The Quality of Financial Statements

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Analysts sometimes speak of the quality of a firm's earnings, or the quality of a firm's balance sheet. In general, quality financial statements are a good reflection of reality; accounting tricks and one-time charges are not used to make the firm appear stronger than it really is. Some factors that lead to lower-quality financial statements were mentioned previously when we discussed ratio analysis. Other quality influences are discussed in the following sections.20

Balance Sheet A high-quality balance sheet typically has a conservative use of debt and leverage. Therefore, the potential of experiencing financial distress resulting from the need to service debt is quite low. Little use of debt also implies the firm has unused borrowing capacity; should an attractive investment opportunity arise, the firm can draw on that unused capacity to invest wisely for the shareholders' benefit.

20For additional discussion, see K. G. Palepu, Victor L. Bernard, and P. M. Healy, Business Analysis and Valuation (Cincinnati, Ohio: South-Western Publishing Co., 1996), Chapter 3.

The Value of Financial Statement Analysis 353

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