An Overview of Financial Statement Analysis: The Mechanics
On September 20, 2000, Jonathan Weill, a Wall Street Journal reporter in Dallas, Texas, published a piece questioning the profitability and accounting of Enron Corporation. He based his article on a study of Enron's financial statements and conversations with staff at the Financial Accounting Standards' Board (FASB), accounting professors, financial analysts, and others. "It took me a while to figure out everything I needed to... It probably took a good month or so. There was a lot of noise in the financial statements." His piece was read by James Chanos, founder and president of Kynikos Associates, a firm that specialized in short-selling. How did Weill and Chanos figure Enron out when so many others were pushing up the stock price? How did they know to do that kind of analysis? Only the answer is simple: through study, application, and more application. You cannot develop financial analysis expertise overnight. Our objective in this document, however, is to present a very basic structure for financial analysis that will help move you toward that goal. We focus on what to look for in the financial statements, how to do basic ratio analysis, what financial forecasting entails, and how analysts use financial statement data in valuation. We intentionally focus on the mechanistic nature of financial analysis because these tools are fundamental building blocks common to the analysis of most firms. Without understanding this basic structure the unique issues facing a firm would be difficult to interpret.