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Chapter One | Overview of Financial Statement Analysis 19

type of business, its plans, and its input and output Revenues, Expenses, and Income
markets. Management decides on the most efficient and 70
effective mix for the company’s competitive advantage. 60
Operating activities are a company’s primary source 50
of earnings. Earnings reflect a company’s success in 40
buying from input markets and selling in output mar- $ Billions 30
kets. How well a company does in devising business 20
plans and strategies, and deciding the mix of operating 10
activities, determines its success or failure. Analysis 0
of earnings figures, and their component parts, reflects a Albertson’s Target Colgate FedEx
company’s success in efficiently and effectively
managing business activities. Net income Expenses
Colgate earned $1.383 billion in 2006. This number
by itself is not very meaningful. Instead, it must be compared with the level of invest-
ment used to generate these earnings. Colgate’s return on beginning-of-year total assets
of $8.51 billion is 15.9% ($1.353 billion/$8.510 billion)—a superior return by any stan-
dard, and especially so when considering the highly competitive nature of the con-
sumer products industry.

Financial Statements Reflect Business Activities

At the end of a period—typically a quarter or a year—financial statements are prepared
to report on financing and investing activities at that point in time, and to summarize
operating activities for the preceding period. This is the role of financial statements and
the object of analysis. It is important to recognize that financial statements report on
financing and investing activities at a point in time, whereas they report on operating
activities for a period of time.

Balance Sheet
The accounting equation (also called the balance sheet identity) is the basis of the
accounting system: Assets Liabilities Equity. The left-hand side of this equation
relates to the resources controlled by a company, or assets. These resources are
investments that are expected to generate future earnings through operating activities. To
engage in operating activities, a company needs financing to fund them. The right-hand
sideofthisequationidenti-
fies funding sources. Lia- Colgate’s Assets and Liabilities
bilities are funding from Assets Liabilities and Equity
creditors and represent Other Stockholders’
obligations of a company assets equity
or, alternatively, claims of 34% 15%
creditors on assets. Equity Current Other Current
(or shareholders’ equity) assets long-term liabilities
is the total of (1) funding 36% liabilities 38%
invested or contributed 17%
by owners (contributed
capital) and (2) accumu- Long-term
lated earnings in excess of Land, building debt
distributions to owners and equipment 30%
(retained earnings) since 30%