Financial Statement Analysis Fundamentals

Firms seek capital from investors and prepare financial
statements to help investors decide whether to invest. Investors
expect the firm to add value to their investment—to return
more than what was invested—and read financial statements to
evaluate the firm's ability to do so. Financial statements are also
used for other purposes. Governments use them in social and
economic policy-making. Regulators such as the antitrust
authorities, financial market regulators, and bank inspectors use
them to control business activity. Courts, and the expert
witnesses who testify in court, use financial statements to assess
damages in litigation.
 
Each type of user needs to understand financial statements.
Each needs to know the statements' deficiencies, what they
reveal, and what they don't reveal. Financial statement analysis
is the method by which users extract information to answer
their questions about the firm.
Here we get the principles of financial statement analysis, with
a focus on the
investor. Many types of investment are entertained. Buying a
firm's equity—its common
stock—is one, and the project has a particular focus on the
shareholder and prospective
shareholder. Buying a firm's debt—its bonds—is another. The
shareholder is concerned
with profitability, the bondholder with default, and financial
statement analysis aids in evaluating both. Banks making loans
to firms are investors, and they are concerned with
default. Firms themselves are also investors when they consider
strategies to acquire other firms, go into a new line of business,
spin off a division or restructure, or indeed acquire or
disinvest in an asset of any form. In all cases financial
statements must be analyzed to make
a sound decision.
 
In market economies, most firms are organized to make money
(or "create value") for
their owners. So financial statements are prepared primarily
with shareholders' investment
in mind: The statements are formally presented to shareholders
at annual meetings and the
main numbers they report are earnings (for the owners) in the
income statement and the
book value of owner's' equity in the balance sheet. But much
of the financial statement
analysis for investors is relevant to other parties. The
shareholder is concerned with profitability. But governmental
regulators, suppliers, the firms' competitors, and employees are
concerned with profitability also. Shareholders and bondholders
are concerned with the riskiness of the business, but so are
suppliers and employees. Thus much of the financial statement
analysis over here is relevant to these users as well.
 
Investors typically invest in a firm by buying equity shares or
the firm's debt. Their primary concern is the amount to
pay—the value of the shares or the debt. Here we see the
development of the principles of fundamental analysis. And it
shows how financial statement analysis is used in fundamental
analysis.