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Updated 02/07/2006
Advanced FinancialStatements Analysis
By David Harperhttp://www.investopedia.com/university/financialstatements/default.aspThank you for downloading the printable version of this tutorial.As always, we welcome any feedback or suggestions.http://www.investopedia.com/contact.aspx 
Table of Contents
1) Financial Statements: Introduction2) Financial Statements: Who's In Charge?3) Financial Statements: The System4) Financial Statements: Cash Flow5) Financial Statements: Earnings6) Financial Statements: Revenue7) Financial Statements: Working Capital8) Financial Statements: Long-Lived Assets9) Financial Statements: Long-Term Liabilities10) Financial Statements: Pension Plans11) Financial Statements: Conclusion
Introduction
Whether you watch analysts on CNBC or read articles in
The 
 
Wall Street Journal 
,you'll hear experts insisting on the importance of "doing your homework" beforeinvesting in a company. In other words, investors should dig deep into thecompany's financial statements and analyze everything from the auditor's reportto the footnotes. But what does this advice really mean, and how does aninvestor follow it?The aim of this tutorial is to answer these questions by providing a succinct yetadvanced overview of financial statements analysis. If you already have a graspof the definition of thebalance sheetand the structure of anincome statement, this tutorial will give you a deeper understanding of how to analyze these reportsand how to identify the "red flags" and "gold nuggets" of a company. In otherwords, it will teach you the important factors that make or break an investmentdecision.
(Page 1 of 74)Copyright © 2006, Investopedia.com - All rights reserved.
 
Investopedia.com– the resource for investing and personal finance education.
If you are new to financial statements, don't despair - you can get the backgroundknowledge you need in the
Intro To Fundamental Analysis 
tutorial.
Who's In Charge?
In the United States, a company that offers its common stock to the publictypically needs to file periodic financial reports with theSecurities and ExchangeCommission(SEC). We will focus on the three important reports outlined in thistable:
 
Filing IncludesMust be filed withSEC10-KAnnualReportAudited financialstatements,management discussion& analysis (MD&A) andschedulesWithin 90 days offiscal year end(shortens to 60 daysfor larger companies,as of Dec. 15, 2005)10-QQuarterlyReportUnaudited financialstatement and MD&A.Within 45 days offiscal quarter(shortens to 35 daysfor larger companiesas of Dec. 15, 2005.)14A ProxyStatementProposed actions takento a shareholder vote,company ownership,executive compensationand performance versuspeers.Ahead of the annualshareholders'meeting, filed whensent to shareholders.The SEC governs the content of these filings and monitors the accountingprofession. In turn, the SEC empowers theFinancial Accounting StandardsBoard(FASB) - an independent, nongovernmental organization - with theauthority to update U.S. accounting rules. When considering important rulechanges, FASB is impressively careful to solicit input from a wide range ofconstituents and accounting professionals. But once FASB issues a finalstandard, this standard becomes a mandatory part of the total set of accountingstandards known asGenerally Accepted Accounting Principles(GAAP).
Generally Accepted Accounting Principles (GAAP)
GAAP starts with a conceptual framework that anchors financial reports to a setof principles such as materiality (the degree to which the transaction is bigenough to matter) and verifiability (the degree to which different people agree on
This tutorial can be found at:http://www.investopedia.com/university/financialstatements/ (Page 2 of 74)Copyright © 2006, Investopedia.com - All rights reserved.
 
Investopedia.com– the resource for investing and personal finance education.
how to measure the transaction). The basic goal is to provide users - equityinvestors, creditors, regulators and the public - with "relevant, reliable and useful"information for making good decisions.Because the framework is general, it requires interpretation, and often re-interpretation, in light of new business transactions. Consequently, sitting on topof the simple framework is a growing pile of literally hundreds of accountingstandards. But complexity in the rules is unavoidable for at least two reasons.First, there is a natural tension between the two principles of relevance andreliability. A transaction is relevant if a reasonable investor would care about it; areported transaction is reliable if the reported number is unbiased and accurate.We want both, but we often cannot get both. For example, real estate is carriedon thebalance sheetat historical cost because this historical cost is reliable.That is, we can know with objective certainty how much was paid to acquireproperty. However, even though historical cost is reliable, reporting the currentmarket valueof the property would be more relevant - but also less reliable.Consider alsoderivative instruments, an area where relevance trumps reliability.Derivatives can be complicated and difficult to value, but some derivatives(speculative nothedgederivatives) increase risk. Rules therefore requirecompanies to carry derivatives on the balance sheet at "fair value", whichrequires an estimate, even if the estimate is not perfectly reliable. Again, theimprecise fair value estimate is more relevant than historical cost. You can seehow some of the complexity in accounting is due to a gradual shift away from"reliable" historical costs to "relevant" market values.The second reason for the complexity in accounting rules is the unavoidablerestriction on the reporting period: financial statements try to capture operatingperformance over the fixed period of a year.Accrual accountingis the practice ofmatching expenses incurred during the year with revenue earned, irrespective ofcash flows. For example, say a company invests a huge sum of cash to purchasea factory, which is then used over the following 20 years.Depreciationis just away of allocating the purchase price over each year of the factory's useful life sothat profits can be estimated each year. Cash flows are spent and received in alumpy pattern and, over the long run, total cash flows do tend to equal totalaccruals. But in a single year, they are not equivalent. Even an easy reportingquestion such as "how much did the company sell during the year?" requiresmaking estimates that distinguish cash received from revenue earned. Forexample, did the company use rebates, attach financing terms or sell tocustomers with doubtful credit?(Please note: throughout this tutorial we refer to U.S. GAAP and U.S.-specificsecurities regulations, unless otherwise noted. While the principles of GAAP aregenerally the same across the world, there are significant differences in GAAP
This tutorial can be found at:http://www.investopedia.com/university/financialstatements/ (Page 3 of 74)Copyright © 2006, Investopedia.com - All rights reserved.
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