K and in what order to read it, what a 10-Q leaves out and why the fourth quarter is never filed on its own, and where the notes are.

Why the footnotes come last and not first

Lesson ten could not have been read before lesson three, and the reason is worth stating because it is the argument for reading in order.

The notes are not commentary on the statements. They are the statements. A note tells you which costs were capitalised rather than expensed, over how many years an asset is being written off, and on what basis inventory is carried. Every one of those decisions changes a number you have already looked at. Read a note before you know which balance it modifies and it is a list of policies. Read it after you have read the balance sheet, and it is the explanation of why that company's total assets are not comparable to a competitor's.

The same holds for the diff procedure lesson ten teaches, which is to put last year's first note beside this year's and read for what changed. That procedure is useless to somebody who does not already know which line each policy feeds.

What is assumed and what is not

No accounting background is assumed. Every worked example is arithmetic on round invented numbers, labelled as such by the page, so a reader can check it by hand and arrive at the same answer.

What the course does assume is that a reader wants the caveat as much as the formula. Each lesson names at least one place where practitioners legitimately build the same figure differently, and at least one circumstance in which the figure stops meaning what it appears to mean. Banks are the recurring example, because a bank's balance sheet is not split into current and non-current, its deposits are operating liabilities rather than borrowings, and roughly half the readings in this course do not transfer to it.

ValueScreener holds ten years of filed US fundamentals and shows, for every filed figure, the formula, the inputs, the statement it was read from and the fiscal year. That is only useful to somebody who can open the filing and check it, which is what these ten lessons are for.

Where this sits

First of nine courses, and the only one that assumes nothing. Every other course divides one line on these statements by another, so a reader who skips this one computes ratios correctly on figures they have not located. Accounting quality comes next, because knowing where a number lives is not the same as knowing whether it is real.