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Learn to Read Financial Statements

imageI earned my MBA over 20 years ago. I specialized in finance but when I started the program, I knew very little about finance in that I had an electrical engineering undergraduate degree and went straight through from undergraduate to business school.

There were a few other folks in my MBA class that had gone straight through from undergrad. We all did pretty well, probably because we were still in academic mode unlike those that had been working real jobs and had to go back.

I didn’t think too much about it at the time. Staying in school to get my Masters just seemed to make more sense. As an electrical engineering graduate, I actually had quite a few good offers of employment. Most of the roles were in IT and/or programming. But those positions just didn’t appeal to me at the time. And I felt that if I left school and started earning money, it would be hard to give that up to go back.

I now know that there are ways to go back to school and continue to earn money, but at the time, I wasn’t thinking in that way.

I sometimes wonder about whether I missed out on a portion of my business school education by not having worked before. I hadn’t managed employees or tried to sell a product and really hadn’t worked in an office much, so the things we studied were just theoretical to me.

But as I have said before, speculating about what could have been, should have been, or would have been doesn’t tend to get you very far. I eventually decided that although I might have gotten a little more out of the education if I had prior work experience, it’s also possible that I wouldn’t have gone back at all. We all make do with the cards we’re dealt.

All that being said, I decided to spend some time reviewing the concepts that I learned in business school and use this site to explore those topics. Some of this might be a refresher for most of you. Some might be new material.

Either way, I am hoping that my perspective, now that I do have work experience, will bring a new viewpoint to these topics. If you don’t have an MBA, look at this as a way to get exposed to the material without spending $100,000 to get it. If you do have an MBA or an undergraduate business degree, or if you just have an experience or perspective that you would like to share, use this platform to have your voice heard.

I haven’t decided how often I will write about these topics or how much detail to go into, but the best way for me to get started is to just jump in and see where it goes.


Introduction to Corporate Finance

Since my MBA specialized in finance and that is the subject of this site, I say let’s start with Corporate Finance.

A typical first semester MBA Corporate Finance course covers the following topics:

  • Time value of money and net present value
  • Techniques for financial analysis
  • Valuation of stocks and bonds
  • Capital budgeting
  • Capital market theory
  • Risk and return
  • Capital structure and dividend policy
  • Corporate finance decisions

The concepts in corporate finance provide a framework for determining the long-term investment strategy for the firm, how to finance that strategy, and what short-term financing is required. In finance, this framework is then captured in the company’s financial statements which is where we will start.


Learn to Read Financial Statements

I am shocked at how few people actually spend the time to read public company financial statements. In my MBA program, we had an entire course dedicated to learning to read financial statements. In my working career, I spent hours and hours writing different portions of our financial statements. If you are willing to spend the time to really understand what you are reading, you can learn a tremendous amount about a company’s past performance, future plans, and whether you agree or disagree with them. If you are investing in that company, it’s an absolute necessity.

I also see over and over people who put all of their focus on a company’s income statement. How much revenue are they generating? What’s the profit margin? Is the company growing? These are all good questions, but by relying solely on the income statement, you are missing the deeper understanding of what is really going on in the company.

How is the company financing its operations? Are they overloaded with short-term debt when their operating assets are long-term? Are they getting paid promptly by their customers? Are they stringing out payment to their own vendors? These questions are much better answered by reading the company’s balance sheet, cash flow statement, and most importantly the notes.

Included in the notes is one of my favorite sections of the financial statements – the Management’s Discussion and Analysis of Results (MD&A). The MD&A is exactly as it sounds. It’s essentially management’s discussion of what is happening in the business. Often there is included metric information and breakdowns of the smaller business units that comprise the total company. Sometimes you will even find mention of competitors. The MD&A is a discussion of the numbers presented in the traditional income statement, balance sheet, and statement of cash flows.

To give you an example of why you need to read deeper into the financial statements, for a brief period I worked in the electric utility industry. Shortly before I was hired, the company completed a large acquisition. They had acquired electric power generating assets (power plants, transmission lines, etc.). Power generation assets would logically be categorized as long-term assets. You don’t build a power plant in one day. And you expect a power plant to continue generating power for many years into the future.

One of the basic concepts in corporate finance is that you want to match the duration of your liabilities with the duration of your assets. You don’t want to be in a situation where what you are paying for the asset goes up, but what you receive from the asset goes down. That’s a recipe for bankruptcy.

But that is exactly what this company had done to acquire these long-term assets. They had financed the transaction using very short-term financing (overnight commercial paper). The commercial paper market essentially requires you to reissue your debt on a daily basis at whatever the market rate is on that day. Not only does this create very high volatility in your cost of debt, there is always a chance that you won’t be able to refinance in the commercial paper market in which case you would be in default.

The other thing about selling electricity is the rate that utility companies can charge is typically regulated and cannot be easily changed. So now we have a situation where the company is receiving a steady, predictable cash flow stream from its customers who are buyer power. And in turn, the company is paying a cost in the form of interest expense that resets on a day-to-day basis. If rates go up, the company will make less and less money to the point where it might be losing money. And there is nothing much that they can do about it.

Credit rating agencies weren’t happy. But the company wasn’t willing to issue long-term fixed rate (predictable) debt to pay for the asset because fixed rate debt was more expensive than floating rate debt and the company was worried about the impact on earnings and ultimately on share price.

My role was on the financial side to advise the ultimate decision makers of the risk of this strategy. Decisions like this are typically made either by the CFO or CEO in a company. But whether you are the financial advisor or you are the decision-maker, having a solid understanding of the underlying corporate finance principles is imperative to making an informed decision.

And if you are an investor in the company, you also need to understand this. Is the stock price artificially high because the company has made a short-term financing decision that might cost them in the end? Just looking at an income statement won’t tell you everything you need to know.


Time Value of Money and Net Present Value

This is probably the most important concept in finance. It’s also the most important concept in investing and wealth building. As we all know, one of the keys to successful retirement (early or otherwise) is to start early. Why? Because of the long-term compounding benefits from the time value of money.

We will start with this concept in our next lesson.


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