Numbers Don’t Lie—Or Do They?
Financial statements provide us with the fundamental information that we use to analyze firms. Although you may be able to become a successful investor without ever understanding financial statements, it does make the investment process a lot easier if you can make sense of them. It is important, therefore, that we examine the principles governing these statements and how they help us (or fail to help us) answer four questions:
1. How valuable are the assets of a firm? The assets of a firm can come in several forms—assets with long lives such as land and buildings, assets with shorter lives such as inventory, and intangible assets that still produce revenues for the firm, such as patents and trademarks.
2. How did the firm raise the funds to finance these assets? In acquiring these assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets age.
3. How profitable are these assets? To evaluate whether the investments that a firm has already made are good investments, we need to estimate what returns it is making on these investments.
4. How much uncertainty (or risk) is embedded in these assets? Estimating how much uncertainty there is in existing investments and the implications for a firm is clearly a first step.
We will look at the way accountants would answer these questions, and why financial statements can sometimes provide a misleading picture of a firm’s health and ...