2026-2027 NEW UPDATE VERSION EDSPIRA’S COMPREHENSIVE GUIDE TO D366
Financial Statement Analysis CHAPTER 1-11 Western Governors University
EDSPIRA’S GUIDE TO
Financial Statement
Analysis
TABLE OF CONTENTS
Chapter 1: Introduction to Financial Statement Analysis.................................... 2
Chapter 2: The Tools of Financial Statement Analysis........................................ 6
Chapter 3: The Balance Sheet ...................................................................... 7
Chapter 4: The Income Statement .............................................................. 10
Chapter 5: Statement of Cash Flows ............................................................ 15
Chapter 6: Vertical Analysis ....................................................................... 38
Chapter 7: Horizontal Analysis................................................................... 44
Chapter 8: Cause-of-Change Analysis ......................................................... 48
Chapter 9: Ratio Analysis ......................................................................... 52
Chapter 10: ROA Decomposition .................................................................. 58
Chapter 11: Earnings Management ............................................................... 59
Supplemental Resources .......................................................................... 75
, EDSPIRA 2
Chapter 1: Introduction to Financial
Statement Analysis
The 3 most important financial statements are:
The Income Statement
The Balance Sheet
The Statement of Cash Flows
The role of the financial statements
The purpose of the financial statements is to communicate information about the company’s
profit, cash flow, and financial condition to investors and creditors.
• The financial statements can be used to predict future earnings.
• The financial statements can also be used to value the firm.
Unfortunately, the financial statements do not always provide an accurate presentation of the
company’s performance (they are an imperfect tool). This is because:
• The financial statements are backward-looking.
• Measuring the value of certain items is impossible or highly subjective.
• Management has an incentive to manipulate the financial statements.
Why would an executive manipulate the financial statements?
• To increase the stock price
• To reduce the cost of borrowing
• To avoid political costs/regulatory scrutiny1
• To conceal poor performance and avoid getting fired
1
Microsoft employed very conservative accounting practices in the 1990’s when it was accused of being a
monopoly. For example, Microsoft expensed 100% of software development costs (even though these costs
can be capitalized once the software reaches technological feasibility) and recorded high amounts of
unearned revenue. Some said Microsoft’s conservative accounting was used to avoid regulatory scrutiny.
, EDSPIRA 3
How common is manipulation?
• If there was no manipulation, companies would be equally likely to:
o Post a small gain as post a small loss
o Just barely meet analysts’ earnings forecast as just barely miss the forecast
• However, research shows that companies are much more likely to (1) post a small gain
than a small loss and to (2) just barely meet a forecast than to just barely report a miss2
o This suggests that executives manage earnings. If they are close to meeting a
threshold (e.g., posting a profit rather than a loss, or meeting a forecast rather
than reporting a miss), they will manipulate earnings to exceed the threshold.
• Some executives resort to manipulating earnings when a company’s growth levels off.
o Sales growth eventually slows down due to:
Everyone has the product, so growth is limited to:
Market
(a) replacement sales and
Saturation
(b) growth in the population
Achieving 60% sales growth is easy when sales are just
$1,000. When sales reach $100 billion, however, it is not
An Increased easy to have 60% sales growth because that involves
Sales Base finding $60 billion in new sales. That is a massive
amount of new sales that is nearly impossible to achieve
in one year even if you launch new products.
If you successfully grow sales, this will attract
Competition
competitors who will erode your market share.
When analyzing the financial statements, you should:
1. Assess their quality
For the balance sheet:
• Have assets been overstated or understated?
o Receivables and inventory could be overstated.
o The fair values of investments might be overly optimistic.
2
Degeorge, Patel, & Zeckhauser (1999). Earnings management to exceed thresholds. The Journal of
Business.
, EDSPIRA 4
o Some assets may be understated due to GAAP rules. Coca-Cola carries its
trademarks at historical cost per GAAP, but the fair market value of Coca-Cola’s
trademarks is much higher.
• Have liabilities been overstated or understated?
o The company might underestimate the damages for a pending lawsuit or
warranty costs.
o A company might even overstate its liabilities. (e.g., if it’s having a bad quarter
and decides to take a big bath with an excessively large restructuring charge,
only to reverse some of the charge in a future period, boosting the future
period’s earnings.3)
• Are there unrecorded assets or liabilities?
o For some companies, valuable assets don’t appear on the Balance Sheet per
GAAP rules (e.g., the company’s brand).
o Some companies take steps to keep liabilities off their Balance Sheet.
For the income statement:
• Have revenues been overstated or understated?
o Improper revenue recognition is the most frequent cause of accounting
restatements.
• Have expenses been understated or overstated?
o Understating expenses inflates current-year profitability.
o In some cases, companies actually overstate expenses as part of a “big bath.”
If you’re having a bad year, you could take more expenses than necessary to
inflate next year’s profit.4
For the statement of cash flows:
• Have investing or financing cash inflows been shifted to the operating section?
o Analysts focus on operating cash flow.5
• Have operating cash outflows been shifted to the investing section?
2. Make adjustments to increase their quality, predictive ability, and comparability
For example, you might:
• Ignore one-time gains (because they are unlikely to recur and not predictive of future
earnings)
3
The company Sunbeam did this in 1996-1997 under its CEO “Chainsaw Al” Dunlap.
4
In 1996, Sunbeam overstated its inventory writedown. This reduced COGS (and thus increased profit) in 1997.
5
For its 1999 fiscal year, Helen of Troy reported a $21.5 million cash inflow from the sale of marketable
securities as part of its operating section (sales of investments are typically reported in the investing section).
Financial Statement Analysis CHAPTER 1-11 Western Governors University
EDSPIRA’S GUIDE TO
Financial Statement
Analysis
TABLE OF CONTENTS
Chapter 1: Introduction to Financial Statement Analysis.................................... 2
Chapter 2: The Tools of Financial Statement Analysis........................................ 6
Chapter 3: The Balance Sheet ...................................................................... 7
Chapter 4: The Income Statement .............................................................. 10
Chapter 5: Statement of Cash Flows ............................................................ 15
Chapter 6: Vertical Analysis ....................................................................... 38
Chapter 7: Horizontal Analysis................................................................... 44
Chapter 8: Cause-of-Change Analysis ......................................................... 48
Chapter 9: Ratio Analysis ......................................................................... 52
Chapter 10: ROA Decomposition .................................................................. 58
Chapter 11: Earnings Management ............................................................... 59
Supplemental Resources .......................................................................... 75
, EDSPIRA 2
Chapter 1: Introduction to Financial
Statement Analysis
The 3 most important financial statements are:
The Income Statement
The Balance Sheet
The Statement of Cash Flows
The role of the financial statements
The purpose of the financial statements is to communicate information about the company’s
profit, cash flow, and financial condition to investors and creditors.
• The financial statements can be used to predict future earnings.
• The financial statements can also be used to value the firm.
Unfortunately, the financial statements do not always provide an accurate presentation of the
company’s performance (they are an imperfect tool). This is because:
• The financial statements are backward-looking.
• Measuring the value of certain items is impossible or highly subjective.
• Management has an incentive to manipulate the financial statements.
Why would an executive manipulate the financial statements?
• To increase the stock price
• To reduce the cost of borrowing
• To avoid political costs/regulatory scrutiny1
• To conceal poor performance and avoid getting fired
1
Microsoft employed very conservative accounting practices in the 1990’s when it was accused of being a
monopoly. For example, Microsoft expensed 100% of software development costs (even though these costs
can be capitalized once the software reaches technological feasibility) and recorded high amounts of
unearned revenue. Some said Microsoft’s conservative accounting was used to avoid regulatory scrutiny.
, EDSPIRA 3
How common is manipulation?
• If there was no manipulation, companies would be equally likely to:
o Post a small gain as post a small loss
o Just barely meet analysts’ earnings forecast as just barely miss the forecast
• However, research shows that companies are much more likely to (1) post a small gain
than a small loss and to (2) just barely meet a forecast than to just barely report a miss2
o This suggests that executives manage earnings. If they are close to meeting a
threshold (e.g., posting a profit rather than a loss, or meeting a forecast rather
than reporting a miss), they will manipulate earnings to exceed the threshold.
• Some executives resort to manipulating earnings when a company’s growth levels off.
o Sales growth eventually slows down due to:
Everyone has the product, so growth is limited to:
Market
(a) replacement sales and
Saturation
(b) growth in the population
Achieving 60% sales growth is easy when sales are just
$1,000. When sales reach $100 billion, however, it is not
An Increased easy to have 60% sales growth because that involves
Sales Base finding $60 billion in new sales. That is a massive
amount of new sales that is nearly impossible to achieve
in one year even if you launch new products.
If you successfully grow sales, this will attract
Competition
competitors who will erode your market share.
When analyzing the financial statements, you should:
1. Assess their quality
For the balance sheet:
• Have assets been overstated or understated?
o Receivables and inventory could be overstated.
o The fair values of investments might be overly optimistic.
2
Degeorge, Patel, & Zeckhauser (1999). Earnings management to exceed thresholds. The Journal of
Business.
, EDSPIRA 4
o Some assets may be understated due to GAAP rules. Coca-Cola carries its
trademarks at historical cost per GAAP, but the fair market value of Coca-Cola’s
trademarks is much higher.
• Have liabilities been overstated or understated?
o The company might underestimate the damages for a pending lawsuit or
warranty costs.
o A company might even overstate its liabilities. (e.g., if it’s having a bad quarter
and decides to take a big bath with an excessively large restructuring charge,
only to reverse some of the charge in a future period, boosting the future
period’s earnings.3)
• Are there unrecorded assets or liabilities?
o For some companies, valuable assets don’t appear on the Balance Sheet per
GAAP rules (e.g., the company’s brand).
o Some companies take steps to keep liabilities off their Balance Sheet.
For the income statement:
• Have revenues been overstated or understated?
o Improper revenue recognition is the most frequent cause of accounting
restatements.
• Have expenses been understated or overstated?
o Understating expenses inflates current-year profitability.
o In some cases, companies actually overstate expenses as part of a “big bath.”
If you’re having a bad year, you could take more expenses than necessary to
inflate next year’s profit.4
For the statement of cash flows:
• Have investing or financing cash inflows been shifted to the operating section?
o Analysts focus on operating cash flow.5
• Have operating cash outflows been shifted to the investing section?
2. Make adjustments to increase their quality, predictive ability, and comparability
For example, you might:
• Ignore one-time gains (because they are unlikely to recur and not predictive of future
earnings)
3
The company Sunbeam did this in 1996-1997 under its CEO “Chainsaw Al” Dunlap.
4
In 1996, Sunbeam overstated its inventory writedown. This reduced COGS (and thus increased profit) in 1997.
5
For its 1999 fiscal year, Helen of Troy reported a $21.5 million cash inflow from the sale of marketable
securities as part of its operating section (sales of investments are typically reported in the investing section).
