Question

2. There are 4 financial statements available for the financial analysts to use in determining the value of a company’s stock. Discuss completely which financial statement you believe provides the most accurate indication of value for an investor? Which financial statement provides the least effective valuation information? Use examples from a company you have analyzed to underscore your point

Answer 1

There are 4 financial statements available for the financial analysts to use in determining the value of a company’s stock.

A complete set of financial statements is used to give readers an overview of the financial results and condition of a business. The financial statements are comprised of four basic reports, which are as follows:

• Income statement. Presents the revenues, expenses, and profits/losses generated during the reporting period. This is usually considered the most important of the financial statements, since it presents the operating results of an entity.
• Balance sheet. Presents the assets, liabilities, and equity of the entity as of the reporting date. Thus, the information presented is as of a specific point in time. The report format is structured so that the total of all assets equals the total of all liabilities and equity (known as the accounting equation). This is typically considered the second most important financial statement, since it provides information about the liquidity and capitalization of an organization.
• Statement of cash flows. Presents the cash inflows and outflows that occurred during the reporting period. This can provide a useful comparison to the income statement, especially when the amount of profit or loss reported does not reflect the cash flows experienced by the business. This statement may be presented when issuing financial statements to outside parties.
• Statement of retained earnings. Presents changes in equity during the reporting period. The report format varies, but can include the sale or repurchase of stock, dividend payments, and changes caused by reported profits or losses. This is the least used of the financial statements, and is commonly only included in the audited financial statement package.

Discuss completely which financial statement you believe provides the most accurate indication of value for an investor?

The key points favoring each of these financial statements as being the most important are:

• Income statement. The most important financial statement for the majority of users is likely to be the income statement, since it reveals the ability of a business to generate a profit. Also, the information listed on the income statement is mostly in relatively current dollars, and so represents a reasonable degree of accuracy. However, it does not reveal the amount of assets and liabilities required to generate a profit, and its results do not necessarily equate to the cash flows generated by the business. Also, the accuracy of this document can be suspect when the cash basis of accounting is used. Thus, the income statement, when used by itself, can be somewhat misleading.
• Balance sheet. The balance sheet is likely to be ranked third by many users, since it does not reveal the results of operations, and some of the numbers listed in it may be based on historical costs, which renders the report less informative. Nonetheless, the balance sheet is of considerable importance when paired with the income statement, since it reveals the amount of investment needed to support the sales and profits shown on the income statement.
• Statement of cash flows. A possible candidate for most important financial statement is the statement of cash flows, because it focuses solely on changes in cash inflows and outflows. This report presents a more clear view of a company's cash flows than the income statement, which can sometimes present skewed results, especially when accruals are mandated under the accrual basis of accounting.

Another way of looking at the question is which two statements provide the most information? In that case, the best selection is the income statement and balance sheet, since the statement of cash flows can be constructed from these two documents.

Another variation on the topic is to infer which statement is the most important, based on the perspective of the user. For example:

• Auditor perspective. Auditors audit the balance sheet, so that is the document that they have the greatest interest in.
• Investor perspective. Investor analysis of share value is largely based on cash flows, so they will have the greatest interest in the statement of cash flows.
• Lawyer perspective. Anyone bringing a lawsuit against a company will want to review its balance sheet first, to see if there are enough assets to attach if the lawsuit is successful. Otherwise, it is not cost-effective to pursue a lawsuit.
• Management perspective. Managers are responsible for fine-tuning the business, so they are likely to delve most deeply into the income statement.

Which financial statement provides the least effective valuation information?

None of the financial statements will report the value of a business. The main financial statements balance sheet, income statement, statement of cash flows, statement of stockholders' equity may provide some helpful partial information, but they will not report the value of the business.

Two reasons why the value of a business is not included in the financial statements are:

• The financial statements are generally based on the company's past recorded transactions. The value of the business will more likely be based on the perceived future transactions.
• The accountants' cost principle prohibits a business from reporting some highly-valued assets such as trademarks, brand names, and an effective management team (assuming these were developed internally).

A contemporary example which demonstrates that the financial statements do not reflect the value of a business is a startup company with a promising future. We may have read that a venture capitalist (VC) invested $10 million in a startup. Based on that investment the startup is assumed to have a total value of $100 million. Well the startup's financial statements will not report amounts anywhere near $100 million. Realistically the financial statements will be reporting negative earnings, few assets and little stockholders' equity. The company's value came from the VC's perception of the company's new breakthrough system that is projected to generate amazing future revenues with a limited amount of expenses.