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Ask Matt: Why does accounting matter to stocks?


Q: Why does accounting matter to stocks? 

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

It's easy to see why traders and speculators need to understand accounting. The importance of financial statements comes into prominent play four times a year when companies report their quarterly results. Short-term traders need to know how to quickly extract from the financial statements how the company performed so they can size up the results with the expectations of analysts. Speculators will often push stocks up and down within seconds after an earnings release as they bet on the future. 

Accounting isn't just for short-term traders. Some long-term investors use so-called fundamental analysis to select companies with solid financial trends. Investors like 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 value-creating potential of a business. Trend analysis of accounting helps reveal these potentially profitable trends. 

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, have demonstrated that 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. 

Paste BN markets reporter Matt Krantz answers a different reader question every weekday. To submit a question, e-mail Matt at mkrantz@usatoday.com or on Twitter @mattkrantz.