Of Financial Statements

After you read this chapter, you should be able to answer the following questions:

What are the major financial statements provided by firms, and what specific information does each of them contain?

Why do we use financial ratios to examine the performance of a firm, and why is it important to examine performance relative to the economy and to a firm's industry? What are the major categories for financial ratios, and what questions are answered by the ratios in these categories?

What specific ratios help determine a firm's internal liquidity, operating performance, risk profile, and growth potential?

How can the DuPont analysis help evaluate a firm's past and future return on equity? What is a "quality" balance sheet or income statement?

Why is financial statement analysis done if markets are efficient and forward-looking? What major financial ratios are used by analysts in the following areas: stock valuation, estimating and evaluating systematic risk, predicting the credit ratings on bonds, and predicting bankruptcy?

You have probably already flipped the pages of this chapter and recognized that it is a fairly long chapter with several financial statements and numerous financial ratios. A logical question is, What is the purpose of this extensive discussion of how to analyze financial statements? To answer this very reasonable question, we need to recall the process of investing. Early on, the point was made that our ultimate goal is to construct a portfolio of investments that will provide rates of return that are consistent with the risk involved with the portfolio. In turn, to determine the expected rates of return on alternative assets, it is necessary to estimate the future value of the asset since a major component of the rate of return is the change in value for the asset over time. Therefore, the crux of investments is valuation! While we will consider alternative valuation models in the next chapter, you are already aware from prior coursework that the value of any earning asset is the present value of the expected cash flows generated by the asset. Therefore, to estimate the value of an asset, you must derive an estimate of (1) the discount rate for the asset (your required rate of return) and (2) its expected cash flows. The point is, the main source of information that will help you make these two estimates is the financial statements. To derive an estimate of your required rate of return, you need to understand the business and financial risk of the firm, which is specifically considered in this chapter. To estimate future cash flows, you must understand the composition of cash flows and what will contribute to the short-run and long-run growth of this series. An analysis of the composition and growth of cash flow is a topic of this chapter. Put another way, a primary purpose of this chapter is to help you understand how to estimate the variables in alternative valuation models.

Financial statements are also the main source of information when deciding whether to lend money to a firm (invest in its bonds) or to buy warrants or options on a firm's stock. In this chapter, we first introduce a corporation's major financial statements and discuss why and how finan-

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