Revenue. Accounts receivable. Inventory. Depreciation and amortization. Prepaid expenses. Assets. Liabilities. Net income.
If you understand those words, John A. Tracy's book How to Read a Financial Report may not be for you. But if those words are nothing more than random letters to you, this book should give you a fresh appreciation of the importance of financial reports.
The above terms are part of the language of financial reports, those statements companies publish to describe how their business is performing in numerical terms. Because these reports describe a living business, they are intimately linked to each other. However, if you sat down and looked at the three common financial statements as they are printed in a company's annual or quarterly reports, you might not make those connections.
In his book, Tracy outlines many of the links between those terms. Using the financial statements of a fictitious company, he shows how a change in one term on one report -- say, the cash flow statement -- affects another in a different report -- say, the income statement. By going through the reports line by line, he shows how, instead of being dry and confusing documents, financial reports contain a wealth of information for the savvy investor.
Tracy starts off with a brief description of accrual accounting, the method followed by public companies that shows revenue, expenses, and profit for a particular period of time. He follows this with an overview of the financial statements -- the balance sheet, the income statement, and the cash flow statement -- and describes in a general way how they are linked to each other. Then he gets down to the nitty gritty details.
Going line by line, he shows how, for instance, inventory on the balance sheet is tied to both cost of goods sold on the income statement and accounts payable further down the balance sheet. Inventory figures are important to consider, particularly when looking at retailers like Gap
After working through the various line items from the financial report, Tracy then introduces several topics that relate to it. These include the information reported in footnotes, and how important it can be. He also discusses two ways in which companies can massage the bottom line -- the most commonly followed number, and the one with the greatest effect on stock price. Different assumptions and methods for handling depreciation and inventory, the two areas he covers, can have different results on that all-important bottom line, while still adhering to generally accepted accounting principles.
He ends the book with a series of questions and answers. For instance, he doesn't advise using the financial reports to look for something no one else has caught, but rather as a means to understand what you are investing in. He points out, as a quick test, the calculation of the percentage increase in revenues compared to last year, which is then compared to other line items. For instance, if revenue increased by 10% while inventory jumped by 50%, you should ask why, because that jump might lead to inventory writedowns in the future.
Don't expect to be able to understand the financial statements of every company after reading this book; many don't break their reports into the level of detail that Tracy does. On the other hand, if financial statements were your favorite part to skip in any annual report, you can now read them without that old sense of confusion.
Gap is both an Inside Value and Stock Advisor pick.
Fool contributor Jim Mueller participated in a review of this book on one of our discussion boards. While he doesn't own shares in any of the companies mentioned, he still invites you to read our serious disclosure rules .