Book Review: The Interpretation Of Financial Statements By Benjamin Graham

Benjamin Graham is known as the father of value investing for a reason.  His voluminous investment tomes, The Intelligent Investor and Security Analysis, are considered to be investment bibles by many, and are certainly a must-read for every investor.  So valuable is the over-arching philosophy presented in these books that even those who never intend to venture into the world of stock picking can glean immense wisdom from their pages.  Benjamin Graham’s third seminal work, The Interpretation of Financial Statements, is often overlooked in favor of its more popular companions.  This is a mistake, in my opinion.

A Practitioner’s Guide

The Intelligent Investor is all about investment philosophy with few concrete lessons.  Security Analysis, on the other hand, overwhelms the reader with real life example after mind-numbing real life example, coming in at well over 700 pages (yes, 700!).  This sort of detail is unquestionably valuable, but tends to make the book less than useful as a reference.  Enter The Interpretation Of Financial Statements, which strikes a happy medium between the two extremes.  At only 122 pages, this book delivers exactly what it promises:  detailed yet concise and easy-to-understand instructions on the down-and-dirty details of interpreting financial statements.

The book is divided into three parts.

Part I:  Balance Sheets And Income Accounts

Part I is about half the book and consists of small chapters (2-4 pages each) focusing on a single topic.  There are chapters on the Current Ratio (and how to calculate it), Working Capital, Inventories, Receivables, Capital And Surplus, Notes Payable, Reserves, Earning Power, and many other topics.  Each chapter completely explains and encapsulates the idea, tells you how to calculate it (if there’s math involved), relates why this particular entry or ratio is important, and gives an example to flesh out the idea.  Needless to say, this approach is absolutely invaluable as a concise learning tool or a quick brushup on a ratio that perhaps you haven’t used for a while.  But don’t let the brevity fool you either:  a beginner could easily learn everything necessary to become functionally competent in any of these areas just by reading the corresponding chapter and working through the examples.

Towards the end of this section, Graham puts it all together and works through typical industrial and railroad income accounts, calculates earnings from all the constituent parts, and even describes how to determine the safety of common stock dividends, interest payments.  The last chapter of this section, ultimately, gives an overview of how to determine the value of a common stock and relate it to the current price.

Part II:  Analyzing A Balance Sheet And Income Account By The Ratio Method

If part I contains the tools of the trade, part II is its bread and butter.  In it, Graham explains the ratio method (the now-popular P/E, P/B, etc) and does a complete analysis from top to bottom, stopping to explain all the relevant details and points of difficult.  The example used is a real-life one from a company you may have heard of, Bethlehem Steel (still going strong in Graham’s day).  Seeing the important ratios calculated and interpreted by a master of the craft proves extremely valuable and is something beginners and expert investors alike can learn something from.  Where in Security Analysis Graham’s hands-on writing approach can sometimes be overwhelming, here it’s brief enough to allow you to wrap your head around it without sacrificing accuracy or usefulness.

Part III:  Definitions Of Financial Terms And Phrases

Part III is exactly what it sounds like, a glossary of important financial terms and phrases you’re likely to hear on TV and see in financial statements.  This section is useful as a reference, but keep in mind some of the terms have changed since Graham wrote this book.  Still, it will be obvious what he’s talking about even if the name has changed.

Conclusion And Criticism

It’s no secret that I love this book.  While I don’t buy individual securities nearly as much as I used to, I used this book extensively when I did.  My process was to sit down with this book and the annual report, calculate all the important ratios, and try to arrive at a reasonable fair-value estimate for the company as a whole, particularly in relation to its Earning Power (Graham devotes a chapter to this).  While my method evolved over time and I eventually switched to a more discounted cash flow method, Graham’s teachings still forms the base of any value-based stock picking method.

The main flaw of this book, of course, is its age.  Modern secuirty analysis makes extensive use of the Cash Flow Statement, a statement, of course, that didn’t even exist in Graham’s day.  Needless to say, you won’t find anything about cash flow here.  Still, the current account and earning power are every bit as important today as they were in 1936.  Hence, The Interpretation Of Financial Statements should be used as a jumping-off point for modern investors and not as a complete solution.

With that one caveat in mind, I believe every investor should read this book and I’m not the only one. None other than Joel Greenblatt, author of one of my favorite investing books You Can Be A Stock Market Genius (read my full review), lists this gem as one of his all-time favorite investment books and recommends it as a good primer on financial statement analysis.

Buy The Interpretation of Financial Statements from Amazon.