Chapter 10
Analysis of Financial Statements
MAJOR FINANCIAL STATEMENTS
1. Financial statements are intended to provide information on the resources
available to management, how these resources were financed, and what the firm
accomplished with them.
2. three required financial statements: the balance sheet, the income statement, and
the statement of cash flows.
3. Generally accepted accounting principles (GAAP)
The balance sheet shows what resources (assets) the firm controls and how it has
financed these assets.
1. Specifically, it indicates the current and fixed assets available to the firm at a
point in time (the end of the fiscal year or the end of a quarter).
2. In most cases, the firm owns these assets, but some firms lease assets on a long-
term basis.
The income statement contains information on the operating performance of the
firm during some period of time (a quarter or a year).
3. In contrast to the balance sheet, which is at a fixed point in time, the income
statement indicates the flow of sales, expenses, and earnings during a period of
time
The statement of cash flows integrates the effects on the firm’s cash flow of
income flows (based on the most recent year’s income statement) and changes on
the balance sheet (based on the two most recent annual balance sheets).
1. Analysts use these cash flow values to estimate the value of a firm and to
evaluate the risk and return of the firm’s bonds and stock.
2. The statement of cash flows has three sections: cash flows from operating
activities, cash flows from investing activities, and cash flows from financing
activities.
Cash Flows from Operating Activities
1. This section of the statement lists the sources and uses of cash that arise from
the normal operations of a firm.
Cash Flows from Operating Activities = Net Income + Non cash Revenue and
Expenses + Changes in Net Working Capital
Cash Flows from Investing Activities
A firm makes investments in both its own noncurrent and fixed assets and the equity
of other firms (which may be subsidiaries or joint ventures of the parent firm; they
are listed in the “investment” account of the balance sheet).
2. Increases and decreases in these noncurrent accounts are considered investment
activities.
3. The cash flow from investing activities is the change in gross plant and
equipment plus the change in the investment account.
4. The changes are positive if they represent a source of funds (e.g., sale of some
plant and/or equipment); otherwise they are negative.
Cash Flows from Financing Activities
1. Cash inflows are created by increasing notes payable and long-term liability and
equity accounts, such as bond and stock issues.
2. Financing uses (outflows) include decreases in such accounts (that is, paying down
liability accounts or the repurchase of common shares).
3. Dividend payments are a significant financing cash outflow.
Purpose of Financial Statement Analysis
4. Financial statement analysis seeks to evaluate management performance in several
important areas, including profitability, efficiency, and risk.
5. Although we will necessarily analyze historical data, the ultimate goal of this
analysis is to provide insights that will help us to project future management
performance, including pro forma balance sheets, income statements, cash flows, and
alternative risk measures.
6. It is the firm’s expected future performance that determines whether we should lend
money to a firm or invest in it.
