Corporate Financial Reporting and Analysis, 3rd Edition

Chapter 6

Financial Statement Analysis

Introduction

Corporate financial reporting serves many purposes, but perhaps its most important role is to provide useful information to investors. In this chapter we look at how to analyze financial statements in order to make better investment decisions.

Financial statement analysis unlocks the clues about a company’s future from its recent past and, in so doing, makes possible intelligent forecasts of future performance. It helps investors to decide whether or not a company’s shares are worth buying, or if the company is a creditworthy borrower. For the equity investor, the decision depends ultimately on perceptions of value. If the value of a company, based on forecasts of future performance, is perceived to be greater than its market price, we buy. Otherwise, we don’t. In short, much of the usefulness of financial statement analysis comes down to the quality of the forecasts and company valuations it produces.

To produce forecasts and valuations that help investors determine where their capital is likely to earn its highest risk-adjusted returns, a thorough financial statement analysis must follow four sequential steps:

1. Business and industry analysis

2. Accounting analysis

3. Financial analysis

4. Valuation.

1. Business and industry analysis identifies the main competitive forces in the company’s industry, its key business risks, and sources of competitive advantage.

2. Accounting analysis identifies the accounting policy choices ...