This in an excerpt from this book
Firms seek capital from investors and prepare financial statements to help investors decide whether to invest. Investors expect the firm to add value to their investment—to return more than what was invested—and read financial statements to evaluate the firm’s ability to do so. Financial statements are also used for other purposes. Governments use them in social and economic policy-making. Regulators such as the antitrust authorities, financial market regulators, and bank inspectors use them to control business activity. Courts, and the expert witnesses who testify in court, use financial statements to assess damages in litigation.
Each type of user needs to understand financial statements. Each needs to know the statements’ deficiencies, what they reveal, and what they don’t reveal. Financial statement analysis is the method by which users extract information to answer their questions about the firm.
Here we get the principles of financial statement analysis, with a focus on the investor. Many types of investment are entertained. Buying a firm’s equity—its common stock—is one, and the project has a particular focus on the shareholder and prospective shareholder. Buying a firm’s debt—its bonds—is another. The shareholder is concerned with profitability, the bondholder with default, and financial statement analysis aids in evaluating both. Banks making loans to firms are investors, and they are concerned with default. Firms themselves are also investors when they consider strategies to acquire other firms, go into a new line of business, spin off a division or restructure, or indeed acquire or disinvest in an asset of any form. In all cases financial statements must be analyzed to make a sound decision.
In market economies, most firms are organized to make money (or “create value”) for their owners. So financial statements are prepared primarily with shareholders’ investment in mind: The statements are formally presented to shareholders at annual meetings and the main numbers they report are earnings (for the owners) in the income statement and the book value of owner’s’ equity in the balance sheet. But much of the financial statement analysis for investors is relevant to other parties. The shareholder is concerned with profitability. But governmental regulators, suppliers, the firms’ competitors, and employees are concerned with profitability also. Shareholders and bondholders are concerned with the riskiness of the business, but so are suppliers and employees. Thus much of the financial statement analysis over here is relevant to these users as well.
Investors typically invest in a firm by buying equity shares or the firm’s debt. Their primary concern is the amount to pay—the value of the shares or the debt. Here we see the development of the principles of fundamental analysis. And it shows how financial statement analysis is used in fundamental analysis.
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