Assessing the Quality of the Financial Statements Essay

†¢Reading the Financial Statements and Creating a Data File Our experience, and that of our students, is that careful and thorough reading of the financial statements yields a great deal of information about the firm. The financial statements, the notes, and management’s discussion and analysis provide valuable insights into the business strategies, profitability, and risk of the firm. Many firms explicitly disclose elements of the business that are performing well or poorly, also providing explanations about the performance. Many firms explicitly disclose projections of future business activities, such as expected future sales growth rates or capital expenditures, which are helpful information for projecting future financial statements. Analysts who do not carefully read the financial statements stand to miss this valuable information. After careful reading, the analyst should enter the financial statement data into a data file. One initial choice in creating a data file is whether to use the accounts and amounts that the firm provides in its Form 10-K or annual report to shareholders or to download and use amounts from various online sources or databases that format the amounts into a standardized template. One advantage of following the first approach is that you rely on the primary source of the financial statements, not on a secondary source about which you may not know all of the reclassifications and adjustments made to confirm the reported amounts to the standardized template. Another advantage of following the first approach is that the financial statement data will be classified into accounts consistent with the notes to the financial statements, the main source of information for assessing the quality of the reported amounts. The principal advantages of using amounts in a standardized template are that use of the template can save time and the financial statement amounts are reasonably comparable across firms. The next decision to be made is whether to input the financial statement data into FSAP, a financial statement analysis package that accompanies this text, or to create a new spreadsheet file. The principal advantages of FSAP are that it provides spreadsheets that have embedded formulas for the various profitability and risk ratios, it provides a template for preparing forecasted financial statements using the previously reported actual amounts as a base, and it inputs the forecasted amounts into several valuation models to arrive at equity values. †¢Assessing the Quality of the Reported Amounts One of the most important steps in financial statement analysis is to assess the quality of the reported amounts and make appropriate adjustments before proceeding to the analysis of profitability and risk. The saying â€Å"garbage in, garbage out† applies with particular importance to financial statements. To assess quality, you must read the financial statements and notes. Material nonrecurring or unusual income items are candidates for adjustment. Significant off-balance-sheet assets or liabilities also are candidates. Some adjustments may be needed to increase the comparability of the financial statement amounts for each of the firms analyzed in the term project.