Financial Accounting: In an Economic Context

PREDICT FUTURE EARNINGS AND/OR CASH FLOW

After the analyst completes the first four steps (assessing business environment, reading and studying the financial statements, assessing earnings quality, and analyzing the financial statements), a prediction is normally prepared. Analysts who follow equity securities predict future earnings or cash flow, using these predictions in mathematical models (e.g., present value)¹¹ that provide estimates of the value of a company's shares of stock. These estimates are compared to current market prices to determine whether a particular security is over- or underpriced. Credit analysts prepare cash flow predictions to see whether loan customers will be able to make their loan payments when they come due.

Predicting future levels of earnings or cash flow is a difficult and subjective process. Nonetheless, it is very important for success, and astute financial statement analysis can improve these predictions significantly.

11. See Appendix A in the back of the text for a discussion of present value. Appendix 5A at the end of this chapter provides a brief discussion of projecting future financial statements.