Equity Markets, Valuation, and Analysis

CHAPTER 6Financial Statement Analysis and Forecasting

Somnath Das

Professor of Accounting, University of Illinois at Chicago

Shailendra Pandit

Associate Professor of Accounting, University of Illinois at Chicago

INTRODUCTION

Financial statement analysis is the process of reviewing and analyzing a company's financial statements with the intent of making better economic decisions. Forecasting is using public information – typically, past historical data – to make predictions. More broadly, forecasting is any analysis aimed at aiding and improving decision-making. Hence, any examination of the role of financial statement analysis in forecasting necessarily begs questions such as “forecasting what?” “forecasting for whom?” “which decisions?” or “which decision-makers?” For the purposes of this chapter, decision-making is limited to financial market participants making asset allocation decisions. From a practitioner's standpoint, asset allocation requires forecasts of stock returns that can lead to improved investment performance. Toward this end, the discussion of financial statement analysis for forecasting primarily includes firm valuation, which also encompasses stock prices. A widely accepted view is that stock prices and hence firm value represent the present value of the business entity's future cash flows. Therefore, an investor's principal challenge is to predict an entity's future cash flows. This chapter examines approaches to forecast future cash flows with a particular ...