Understanding Financial Statements Financia! stamens provide the fundamental information that we use ro analyze ‘and answer valuation questions. It is important, therefore, that we understand the principles governing these statements by looking at four questions: 1. How valuable are the assets ofa firm? The assets of a firm can come in several forms—assets with long lives such as land and buildings, assets with shorter lives such as inventory, and intangible assets that nevertheless produce revenues for the firm such as patents and trademarks. 2. How did the firm raise the funds to finance these assets? In acquiring assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets age. 3. How profitable are these assets? A good investment is one that makes a return greater than the cost of funding it. To evaluate whether the investments that a firm has already made are good investments, we need to estimate what returns these investments are producing 4. How much uncertainty (or risk) is embedded in these assets? While we have not yet directly confronted the issue of risk, estimating how much uncertainty there is in existing investments, and the implications for a firm, is clearly a frst step, This chapter looks at the way accountants would answer these questions, and why the answers might be different when doing valuation. Some of these differ- ences can be traced to the differences in objectives: Accountants try to measure the current standing and immediate past performance of a firm, whereas valuation is much more forward-looking. THE BASIC ACCOUNTING STATEMENTS ‘There are three basic accounting statements that summarize information about a firm. The first is the balance sheet, shown in Figure 3.1, which summarizes the as- sets owned by a firm, the value of these assets, and the mix of financing (debt and equity) used to finance these assets at a point in time. ‘The next is the income statement, shown in Figure 3.2, which provides infor- ‘mation on the revenues and expenses of the fim, and the resulting income made by the firm, during a period. The period can be a quarter (if it is a quartecly income statement) or a year (if it is an annual report). Finally, there is the statement of cash flows, shown in Figure 3.3, which speci- fies the sources and uses of cash to the firm from operating, investing, and financing a28 UNDERSTANDING FINANCIAL STATEMENTS Assets Liabilities a er FIGURE 8.1 ‘The Balance Sheet Gross revenues from sale OpngIComeTORRD, = Operating Income a ‘Bammings to common and preferred equity for ‘current period = Net Income before Extraordinary Items ~ (+) Extraordinary Losses (Profits) associated with operation fits or losses associated >\ - Income Changes Associated with Accounting Changes with changes in accounting ules Dividends paidio prefered) ~ Preferred Dividends siockingldeFs = Net Income to Common Stockholders FIGURE 3.2. Income Statement‘Asset Meesurement and Valuation cee ee ea eee ‘Net cash flow from operations, after taxes and interest expenses Cash Flows from Operations Net cash flow from divestiture and acquisition of real assets (capital expenditures) and disposal and purchase of financial assets: also Includes acquisitions of other fiems + Cash Flows fiom Investing "Net eash flow from the issue and repurchase of equity, from the ++ Cash Flows from Financing ue and repayment of debt, and after dividend payments = Net Change in Cash Balance FIGURE 3.3. Statement of Cash Flows activities during a period. The statement of cash flows can be viewed as an attempt to explain what the cash flows during a period were, and why the cash balance ‘changed during the period. ASSET MEASUREMENT AND VALUATION When analyzing any firm, we want to know the types of assets that it owns, the value of these assets, and the degree of uncertainty about this value. Accounting statements do a reasonably good job of categorizing the assets owned by a firm, a partial job of assessing the value of these assets, and a poor job of reporting uncer- tainty about asset value. This section begins by looking at the accounting principles underlying asset categorization and measurement, and the limitations of financial statements in providing relevant information about assets ting Principles Underlying Asset Measure ‘An asset is any resource that has the potential either to generate future cash inflows or to reduce future cash outflows. While that is a general definition broad enough to cover almost any kind of asset, accountants add a caveat that for a resource to be an asset a firm has to have acquired it in a prior transaction and be able to quan- tify future benefits with reasonable precision. The accounting view of asset value is 0.2 great extent grounded in the notion of historical cost, which is the original cost of the asset, adjusted upward for improvements made to the asset since purchase and downward for the loss in value associated wich the aging of the asset. This his- torical cost is called the book value. While the generally accepted accounting prin- ciples (GAAP) for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting statements: