Financial Accounting: In an Economic Context

ANALYZING THE FINANCIAL STATEMENTS

Now that the analyst has examined the business environment, read the financial statements, and assessed the quality of the reported numbers, the statements can be analyzed. Financial statement analysis is a broad and complex topic. In this chapter, we discuss comparison analysis, which includes common-size analysis and ratio analysis. Appendix 5A introduces the concept of shareholder value creation and contains a framework designed to help identify it and analyze its determinants via the analysis of ratios as a package (called the ROE model).⁴ It also describes the basics of cash flow analysis.

Accounting numbers are not very meaningful in and of themselves. They become useful only when they are compared to other numbers. For example, suppose that you read in the Wall Street Journal that PepsiCo reported net income of $1 billion for 2010. Would you interpret that announcement as favorable or unfavorable news? This question is difficult to answer in the absence of a basis for comparison. Income of $1 billion is neither large nor small in an absolute sense. It depends on such factors as the amount of net income reported by PepsiCo in previous years, the amount of net income reported by other companies similar to PepsiCo, normally in the same industry, the size of PepsiCo's operations and capital base, or even the profit expected by analysts. Thus, financial accounting numbers are only meaningful when compared to other relevant numbers. Such comparisons ...