Becoming Financially Intelligent
Trusting the numbers, reporting biases, accounting rules, and more. Part 1/4
“If you don’t have a good working understanding of the financial statements and know what they’re looking at or why, you are at their mercy.”
I recently read one of the best accounting books I’ve come across, it’s called Financial Intelligence, by Karen Berman and Joe Knight.
I first came across it when recommended by Guiliano at From 0 to 1 in the Stock Market. It’s a practical guide to understanding accounting. The reason it’s fantastic is that it deals in nuances. It’s practical. It wasn’t made for someone trying to pass an exam, it was made for someone who needs to understand the numbers to improve real-life financial decisions.
Starting today, this’ll be a short series diving into a few of the key ideas — how to read the numbers, analyse them, and understand the biases that might be embedded in them. I’ve split it into four pieces, to be released in the coming weeks:
Part one - Becoming Financially Intelligent
Part two - The Income Statement
Part three - The Balance Sheet
Part four - The Cash Flow Statement
I’ll be summarising the key sections, but if you enjoy this series you have to go out and buy it. For a book on accounting it was a real page turner… I’m semi-embarrassed to say I’m really not joking.
Today we look at what it is to be financially intelligent, accounting rules that we might not want to follow, and biases in numbers we thought were concrete. Berman and Knight say “financial intelligence is no more than a set of skills that can be learned... (It) boils down to four distinct skill sets:”
Understanding the foundation: Understanding financial statements, why the balance sheet balances, the difference between profit and cash, and so on.
Understanding the art: It’s art as well as science, some assumptions have to be made as some things can not be quantified. This requires skill and estimation.
Understanding analysis: With the above knowledge, you can begin to analyse what it all really means.
Understanding the big picture: The numbers can’t and don’t tell the whole story. It must be understood in context, many external factors will go into how you interpret the numbers.
This series will go some of the way in mastering all four. No matter your skill level you will have something to learn from this.
The usual disclaimer: no summary worth doing will beat the original material, I recommend you buy the book. If you haven’t the time nor money, this series is definitely your next best option. And if you already have the book this summary still has great utility; repetition is persuasive, after all.
Why increase your financial intelligence?
This is about understanding a companies figures and what they really mean — the assumptions, biases, and estimates behind them — and what that implicates about a business and its future. The book was not targeted to accountants or investors but to business-people who need to understand the information properly, with all its nuances, in order to do their job better. It’s no nonsense information for people who want to more effectively run an operation.
The great thing for us investors is that we want to take the stance of the manager — to think like an operator — to get a better grasp on a businesses financial nuance, which makes this book enormously helpful.
Acquiring financial intelligence allows you to:
Critically evaluate and analyse a company.
Have a better understanding of the bias in the numbers.
Gain the ability to use numbers and financial tools to make and analyse decisions.
Let’s look at a few ways we can better look at the numbers.
You can’t always trust the numbers
There are many ways a company can lie to us, and a phrase I’ve stolen from Anthony Bolton is that if a company wants to hide something from you, they will, and they can do so for a very long time. As long as there’s liars out there, there’ll be financial shenanigans. We can’t trust anyone until they’ve earned it. It’s surprising how much a company can also hide legally; shuffle a few figures here and there and you can boost the numbers in a totally legal way.
There’s no escaping it. It’s shocking how subjective the numbers are. We presume they’re set in stone, a company can’t lie about it, surely? The fact is this is as much art as it is science, you simply can’t know everything about a business — what employees are doing everyday, how long a piece of machinery might last, and so on — which means it’s very hard to report with 100% accuracy.
The numbers are a complete representation of the company, based on incomplete information, it is up to them to make it as accurate as possible, which blurs the lines.
“Accounting and finance are not reality, they are a reflection of reality.”
It relies on an objective accountant to make an objective reflection. Since objectivity is difficult, the numbers might be unintentionally skewed based on the mood, background, and experience of the person putting them together.
They give the example of Xerox, who managed to cook the books through not-so-subtle revenue recognition techniques; some of their products were sold with four-year leases, including service and maintenance. This is money they would receive over a four-year period, but at what point this revenue should be recognised is a blurred line. After Xerox profits began to slump, they’d recognise the nearly the entire four years of future revenue all in one go, artificially boosting short-term revenue and profit in enormous ways.
There’s plenty of room in the short-run to cook the books. Xerox is one of a vast array of high-profile examples.
Spotting assumptions, estimates, and biases
