Books say a lot about company

Q: Why does accounting matter to stocks?

A: Accounting is the language spoken by companies. Investors need to understand it.

Short-term traders need to know how to quickly extract from financial statements how the company performed so they can size up the results with the expectations of analysts. Speculators often will push stocks up and down within seconds after an earnings release as they bet on the future.

Accounting isn’t just for shortterm traders. Long-term inves- tors such as Warren Buffett, for instance, will parse the company’s accounting to see if it has sustainable competitive advantages that help increase value over time. These types of investors aren’t looking for short-term shifts in the business, but rather insights on the long-term valuecreating potential of a business.

But even passive and index fund investors, who don’t try to pick individual stocks, need to have some understanding of accounting as well. Academic studies, for instance, show so-called “value” stocks tend to be among the best performers over time adjusted for risk. These stocks have low price-to-book ratios.

Investors should understand basic financial ratios like this so they can choose low-cost index funds that best suit them.