Literature Advanced Financial Statement Analysis
Chapter 1
The role of intermediaries in capital markets to allocate savings to investment opportunities:
The information and incentive issues lead to the lemons problem:
If inventors cannot distinguish between good and bad investment opportunities, they
value these opportunities at an average level.
This penalizes good investment opportunities, which leads to good entrepreneurs to not
have attractive financing opportunities.
Lack of attractive financing opportunities for good investment opportunities leads them to
leave the market. The proportion of bad investment opportunities will crowd out good
investment opportunities.
This is where intermediaries come in to prevent this problem by helping investors
distinguish good and bad investment opportunities.
Two types of intermediaries in capital markets:
1. Financial intermediaries: focus on aggregating funds from individual investors and
analyzing different investment alternatives to make investment decisions.
a. Examples: venture capital firms, banks, pensions funds, insurance companies
2. Information intermediaries: focus on providing or assuring information to investors.
a. Examples: auditors, financial analysts, credit-rating agencies, financial press
The process of business activities to financial statements:
Firms typically produce five financial reports:
1. Income statement: describes operating performance during a period.
2. Balance sheet: states the firm’s assets and how they are financed.
3. Cash flow statement: summary of cash flows of the firm.
4. Statement of other comprehensive income: outlines the sources of changes in equity that
are not the result of transactions with the owners of the firm and not included in the
income statement.
5. Statement of changes in equity: summary of all sources of changes in equity during the
period between two consecutive balance sheets, consisting of total comprehensive
income (profit/loss + other comprehensive income) and the financial effects of
transactions with owners of the firm
, Balance sheet items:
Assets: economic resources controlled by a firm that have the potential to produce future
economic benefits and are measurable with a reasonable degree of certainty
Liabilities: economic obligations of a firm that arise from benefits received in the past,
have the potential of being required to be met, and cannot be feasibly avoided by the
firm
Equity: difference between a firm’s assets and its liabilities
Income statement items:
Income or revenue: economic resources earned, and performance obligations settled.
Expenses: economic resources used up and economic obligations created during a
period.
Profit or loss: difference between a firm’s income and expenses in a period.
Three alternative mechanisms to communicate with investors:
1. Analyst meetings
a. At these meetings management will field questions about the firm’s current
financial performance and discuss its future business plans.
b. May be subject to regulation: for example, providing all information to all
investors.
2. Voluntary disclosures
a. Voluntary providing additional information that is not required.
b. For example: long-term strategy, forecasts, specification of non-financial leading
indicators.
c. Constraints providing voluntary disclosures: competitive dynamics with other
firms and legal liability through civil actions against management.
3. Non-financial reporting
a. Commonly referred to as environmental, social, and governance (ESG)
disclosures
b. May include information that is qualitative as well as quantitative.
Analysis is done through 4 steps using the financial statements, other public data, and
business application context:
1. Business strategy analysis: generate performance expectations through industry
analysis and competitive strategy analysis.
2. Accounting analysis: evaluate accounting quality by assessing accounting policies and
estimates.
3. Financial analysis: evaluate performance using ratios and cash flow analysis.
4. Prospective analysis: make forecasts and value business.
Chapter 2: Strategy analysis
Strategy analysis involves industry analysis, competitive strategy analysis and corporate
strategy analysis.
1. Industry analysis: choice of an industry or a set of industries in which the firm operates.
2. Competitive strategy analysis: how the firm intends to compete with other firms in its
chosen industry or industries.
3. Corporate strategy analysis: how the firm expects to create and exploit synergies across
the range of business it operates.
Industry analysis: five forces that influence the average profitability of an industry.
Chapter 1
The role of intermediaries in capital markets to allocate savings to investment opportunities:
The information and incentive issues lead to the lemons problem:
If inventors cannot distinguish between good and bad investment opportunities, they
value these opportunities at an average level.
This penalizes good investment opportunities, which leads to good entrepreneurs to not
have attractive financing opportunities.
Lack of attractive financing opportunities for good investment opportunities leads them to
leave the market. The proportion of bad investment opportunities will crowd out good
investment opportunities.
This is where intermediaries come in to prevent this problem by helping investors
distinguish good and bad investment opportunities.
Two types of intermediaries in capital markets:
1. Financial intermediaries: focus on aggregating funds from individual investors and
analyzing different investment alternatives to make investment decisions.
a. Examples: venture capital firms, banks, pensions funds, insurance companies
2. Information intermediaries: focus on providing or assuring information to investors.
a. Examples: auditors, financial analysts, credit-rating agencies, financial press
The process of business activities to financial statements:
Firms typically produce five financial reports:
1. Income statement: describes operating performance during a period.
2. Balance sheet: states the firm’s assets and how they are financed.
3. Cash flow statement: summary of cash flows of the firm.
4. Statement of other comprehensive income: outlines the sources of changes in equity that
are not the result of transactions with the owners of the firm and not included in the
income statement.
5. Statement of changes in equity: summary of all sources of changes in equity during the
period between two consecutive balance sheets, consisting of total comprehensive
income (profit/loss + other comprehensive income) and the financial effects of
transactions with owners of the firm
, Balance sheet items:
Assets: economic resources controlled by a firm that have the potential to produce future
economic benefits and are measurable with a reasonable degree of certainty
Liabilities: economic obligations of a firm that arise from benefits received in the past,
have the potential of being required to be met, and cannot be feasibly avoided by the
firm
Equity: difference between a firm’s assets and its liabilities
Income statement items:
Income or revenue: economic resources earned, and performance obligations settled.
Expenses: economic resources used up and economic obligations created during a
period.
Profit or loss: difference between a firm’s income and expenses in a period.
Three alternative mechanisms to communicate with investors:
1. Analyst meetings
a. At these meetings management will field questions about the firm’s current
financial performance and discuss its future business plans.
b. May be subject to regulation: for example, providing all information to all
investors.
2. Voluntary disclosures
a. Voluntary providing additional information that is not required.
b. For example: long-term strategy, forecasts, specification of non-financial leading
indicators.
c. Constraints providing voluntary disclosures: competitive dynamics with other
firms and legal liability through civil actions against management.
3. Non-financial reporting
a. Commonly referred to as environmental, social, and governance (ESG)
disclosures
b. May include information that is qualitative as well as quantitative.
Analysis is done through 4 steps using the financial statements, other public data, and
business application context:
1. Business strategy analysis: generate performance expectations through industry
analysis and competitive strategy analysis.
2. Accounting analysis: evaluate accounting quality by assessing accounting policies and
estimates.
3. Financial analysis: evaluate performance using ratios and cash flow analysis.
4. Prospective analysis: make forecasts and value business.
Chapter 2: Strategy analysis
Strategy analysis involves industry analysis, competitive strategy analysis and corporate
strategy analysis.
1. Industry analysis: choice of an industry or a set of industries in which the firm operates.
2. Competitive strategy analysis: how the firm intends to compete with other firms in its
chosen industry or industries.
3. Corporate strategy analysis: how the firm expects to create and exploit synergies across
the range of business it operates.
Industry analysis: five forces that influence the average profitability of an industry.
