Pretending to understand makes you look smarter with dumber friends, but it does not make you any richer. In today's fast-paced market, it's easy to get caught up in the hype, chasing hot stocks and relying on quick tips. However, successful investing, the kind that builds long-term wealth, requires something more fundamental: a deep understanding of the companies you invest in. This goes beyond merely glancing at earnings reports; it demands a thorough comprehension of the business itself. Real conviction in an investment comes from knowledge, not speculation.

Key Questions to Understand a Business

Understanding a company requires more than just reading financial statements and, while those are important, they provide only a historical snapshot. To truly grasp a business, you need to investigate deeper. 

Ask yourself:

• What is the business model? How does the company create, deliver, and capture value? This includes understanding the products or services offered, the target market, and the revenue streams.

• What are the key drivers of the business? What factors influence the company's revenue and profitability? Understanding these drivers allows you to better assess the company's future prospects. Is the company reliant on a single product or customer? What are the risks and opportunities associated with these drivers?

• What is the company's competitive advantage (moat)? What sets the company apart? A strong brand, cost advantage, network effects, or proprietary technology can form a sustainable moat. As Warren Buffett notes, investing is about determining a company's competitive advantage and, above all, its durability. A wide, deep moat is what protects your investment from the inevitable waves of competition.

• Who is running the company, and what is their track record? Management quality is crucial. Are they competent? Are they ethical? Do they have a long-term vision? Are they aligned with shareholder interests? Peter Lynch, another investing giant, emphasized the importance of understanding management, stating, "Invest in what you know." This includes knowing the people at the helm.

• What is the company's industry landscape? Is the industry growing? Is it mature? Is it cyclical? Understanding the industry dynamics helps you assess the company's position within it and the potential for future growth. Porter's Five Forces framework can be a useful tool here.

• Who are the clients? Understanding customer demographics, behaviors, preferences and satisfaction levels is vital. A company that effectively retains customers has a significant advantage.

• What are the company's risks? Every investment carries risk. Understanding the specific risks associated with a particular company is crucial. These risks could be anything from regulatory changes to technological disruptions or shifting consumer preferences. By understanding the potential risks, you can better assess the potential rewards.

• How does the company allocate capital? Is it reinvesting profits back into the business? Is it paying dividends? Is it buying back shares? A company's capital allocation strategy is a key indicator of its long-term vision and its commitment to shareholders.

Beyond the Numbers: Analyzing Financial Statements

Financial statements are the backbone of any business analysis. They provide a snapshot of a company’s financial health, performance, and potential.

The main parts of the financial statements include:

• Income Statement: Shows revenue, expenses, and profits over a specific period. It answers the question, “Is the company making money?”

• Balance Sheet: Provides a snapshot of the company’s assets, liabilities, and equity at a given point in time. It answers, “What does the company own and owe?”

• Cash Flow Statement: Tracks the flow of cash in and out of the business, categorized into operating, investing, and financing activities. It answers, “Is the company generating cash?”

• Statement of Changes in Equity: This statement explains changes in the company’s equity over a specific period. It answers the question: “How has the company’s equity changed?”

While these statements are essential, for many investors and analysts, the process of reviewing financial statements often stops at the surface level: crunching ratios, comparing revenue growth, or scanning profit margins. While these quantitative metrics are important and they give you a story, it's our job as investors to decipher that narrative. Ratios and quantitative analysis only provide a snapshot, they tell us what happened, but not necessarily why. The real insights lie in understanding the context, the assumptions, and the management's perspective. Here's what to look for beyond the numbers:

1. Management Discussion and Analysis (MD&A): This section, often found at the beginning of a company's Annual Report (also known as financial statements or, in US, 10-K) or quarterly report (10-Q in the US), is a goldmine of information. It's where management explains the company's performance, discusses key challenges and opportunities, and outlines its future strategy. Pay close attention to:

   1. Tone and Language: Is management optimistic and confident, or cautious and defensive? Are they transparent about challenges, or do they gloss over them? Consistent, clear communication is a positive sign. Be wary of overly promotional language or vague explanations.

   2. Key Performance Indicators (KPIs): What metrics does management focus on? Are these the right metrics for the business? How has performance trended over time? Understanding what management prioritizes reveals their strategic focus.

   3. Forward-Looking Statements: While these statements should be taken with a grain of salt, they can provide insights into management's expectations for the future. Look for consistency with past performance and stated strategies.

2. Footnotes, hidden details in plain sight: Don't underestimate the power of footnotes! They often contain crucial details that are not readily apparent in the main financial statements. Pay attention to:

   1. Accounting Policies: How does the company recognize revenue? What are its depreciation methods? Understanding the company's accounting policies is essential for comparing it to its peers. Look for any changes in accounting policies, as these could signal underlying issues.

   2. Contingencies and Commitments: Are there any pending lawsuits or other legal issues? What are the company's contractual obligations? These can have a significant impact on future financial performance.

   3. Related Party Transactions: Are there any transactions with related parties, such as family members of management or other affiliated companies? These transactions can be a red flag if they are not conducted at arm's length.

   4. Debt Structure: What is the company's debt load? What are the interest rates and maturity dates? Understanding the company's debt structure is crucial for assessing its financial risk.

3. Industry Context: Financial statements should always be analyzed within the context of the company's industry. How does the company's performance compare to its peers? What are the key industry trends? Understanding the industry landscape is essential for assessing the company's competitive position.

4. Connecting the Dots: The real power of financial statement analysis comes from connecting the dots between different sections of the report. For example, how do the risk factors discussed in the MD&A relate to the company's financial performance? How does the company's capital allocation strategy impact its future growth prospects?

5. Look for Red Flags: Be wary of any inconsistencies or unusual items in the financial statements. For example, a sudden increase in revenue without a corresponding increase in cash flow could be a red flag. Other red flags include:

   1. Frequent changes in accounting policies

   2. Unusual or complex transactions

   3. Related party transactions that are not part of usual operations

   4. Aggressive revenue recognition practices

   5. High levels of debt

By going beyond the raw numbers and delving into the qualitative aspects of financial statements, you can gain a deeper understanding of the company's business, its management, and its future prospects. This will allow you to make more informed investment decisions and increase your chances of long-term success.

Conclusion: The Art of Financial Analysis

Analysing financial statements is both a science and an art. The science lies in understanding the numbers, ratios, and metrics. The art lies in interpreting the story behind those numbers: the context, the risks, and the opportunities.

By carefully reading the financial statement, you can uncover insights that others might miss. You can identify companies with strong fundamentals, sustainable competitive advantages, and capable management. More importantly, you can avoid the pitfalls that come with superficial analysis.

As Warren Buffett famously said, “Accounting is the language of business.” To be a successful investor, you need to be fluent in that language, not just the vocabulary, but the nuances and subtleties that make it meaningful.

Attilio and I passionately dislike both accounting and the mere reading of financial statements, but nonetheless it is the crucial starting point to understand a business. True investing success is not about following trends or hype, it is about knowledge, diligence, and independent thinking. By developing a deep understanding of a business, you can separate yourself from the speculators and build lasting wealth.