Ben Graham On Accounting

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At the end of the last blog I mentioned accounting.  I never took an accounting course in school and felt that I was no worse for it.  However, when I became interested in the stock market, I realized that I needed to know some accounting in order to invest.  I made the mistake of buying an introductory college accounting textbook.  I couldn't make it past page 13.  It sat on the shelf with a dogeared page 13 for several years before I threw it out.

Fortunately, I discovered Ben Graham's short book on financial statements geared for investors, The Interpretation of Financial Statements.  It was published in 1937, just three years after the publication of Security Analysis.  I imagine he did this for his students who had not majored in accounting.  I have used it as a reference book to look up terms I needed to understand.  Over the years with the help of Graham's book, I have learned the investment terms necessary for understanding a company's financial position.  An individual investor needs to understand a limited number of accounting principles to be able to glean needed investment information from a company's balance sheet, income (profit/loss) statement and cash flow statement.

In the last blog, I listed five of the financial characteristics that Graham used when analyzing a company.  He included three terms, current assets, current liabilities and net tangible assets which require some familiarity with accounting.  Those and others are clearly explained in his book.  Current assets are defined as cash, cash equivalents (assets immediately convertible into cash), receivables due within one year and inventories.  Inventories, for a manufacturing concern, would include raw materials, goods in process of manufacture and finished goods.  Sometimes packing and shipping supplies are included.  These assets are usually stated at the lower of cost or market value.  Current liabilities are claims payable to third parties within one year.  Tangible assets are all physical and financial assets, such as factories, inventory, cash, accounts receivable and investments.  Intangible assets include items such as good will, intellectual property such as patents, trademarks and the like.  Although trademarks and patents obviously help generate a company's earnings (think of the words Coca Cola in their distinctive script), it is hard to establish a value for them.  Mr. Graham usually excluded them from his valuation of assets when analyzing a company.  He defined net tangible assets as a company's tangible assets less all of the company's liabilities.  He included both current and long term debts.  The one year period for calculating current assets and current liabilities begins as of the date of the financial statements in which they appear.

I promised that the discussion of accounting terms would be short, so I will stop here.  If an individual intends to invest in common stocks and does not have an accounting background, he or she will need to get a copy of this book.  An investor with accounting training will benefit from this book as well, since it focuses on the aspects of financial statements which are most important for an investor.

A hardcover version of the 1937 edition was republished by HarperBusiness, a division of HarperCollins Publishers, with an introduction by Michael Price in 1998.  It is still in print.

Comments, as always, are welcome.