The Interpretation of Financial Statements

The Interpretation of Financial Statements: The Classic 1937 Edition

by Benjamin Graham and Spencer B. Meredith. New Introduction by Michael F. Price

Benjamin Graham (1894-1976) was a pioneer in the field of value investing. He is most famous for being Warren Buffet’s teacher at Columbia Business School. The Interpretation of Financial Statements was originally published in 1937. This 122-page book focuses on the balance sheet and income statement. Graham also wrote Security Analysis, first published in 1934, and The Intelligent Investor, first published in 1949.

There are a number of intangible assets on the balance sheet. In the introduction, Michael Price describes an experience early in his career. F&M Schaefer Brewing Company appeared to be trading well below intrinsic value. “I’ll never forget looking at the balance sheet and seeing a +/- $40 million net worth and $40 million in intangibles… I looked in the notes and at the financial statements, but they didn’t reveal where the intangibles figure came from. I called Schaefer’s treasurer [and asked]… He replied, ‘Don’t you know our jingle, Schaefer is the one beer to have when you’re having more than one?’ That was my first analysis of an intangible asset which, of course, was way overstated.”

Graham writes about the smoke and mirrors of goodwill. “Many companies which started with a substantial good-will item have written this down to $1 by making corresponding reductions in their surplus or even their capital accounts. This writing down of good-will does not mean that it is actually worth less than before, but only that the management has decided to be more conservative in its accounting policy. This point illustrates one of the many contradictions in corporate accounting. In most cases the writing off of good-will takes place after the company’s position has improved. But this means that the good-will is in fact considerably more valuable than it was at the beginning.”

“Patents constitute a somewhat more definite form of asset than good-will. But it is extremely difficult to decide what is the true or fair value of a patent at any given time… The value which the patents are carried on the balance sheet seldom offers any useful clue to their true worth.”

“In general, it may be said that little if any weight should be given to the figures in which intangible assets appear on the balance sheet. Such intangibles may have a very large value indeed, but it is the income account and not the balance sheet that offers the clue to this value. In other words, it is the earning power of these intangibles, rather than the balance sheet valuation, that really counts.”

It can be insightful to compare figures over several time periods to determine if performance is improving or deteriorating.

• “In the working capital is found the measure of the company’s ability to carry on its normal business comfortably and without financial stringency, to expand its operations without the need of new financing, and to meet emergencies and losses without disaster… The growth or decline of the working capital position over a period of years is also worthy of the investor’s attention.”
• “Receivables should be studied in relation to the annual sales… and in relation to changes shown over a period of years. If the receivables seem unusually large in proportion to sales, or to other items, there is some indication that an unduly liberal credit policy has been pursued, and that more or less serious losses are likely to be sustained from bad accounts.”
• “The most important individual item among the current liabilities is that of Notes Payable. This generally represents bank loans… If the notes payable are substantially exceeded by the cash holdings they can ordinarily be dismissed as relatively unimportant. But if borrowings are larger than the cash and receivables combined, it is clear that the company is relying heavily on the banks… Such a situation may justify misgivings. In such a case the bank loans should be studied over a period of years to see whether they have been growing faster than sales and profits. If they have, it is a definite sign of weakness.”

“An abnormally large inventory suggests that a good part of the merchandise may be unsalable and that its price may have to be drastically reduced in order to move it… The chief criterion is the ‘turnover’—defined as the annual sales divided by the inventory… Inventory turnover is important because the more times a year a company can turn its inventory, the less capital is invested in inventory, and there is less chance of loss through obsolete material.”

“The book value of a security is in most cases a rather artificial value… Outside of the field of banks, insurance companies, and, particularly, investment trusts, it is only in the exceptional case that book value or liquidating value plays an important role in security analysis. In the great majority of instances the attractiveness or the success of an investment will be found to depend on the earning power behind it.”

In a chapter on public utilities, Graham explains, “subsidiary preferred dividends are the dividends paid on preferred stock outstanding in the hands of the public—i.e., not held by the parent company… In dealing with the bonds of public utility and other holding companies, it is usually necessary to consider the subsidiaries’ preferred dividends as fixed charges, for these may have to be paid before there is any income available for the parent company’s bonds.”

Approximately one-quarter of the book is a glossary of financial terms. Here are some examples:

“Earning Power. Properly, a rate of earnings which is considered as ‘normal,’ or reasonably probable, for the company or particular security. It should be based both upon the past record, and upon a reasonable assurance that the future will not be vastly different from the past. Hence companies with highly variable records or especially uncertain futures may not logically be thought of as having a well-defined earning power.”

“Expenditures vs. Expenses. Expenditures are outlays of cash or the equivalent; frequently they involve no concurrent charge against operations or earnings (e.g. Capital Expenditures). Expenses are costs, i.e. charges against current operations or earnings; frequently they involve no concurrent cash expenditure (e.g. Accruals, Depreciation).”

“Going Concern Value… The special profit-making character that attaches to a well-established and successful business.”

“Good-Will. Intangible Asset purporting to reflect the capitalization of excess future profits expected to accrue as a result of some special intangible advantage held, such as good name, reputation, strategic location, or special connections. In practice, the amount at which good-will is carried on the balance sheet is rarely an accurate measure of its true value.”

“Intrinsic Value. The ‘real value’ behind a security issue, as contrasted with its market price. Generally a rather indefinite concept; but sometimes the balance sheet and earnings record supply dependable evidence that the intrinsic value is substantially higher or lower than the market price.”

“Joint and Several Guarantee. A guarantee by more than one party under which each party is potentially liable for the full amount involved if his associates do not meet their share of the obligation.”

“Junior Issue. An issue whose claim for interest or dividends, or for principal value, comes after some other issue, called a senior issue. Second mortgages are junior to first mortgages on the same property; common stock is junior to preferred stock, etc.”

“Leasehold. The right to occupy a property at a specified rental for a specified period of years. To obtain a long term lease at a favorable rental a cash bonus is frequently paid by the lessee to the lessor (owner), if it is a new lease, or to the former lessee, if the lease is taken over. The balance sheet item ‘Leaseholds’ should represent only this cash consideration, and should be amortized over the life of the lease.”

“Leasehold improvements. The cost of improvements or betterments to property leased for a period of years. Such improvements ordinarily become the property of the lessor (owner) on expiration of the lease; consequently their cost must be amortized over the life of the lease.”

“Protective Covenants. Provisions in a bond indenture, or charter provisions affecting a preferred stock, (a) which bind the company not to do certain things considered injurious to the issue or, (b) which set forth remedies in the event of unfavorable developments. Example of (a): Agreement not to place a lien on the property ahead of the bond issue. Example of (b): The passing of voting power to the preferred stock if dividends are not paid.”

“Secular Trend. A long term movement—e.g. of prices, production, etc.—in some definite direction. Opposed to seasonal fluctuations or variations.”

“Sinking Fund. An arrangement under which a portion of a bond or preferred stock issue is retired periodically in advance of its fixed maturity…”

Michael Price writes, “a stock price must relate to its financials… It is especially common during periods of exuberance or fear that investors depart from the fundamental methods of successful investing… Focus on the fundamentals—how much you are paying for steak and how much for the sizzle—and you shouldn’t go wrong.”

Graham concludes, “the investor who buys securities when the market price looks cheap on the basis of the company’s statements, and sells them when they look high on this same basis, probably will not make spectacular profits. But on the other hand, he will probably avoid equally spectacular and more frequent losses. He should have a better than average chance of obtaining satisfactory results. And this is the chief objective of intelligent investing.”

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Graham, Benjamin, and Spencer B. Meredith. The Interpretation of Financial Statements: The Classic 1937 Edition. New York: HarperBusiness, 1998. Buy from Amazon.com

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