Financial
Statement
Analysis
Chapter
1
In
almost
all
countries
in
the
world
today,
capital
markets
play
an
important
role
in
channeling
financial
resources
from
savers
to
business
enterprises
that
need
capital.
While
both
savers
and
entrepreneurs
would
like
to
do
business
with
each
other,
matching
savings
to
business
investment
opportunities
through
the
use
of
capital
markets
–
funding
business
ideas
with
the
highest
prospects
first
–
is
complicated
for
at
least
three
reasons:
-‐ Information
asymmetry
between
savers
and
entrepreneurs.
-‐ Potentially
conflicting
interests
–
credibility
problems.
-‐ Expertise
asymmetry.
The
information
and
incentive
issues
lead
to
what
economists
call
the
lemons
problem,
which
can
potentially
break
down
the
functioning
of
the
capital
market.
It
works
like
this.
Consider
a
situation
where
half
the
business
ideas
are
“good”
and
the
other
half
are
“bad”.
If
investors
cannot
distinguish
between
the
two
types
of
business
ideas,
entrepreneurs
with
“bad”
ideas
will
try
to
claim
that
their
ideas
are
as
valuable
as
the
“good”
ideas.
Realizing
this
possibility,
investors
value
both
good
and
bad
ideas
at
an
average
level.
Unfortunately,
this
penalizes
good
ideas,
and
entrepreneurs
with
good
ideas
find
the
terms
on
which
they
can
get
financing
to
be
unattractive.
As
these
entrepreneurs
leave
the
capital
market,
the
proportion
of
bad
ideas
in
the
market
increases.
Over
time,
bad
ideas
“crowd
out”
good
ideas,
and
investors
lose
confidence
in
this
market.
The
emergence
of
intermediaries
can
prevent
such
a
market
breakdown.
There
are
two
types
of
intermediaries
in
the
capital
markets.
Financial
intermediaries,
such
as
venture
capital
firms,
banks,
collective
investment
funds,
pension
funds,
and
insurance
companies,
focus
on
aggregating
funds
from
individual
investors
and
analyzing
different
investment
alternatives
to
make
investment
decisions.
Information
intermediaries,
such
as
auditors,
financial
analysts,
credit-‐rating
agencies,
and
the
financial
press,
focus
on
providing
or
assuring
information
to
investors
(and
to
financial
intermediaries
who
represent
them)
on
the
quality
of
various
business
investment
opportunities.
Corporate
managers
are
responsible
for
acquiring
physical
and
financial
resources
from
the
firm’s
environment
and
using
them
to
create
value
for
the
firm’s
investors.
Value
is
created
when
the
firm
earns
a
return
on
its
investment
in
excess
of
the
return
required
by
its
capital
suppliers.
Managers
formulate
business
strategies
to
achieve
this
goal,
and
they
implement
them
through
business
activities.
A
firm’s
business
activities
are
influenced
by
its
economic
environment
and
its
own
business
strategy.
The
economic
environment
includes
the
firm’s
industry,
its
input
and
output
markets,
and
the
regulations
under
which
the
firm
operates.
The
firm’s
business
strategy
determines
how
the
firm
positions
itself
in
its
environment
to
achieve
a
competitive
advantage.
A
firm’s
financial
statements
summarize
the
economic
consequences
of
its
business
activities.
Statement
Analysis
Chapter
1
In
almost
all
countries
in
the
world
today,
capital
markets
play
an
important
role
in
channeling
financial
resources
from
savers
to
business
enterprises
that
need
capital.
While
both
savers
and
entrepreneurs
would
like
to
do
business
with
each
other,
matching
savings
to
business
investment
opportunities
through
the
use
of
capital
markets
–
funding
business
ideas
with
the
highest
prospects
first
–
is
complicated
for
at
least
three
reasons:
-‐ Information
asymmetry
between
savers
and
entrepreneurs.
-‐ Potentially
conflicting
interests
–
credibility
problems.
-‐ Expertise
asymmetry.
The
information
and
incentive
issues
lead
to
what
economists
call
the
lemons
problem,
which
can
potentially
break
down
the
functioning
of
the
capital
market.
It
works
like
this.
Consider
a
situation
where
half
the
business
ideas
are
“good”
and
the
other
half
are
“bad”.
If
investors
cannot
distinguish
between
the
two
types
of
business
ideas,
entrepreneurs
with
“bad”
ideas
will
try
to
claim
that
their
ideas
are
as
valuable
as
the
“good”
ideas.
Realizing
this
possibility,
investors
value
both
good
and
bad
ideas
at
an
average
level.
Unfortunately,
this
penalizes
good
ideas,
and
entrepreneurs
with
good
ideas
find
the
terms
on
which
they
can
get
financing
to
be
unattractive.
As
these
entrepreneurs
leave
the
capital
market,
the
proportion
of
bad
ideas
in
the
market
increases.
Over
time,
bad
ideas
“crowd
out”
good
ideas,
and
investors
lose
confidence
in
this
market.
The
emergence
of
intermediaries
can
prevent
such
a
market
breakdown.
There
are
two
types
of
intermediaries
in
the
capital
markets.
Financial
intermediaries,
such
as
venture
capital
firms,
banks,
collective
investment
funds,
pension
funds,
and
insurance
companies,
focus
on
aggregating
funds
from
individual
investors
and
analyzing
different
investment
alternatives
to
make
investment
decisions.
Information
intermediaries,
such
as
auditors,
financial
analysts,
credit-‐rating
agencies,
and
the
financial
press,
focus
on
providing
or
assuring
information
to
investors
(and
to
financial
intermediaries
who
represent
them)
on
the
quality
of
various
business
investment
opportunities.
Corporate
managers
are
responsible
for
acquiring
physical
and
financial
resources
from
the
firm’s
environment
and
using
them
to
create
value
for
the
firm’s
investors.
Value
is
created
when
the
firm
earns
a
return
on
its
investment
in
excess
of
the
return
required
by
its
capital
suppliers.
Managers
formulate
business
strategies
to
achieve
this
goal,
and
they
implement
them
through
business
activities.
A
firm’s
business
activities
are
influenced
by
its
economic
environment
and
its
own
business
strategy.
The
economic
environment
includes
the
firm’s
industry,
its
input
and
output
markets,
and
the
regulations
under
which
the
firm
operates.
The
firm’s
business
strategy
determines
how
the
firm
positions
itself
in
its
environment
to
achieve
a
competitive
advantage.
A
firm’s
financial
statements
summarize
the
economic
consequences
of
its
business
activities.
