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.

Sources of information

Financial information about publicly owned corporations can come from different sources such as published reports, government reports, financial service information, business publications, newspapers, and periodicals.

Public corporations must publish annual financial reports. The Annual report appendix gives such data for The Limited, Inc. The major sections of an annual report are (not necessarily in this order):

•  Consolidated financial statements Consolidated financial statements include a balance sheet containing two years of comparative data; an income statement containing three years of comparative data; a statement of cash flows containing three years of comparative data; and a statement of shareholders' equity containing three years of comparative data. For examples of each statement, refer to the annual report booklet.

•  Notes to consolidated financial statements Notes to consolidated financial statements provide an in depth look into the numbers contained in the financial statements. The notes usually contain sections on significant accounting policies, long-term debt, leases, stock option plans, etc. These explanations allow stockholders to look beyond the numbers to the events that triggered the dollar amounts recorded in the financial statements.

•  Letters to stockholders Most annual reports are introduced with a letter to the stockholders. The letter often includes information about the company's past history, its mission, current year operating results, and the company's future goals.

•  Reports of independent accountants The Securities and Exchange Commission (SEC) requires the financial statements of certain companies to be audited. The report of independent accountants, found at the end of the financial statements, provides assurance that the financial statements prepared by the company have been audited and are free of material misstatements. The report also may include a paragraph highlighting the significant accounting policies that the company has changed recently.

•  Management discussion and analysis The management discussion and analysis section of the annual report provides management's view of the performance of the company. The analysis is based on the financial statements, the conditions of the industry, and ratios.

Publicly held companies must file detailed annual reports (Form 10-K), quarterly reports (Form 10-Q), and special events reports (Form 8-K) with the Securities and Exchange Commission. These reports are available to the public for a small charge and sometimes contain more detailed information than the published reports.

Financial statement information is often more meaningful when users compare it with industry norms. Two firms that provide information on individual companies and industries are Moody's Investors Service and Standard & Poor's. Dun & Bradstreet Companies, Inc., publishes Key Business Ratios and Robert Morris Associates publishes Annual Statement Studies; both provide information for specific industries. Standard & Poor's Industry Surveys contains background descriptions and the economic outlook for different industries.

Business publications such as The Wall Street Journal, Barron's, Forbes, and Fortune also report industry financial news. Because financial statement users must be knowledgeable about current developments in business, the information in financial newspapers and periodicals is very valuable to them.