Why you should not rely on the financial statements of a company blindly and what are some of the parameters you should focus on while analyzing financial statements?



Why you should not rely on the financial statements of a company blindly and what are some of the parameters you should focus on while analyzing financial statements?

Look at at the balance sheet of these 2 companies below and tell me which company would you invest in?


At first glance, one would think that Company B is obviously a lot better than Company A. It is very clear that company B has a higher value of the land. Also, company B has more machinery than company A. Same goes for the current assets. Other than that since equity is higher in company B, therefore most of the assets are bought without a debt which would have otherwise increased our fixed cost i.e. the interest. Also, company B's current liability is lower than companyA's. So all aspects here would force you to invest your money in company B.

Now let me dig a bit deeper for you. Consider the following situations:


  • Company A bought the land 15 years ago whereas company B bought the land 3 years ago.
  • Company A bought the machinery all at one go whereas company B bought the machinery in installments during the course of its business.
  • Company A gives debt to its customers for 30 days whereas company B gives debt to its customers for 50 days.
  • Company A has a bank loan for a period of 20 years at an interest rate of 6% and company B has borrowed the loan for the same tenure but at an interest rate of 11%.
  • Company A gets credit from its suppliers for 50 days and Company B gets credit from its suppliers for 30 days.
All the things I have mentioned above cannot be understood just by blindly looking at the face of the balance sheet. You need to get into the tiniest details about the particulars. Now if I ask you which company would you invest in, you should go with company A. Here's why:

  • The value of land that company A holds is recorded at the book value in its balance sheet and in these 15 years that have passed the value must have become much bigger. Probably close to 18 lacs assuming a 9 percent per annum return on real estate. Clearly, the balance sheet does not do justice.
  • If company A bought all its machinery in one go, it might have got a handsome discount on the price and other than that since it's operating for like 15 years it bought the machinery way earlier than company B. So the prices must have been cheaper then. Keeping all this in mind, we can say that company A has more production capacity than company B.
  • This clearly explains why company A has lower current assets in its balance sheet. The reason is the high debtors turnover ratio. Company A is more efficient in collecting money from its customers.
  • Now if you look at the interest amount of both companies, you would see that company B actually ends up paying more interest than company A. Other than that Company A has more debt than equity which signifies that company A is running its operations on someone else's money whereas company B's debt to equity ratio is nowhere close to the industry standard of 2:1.
  • The 5th point similarly explains why company A has more current liabilities. It is because company A has better relations from its suppliers and therefore it makes leverage out of that situation by asking for a longer credit period.
So, whenever you analyze a company by seeing the financial statements you need to keep in mind that the assets are recorded at book value and accounting conventions like these may hinder the true picture of the company.

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Thanks for reading!
Please comment on any financial query you had like me to address. I will try to post something worthwhile. 

Coming up Next: How much money do you need to retire?

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