Despite the inherent ambiguities in assessing companies qualitatively, you should do this instead of relying wholly on quantitative factors. Most of you may not be aware of this but some companies resort to “window-dressing” their financial statements every year end to reflect better results. Financial statement fraud cases such as Enron and Worldcom are more common than you think!
How do I assess the companies quantitatively?
Now, this is tricky question. As an Accountant by profession, I can tell you truthfully that Financial Statements are not easy to understand. Assessing companies by looking at their Financial Statements is an art. The best method would be to take up a professional accounting qualification such as ACCA but that may be too arduous for some.
So, are you going to help me?
Yes, instead of boring you to death with the theory and nitty-gritty details, I will teach you the mystic arts of “Analytical Review”. So what is Analytical Review? Well, it’s a series of techniques of extracting information from the financial statements so that you have a general idea of how the company is doing.
Huh! What the [insert expletive here] !!!
Imagine this; you are sitting beside your wife who is driving her car. Now, imagine I am asking you the following:
· How far has she travelled today?
· How much petrol has she got left on her car?
How are you going to tell me this?
· Are you going to set up sophisticated speed measuring equipment along the highway to measure the speed of the car?
· Are you going to rely on your note book to jot down the distance in kilometers travelled since this morning?
· Are you going to use a dipstick on the petrol tank to measure the gallons of petrol still left?
I imagine most of you will tell me: look at the dashboard, you silly boy!
Exactly! Same thing with financial statements, we will try to construct a dashboard with the important indicators. These will tell us the financial status of the Company we intend to invest in.
The process of reviewing financial statements (i.e. constructing the dashboard) is called Analytical Review. Please look out for my future Analytical Review 101 posts. In that series of posts, I shall explain the process of evaluating companies quantitatively via Analytical Reviews.
However, I have to warn you that reviewing companies quantitatively is an art and there are no hard and fast rules. Even with certain guidelines, you still must exercise your own judgment as to the worth of a company.
Assess companies qualitatively first. Then, use Analytical Review techniques to assess companies quantitatively. The combination of your analysis will reveal to you whether the company is worth investing based on its’ current market price.