Ben Graham on Interpreting Financial Statements

Widely regarded as the founder of value investing, Benjamin Graham’s principles have impacted scores of individuals, from Warren Buffett to Bruce Berkowitz. His 1937 book, “The Interpretation of Financial Statements,” guides the reader through the insights that can be gleaned from financial statements and financial ratios.

Here are seven key points of advice and the specific financial ratios in this essential guide to investing.

Key Takeaways

• Benjamin Graham is regarded as the founding father of value investing and mentored many famous value investors, such as Warren Buffett.
• Graham’s philosophy was to closely examine a company’s financial statements to identify undervalued opportunities.
• Graham notes key ratios and items, such as a company’s working capital ratio, current ratio, intangible assets, cash, notes payable, liquidation value, net asset value, and margin of profit.

Working Capital Ratio

Working capital is calculated by subtracting current liabilities from current assets. This ratio indicates the ability of a company to pay its expenses in the near future. This requires particular attention because, as Graham points out, it is useful in determining the strength of a company’s financial position. A healthy working capital number shields the company from being unable to meet demands, fund emergency losses, and helps with the prompt payment of bills.

Graham further advises that observations of working capital must be made over several years to watch its corresponding inclining or descending levels.

Current Ratio

The current ratio can be calculated by dividing quick assets (current assets minus inventory) by current liabilities. This ratio is also known as the quick ratio or acid test. Regarding current assets and liabilities, Graham states, “When a company is in a sound position the current assets well exceed the current liabilities, indicating that the company will have no difficulty in taking care of its current debts as they mature.”

Note

Each industry is different regarding what makes up a decent current ratio.

Intangible Assets

When looking at intangible assets on a company’s balance sheet, you should pay particular attention to how a company presents this figure. It should be recognized how high the value of goodwill is presented—if it is presented at all. Graham further explains that companies vary dramatically in how they present goodwill on their balance sheet. Often, companies exaggerate the value attached to the goodwill figure because it is difficult for analysts and auditors to determine—this can be telling. Conservative accounting practices can be revealed by presenting a low goodwill figure.

Essentially, Graham advises the reader not to look at the balance sheet valuation of intangibles but at their contribution to the company’s earning power.

Cash

It is noteworthy to observe how companies organize their cash accounts. In these cases, the key is to examine how the cash account is being represented.

In some cases, companies may liquidate a large portion of the inventory and receivable portion of their assets to store more cash in their cash account. If a company has a significant cash account, this can prove to be very attractive to some investors who believe large cash positions are good for a company. Why do they believe this? This excess cash may be distributed to the stockholders or invested back favorably into the business. However, if the company does not publish its intended uses for excess cash or it sits idle over long periods, it should raise a flag for the analyst.

Notes Payable

Graham informs the investor that notes payable is the most important item to watch among the current liabilities. Here, notes payable tend to represent bank loans or loans from other companies or individuals. In the case that the notes payable have increased at a faster rate than sales over the years, it could be bad for the company because it signals a possible overreliance on borrowings from the bank.

Liquidation Value and Net Current Asset Value

A high percentage of current assets over fixed assets can be a good sign when assessing a company’s liquidation value or net current asset value. The net current asset value is calculated by subtracting a firm’s total liabilities and preferred shares from its current assets.

This is important because fixed assets tend to suffer a greater loss than easily liquidated cash or cash equivalents in the current asset category.

Graham reminds the reader: “When a stock is selling at much less than its net current asset value, this fact is always of interest, although it is by no means conclusive proof that the issue is undervalued.”

Margin of Profit

As a crucial part of value investing, the margin of profit (also known as the margin of safety) can be calculated by dividing the operating income by sales. The margin of profit is significant because it informs you how efficiently the company is operating. For example, a ratio of 74% shows that the company would have $0.74 left for every dollar paid after paying all operating expenses. Here, you would be purchasing a $1 company for $0.74. A strong margin of profit is beneficial and adds a competitive edge to the company.

This is perhaps one of the most essential principles underscoring Graham’s investment principles. It not only helps minimize the downside risk of an investment but has been shown to produce higher-than-average returns as the market eventually realizes the fair value of the company.

Seth Klarman, another legendary value investor, has said, “There are only a few things investors can do to counteract risk: Diversify adequately, hedge when appropriate and invest with a margin of safety. It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”

What Were Graham’s 2 Rules of Investing?

Benjamin Graham published several rules for investing, some of which were to expect volatility and profit from it and always invest with a margin of safety.

Did Warren Buffet Know Benjamin Graham?

Buffet was a student at Columbia University, where Graham taught him value investing.

Is The Intelligent Investor Still Relevant?

Graham’s book “The Intelligent Investor” is still recommended by investors to investors for its principles on value investing.

The Bottom Line

When analyzing financial statements, the key figures to look for in determining the strength of a company are its earning power, asset value, how the company compares to its industry, and the company’s earnings trends over several years. The goal of “The Interpretation of Financial Statements” is to demonstrate how to assess these factors with the objective of achieving intelligent and reasonable results.