Financial Statement Analysis Fundamentals

Firms seek capital from investors and prepare financialstatements to help investors decide whether to invest. Investorsexpect the firm to add value to their investment-to returnmore than what was invested-and read financial statements toevaluate the firm's ability to do so. Financial statements are alsoused for other purposes. Governments use them in social andeconomic policy-making. Regulators such as the antitrustauthorities, financial market regulators, and bank inspectors usethem to control business activity.
Courts, and the expertwitnesses who testify in court, use financial statements to assessdamages in litigation. Each type of user needs to understand financial statements. Each needs to know the statements' deficiencies, what theyreveal, and what they don't reveal. Financial statement analysisis the method by which users extract information to answertheir questions about the firm. Here we get the principles of financial statement analysis, witha focus on theinvestor.
Many types of investment are entertained. Buying afirm's equity-its commonstock-is one, and the project has a particular focus on theshareholder and prospectiveshareholder. Buying a firm's debt-its bonds-is another. Theshareholder is concernedwith profitability, the bondholder with default, and financialstatement analysis aids in evaluating both. Banks making loansto firms are investors, and they are concerned withdefault.
Firms themselves are also investors when they considerstrategies to acquire other firms, go into a new line of business, spin off a division or restructure, or indeed acquire ordisinvest in an asset of any form. In all cases financialstatements must be analyzed to makea sound decision. In market economies, most firms are organized to make money(or "create value") fortheir owners. So financial statements are prepared primarilywith shareholders' investmentin mind: The statements are formally presented to shareholdersat annual meetings and themain numbers they report are earnings (for the owners) in theincome statement and thebook value of owner's' equity in the balance sheet.
But muchof the financial statementanalysis for investors is relevant to other parties. Theshareholder is concerned with profitability. But governmentalregulators, suppliers, the firms' competitors, and employees areconcerned with profitability also. Shareholders and bondholdersare concerned with the riskiness of the business, but so aresuppliers and employees. Thus much of the financial statementanalysis over here is relevant to these users as well. Investors typically invest in a firm by buying equity shares orthe firm's debt.
Their primary concern is the amount topay-the value of the shares or the debt. Here we see thedevelopment of the principles of fundamental analysis. And itshows how financial statement analysis is used in fundamentalanalysis.