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Financial Accounting: In an Economic Context by Jamie Pratt

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FRAMEWORK FOR USING FINANCIAL STATEMENTS TO PREDICT FUTURE EARNINGS AND CASH FLOWS

Equity investors use financial information to predict future earnings and cash flows in their efforts to identify securities that will provide high returns. Creditors use financial information to predict whether companies can generate enough cash in the future to cover debt payments. Future cash flows are at the heart of a company's true value, which is of interest to both investors and creditors. The balance sheet provides a measure of a company's value at a given point in time—its book value (assets – liabilities). Unfortunately, book value is a far cry from true value or even the stock market's estimate of true value. As of December 31, 2008, for example, the book value of Yahoo! was $11.25 billion, while the total market price of its outstanding shares of stock was just under $17 billion!

As illustrated in Figure 5-1, reported book value and true value differ for three reasons: (1) the financial statements do not reflect the company's prospects within its business environment, (2) the financial statements do not reflect important unrecorded events, and (3) management prepares the reports in a biased manner.

FIGURE 5-1 Framework for financial statement analysis

image

Business Environment

Book value fails to reflect “true value” primarily because the financial statements are backward looking, and what ...

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