Analysis and Interpretation of Financial Statements

Read this chapter, which discusses how to analyze financial statements and demonstrates the use of ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors, and top management use when they want to identify the strengths and weaknesses in an organization. Analysis tools can help you compare companies of different sizes, companies in different industries, and the same company over time.

Accountants as investment analysts

More than ever, accounting students are being hired as securities analysts, portfolio managers, strategists, consultants, or other investment specialists. Duties in these fields involve understanding the operations of the company, assessing the value of the company, and predicting its future performance. These fields can be enormously exciting and may reap tremendous monetary rewards to those who are successful. For example, Apple's stock closed at USD 21.82 per share in January 2002, and at USD 218.95 in March 2010. So, if you had invested in Apple stock in 2002 your investment would have been worth ten times as much in 2010. Not bad! 

Of course, failure to understand the relationship between financial accounting information and company value can result in negative consequences as well. For example, during the boom, the stock of Webvan, an online grocer, plummeted from a high of USD 40 to just six cents within a few months as investors realized that the company could not meet expected earnings projections and was therefore highly overvalued. (Later, however, framed Webvan stock certificates were selling on Ebay for over USD 100.00 as stark symbols of the bust). 

In the area of investing, what accounting information can be used to separate the winners from the losers?

This is the goal of investment analysts - to understand the current value of a company and then use available information in predicting future performance. Investment analysts rely heavily on financial statements as a source of information in predicting stock price movements. Since financial statements are prepared by accountants, it is no surprise that accountants are being hired for purposes of interpreting financial information and making predictions. Given the complexity of business organizations and business transactions in today's global markets, accounting professionals no longer are solely responsible for preparing financial statements, but are being asked to interpret these statements as well.

The two primary objectives of every business are solvency and profitability. Solvency is the ability of a company to pay debts as they come due; it is reflected on the company's balance sheet. Profitability is the ability of a company to generate income; it is reflected on the company's income statement. Generally, all those interested in the affairs of a company are especially interested in solvency and profitability.

This chapter discusses several common methods of analyzing and relating the data in financial statements and, as a result, gaining a clear picture of the solvency and profitability of a company. Internally, management analyzes a company's financial statements as do external investors, creditors, and regulatory agencies. Although these users have different immediate goals, their overall objective in financial statement analysis is the same - to make predictions about an organization as an aid in decision making.