2. SCOPE OF FINANCIAL STATEMENT ANALYSIS

The role of financial reporting by companies is to provide information about a company’s performance, financial position, and changes in financial position that is useful to a wide range of users in making economic decisions.1The role of financial statement analysis is to use financial reports prepared by companies, combined with other information, to evaluate the past, current, and potential performance and financial position of a company for the purpose of making investment, credit, and other economic decisions. (Managers within a company perform financial analysis to make operating, investing, and financing decisions but do not necessarily rely on analysis of related financial statements. They have access to additional financial information that can be reported in whatever format is most useful to their decision.)

In evaluating financial reports, analysts typically have a specific economic decision in mind. Examples of these decisions include the following:

• Evaluating an equity investment for inclusion in a portfolio.

• Evaluating a merger or acquisition candidate.

• Evaluating a subsidiary or operating division of a parent company.

• Deciding whether to make a venture capital or other private equity investment.

• Determining the creditworthiness of a company in order to decide whether to extend a loan to the company and if so, what terms to offer.

• Extending credit to a customer.

• Examining compliance with debt covenants or other contractual arrangements.

• Assigning a debt rating to a company or bond issue.

• Valuing a security for making an investment recommendation to others.

• Forecasting future net income and cash flow.

These decisions demonstrate certain themes in financial analysis. In general, analysts seek to examine the past and current performance and financial position of a company in order to form expectations about its future performance and financial position. Analysts are also concerned about factors that affect risks to a company’s future performance and financial position. An examination of performance can include an assessment of a company’s profitability (the ability to earn a profit from delivering goods and services) and its ability to generate positive cash flows (cash receipts in excess of cash disbursements). Profit and cash flow are not equivalent. Profit (or loss) represents the difference between the prices at which goods or services are provided to customers and the expenses incurred to provide those goods and services. In addition, profit (or loss) includes other income (such as investing income or income from the sale of items other than goods and services) minus the expenses incurred to earn that income. Overall, profit (or loss) equals income minus expenses, and its recognition is mostly independent from when cash is received or paid.