Financial Analysis and the Statement of Cash Flows

Financial Statement Analysis

As you know, this text provides a substantial amount of material about accounting principles, and anyone wishing to study it with due diligence can learn valuable insights about accounting. Does the mere fact that this text exists mean that everyone with access now knows about accounting principles? Obviously not. Does it mean that everyone who happens to "read it" will learn about accounting? Again, no. By analogy, the same can be said about financial information. Companies, especially public companies, spend substantial amounts of money preparing and presenting financial statements that are readily available (the reports for U.S. public companies are freely available at sec.gov). Does this mean that everyone with internet access now has in-depth knowledge about these companies? For that matter, if you print the annual report of a company that you find interesting, does this really help you? My point is that some degree of study is required to benefit from information.

It is important for you to know that CPAs and the SEC provide safeguards to protect the integrity of reported information, but this is entirely different than suggesting that reporting companies are necessarily good investments. For example, a company could report that its revenue stream is in decline, expenses are on the rise, and significant debt is coming due without a viable plan for making the payments. The financial statements may fully report this predicament with perfect integrity, painting a rather gloomy picture. But, if financial statement users choose to ignore that report, only they are to blame.

The moral of the preceding point is that you must be very thorough in examining the financial statements of companies in which you are considering making an investment. It is not sufficient to merely determine that reports exist and look nice; you must study them, drill down in the detail, and think carefully about what you are observing. Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios. For example, a doctor will consider your health in conjunction with measurements of your blood pressure, heart rate, cholesterol level, etc. Likewise, you measure a company's health by considering certain important ratios.

The following ratios have been presented throughout this book series and are summarized below.