THE IMPORTANCE OF ANALYSIS

     As you know, this website provides a substantial amount of material about accounting principles, and anyone wishing to study it with due diligence can learn valuable insights about accounting.  Does the mere fact that this website exists mean that everyone with internet access now knows about accounting principles?  Obviously not.  Does it mean that everyone who happens to "click by" will learn about accounting?  Again, no.  By analogy, the same can be said about financial information.  Companies, especially public companies, spend substantial amounts of money preparing and presenting financial statements that are readily available (the reports for U.S. public companies are freely available at www.sec.gov).  Does this mean that everyone with internet access now has in-depth knowledge about these companies?  For that matter, if you print the annual report of a company that you find interesting, does this really help you?  My point is that some degree of study is required to benefit from information.

    It is important for you to know that CPAs and the SEC provide safeguards to protect the integrity of reported information, but this is entirely different than suggesting that reporting companies are necessarily good investments.  For example, a company could report that its revenue stream is in decline, expenses are on the rise, and significant debt is coming due without a viable plan for making the payments.  The financial statements may fully report this predicament with perfect integrity, painting a rather gloomy picture.  But, if financial statement users choose to ignore that report, only they are to blame.

    The moral of the preceding point is that you must be very thorough in examining the financial statements of companies in which you are considering making an investment.  It is not sufficient to merely determine that reports exist and look nice; you must study them, drill down in the detail, and think carefully about what you are observing.  Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios.  For example, a doctor will consider your health in conjunction with measurements of your blood pressure, heart rate, cholesterol level, etc.  Likewise, you measure a company's health by considering certain important ratios.

    The following ratios have been presented throughout this book, and are summarized below:


    COMPREHENSIVE ILLUSTRATION:  At this point, it may be helpful to consider these ratios as they relate to a comprehensive illustration.  Presented below are financial statements for Emerson Corporation.  Study them carefully.  Then, examine the ratio calculations for Emerson Corporation that can be found immediately following the financial statements.



Additional facts:  No dividends were due or paid on the $300,000 of preferred stock which was issued in exchange for a building in late 20X5.  Average common equity is assumed to be $2,095,000 ((($2,910,000 - $300,000) + $1,580,000)/2).  Assume most other balance sheet items change uniformly throughout the year (e.g., average receivables = ($600,000 + $850,000)/2 = $725,000, etc.).  The year end market value of the common was $10 per share, and the cash dividend was paid on shares outstanding at the end of the year ($50,000/910,000 shares = $0.055 per share). 


     In examining the ratios of Emerson, it would appear that the company is doing fairly well.  Its liquidity suggests no problem in meeting obligations, the debt is at a manageable level, receivables and inventory appear to be turning reasonably well, and profits are good.

    TREND ANALYSIS:  Financial statement data are often reproduced in percentage terms.  For example, Emerson's cash is 17% of total assets ($700,000/$4,100,000).  Such percentage data can be monitored closely, year after year.  This provides sharp investors and managers with a keen sense of subtle shifts that can foretell changes in the underlying business environment.