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Business Valuation and Federal Taxes: Procedure, Law and Perspective, 2nd Edition by Shannon P. Pratt, David Laro

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Chapter 12

Comparative Financial Statement Analysis

Summary

Once the financial statements have been adjusted to provide a sound basis for arriving at an opinion as to fair market value, the next step is to analyze the statements to reveal trends, strengths, and weaknesses.

Objective of Financial Statement Analysis

The objective of financial statement analysis is to provide analytical data to guide the valuation. The reliability of a valuation report may be evaluated partially on whether the financial analysis is adequate, and on the relevance of that analysis to the valuation conclusion.

Since “valuation . . . is, in essence, a prophecy [sic] as to the future,”1 the relevance of historical financial statements is merely as a guide for what to expect in the future. For most companies, a pure extrapolation of past results would provide a misleading prophecy as to the company's future.

Assessment of Risk

Risk can be defined as the degree of certainty (or lack thereof) of achieving future expectations at the times and in the amounts expected.

One of the most important products of financial statement analysis is to provide an objective basis for assessment of risk relative to industry average risk and/or risk of specific guideline companies. Risk analysis is of critical importance because, other things being equal, the higher the risk, the lower the fair market value of the company.

In the income approach, the higher the risk, the higher the market's required rate of expected return ...

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