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14 Financial Statement Analysis

is of foremost concern to creditors, risk analysis is often discussed in the context of
credit analysis. Still, risk analysis is important to equity analysis, both to evaluate the
reliability and sustainability of company performance and to estimate a company’s
cost of capital. We explain risk analysis along with credit analysis in Chapter 10.
Analysis of cash flows is the evaluation of how a company is obtaining and deploying
its funds. This analysis provides insights into a company’s future financing implica-
tions. For example, a company that funds new projects from internally generated cash
(profits) is likely to achieve better future performance than a company that either
borrows heavily to finance its projects or, worse, borrows to meet current losses. We
explain analysis of cash flows in Chapter 7.

Prospective Analysis

Prospective analysis is the forecasting of future payoffs—typically earnings, cash flows,
or both. This analysis draws on accounting analysis, financial analysis, and business
environment and strategy analysis. The output of prospective analysis is a set of
expected future payoffs used to estimate company value.
While quantitative tools help improve forecast accuracy, prospective analysis
remains a relatively subjective process. This is why prospective analysis is sometimes
referred to as an art, not a science. Still, there are many tools we can draw on to help
enhance this analysis. We explain prospective analysis in detail in Chapter 9.

Valuation
Valuation is a main objective of many types of business analysis. Valuation refers to the
process of converting forecasts of future payoffs into an estimate of company value. To
determine company value, an analyst must select a valuation model and must also esti-
mate the company’s cost of capital. While most valuation models require forecasts of
future payoffs, there are certain ad hoc approaches that use current financial informa-
tion. We examine valuation in a preliminary manner later in this chapter and again in
Chapter 11.

Financial Statement Analysis and Business Analysis
Exhibit 1.4 and its discussion emphasizes that financial statement analysis is a collection
KNOW-NOTHING of analytical processes that are part of business analysis. These separate processes share
CEOs a common bond in that they all use financial statement information, to varying degrees,
The know-nothing defense for analysis purposes. While financial statements do contain information on a com-
of CEOs such as MCI’s pany’s business plans, analysis of a company’s business environment and strategy is
Bernie Ebbers was
shattered by novel legal sometimes viewed outside of conventional financial statement analysis. Also, prospec-
moves. Investigators tive analysis pushes the frontier of conventional financial statement analysis. Yet most
proved that CEOs knew the agree that an important part of financial statement analysis is analyzing a company’s
internal picture was business environment and strategy. Most also agree that valuation, which requires fore-
materially different than casts, is part of financial statement analysis. Therefore, financial statement analysis
the external picture
presented to shareholders. should be, and is, viewed as an important and integral part of business analysis and all
of its component analyses. At the same time, it is important to understand the scope of
financial statement analysis. Specifically, this book focuses on financial statement analy-
sis and not on aspects of business analysis apart from those involving analysis of finan-
cial statements.