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A critical challenge for any economy is the allocation of savings to investment opportunities. Economies that do this well can exploit new business ideas to spur innovation and create jobs and wealth at a rapid pace. In contrast, economies that manage this process poorly dissipate their wealth and fail to support business opportunities.

In the twentieth century, we have seen two distinct models for channeling savings into business investments. Communist and socialist market economies have used central planning and government agencies to pool national savings and to direct investments in business enterprises. The failure of this model is evident from the fact that most of these economies have abandoned it in favor of the second model—the market model. In al-most all countries in the world today, capital markets play an important role in channel-ing financial resources from savers to business enterprises that need capital.

For example: how capital markets typically work. Savings in any economy are widely distributed among households. There are usually many new entrepreneurs and existing companies that would like to attract these savings to fund their business ideas. While both savers and entrepreneurs would like to do business with each other, matching savings to business investment opportunities is com-licated for at least two reasons. First, entrepreneurs typically have better information than savers on the value of business investment opportunities. Second, communication by entrepreneurs to investors is not completely credible because investors know entrepreneurs have an incentive to inflate the value of their ideas.

These information and incentive problems 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. Intermediaries are like a car mechanic who provides an independent certification of a used car’s quality to help a buyer and seller agree on a price. There are two types of intermediaries in the capital markets. Financial intermediaries, such as venture capital firms, banks, mutual funds, and insurance companies, focus on aggregating funds from individual investors and analyzing different investment alternatives to make investment decisions. In-formation intermediaries, such as auditors, financial analysts, bond-rating agencies, and the financial press, focus on providing information to investors (and to financial intermediaries who represent them) on the quality of various business investment opportunities. Both these types of intermediaries add value by helping investors distinguish “good” investment opportunities from the “bad” ones.

Financial reporting plays a critical role in the functioning of both the information intermediaries and financial intermediaries. Information intermediaries add value by either enhancing the credibility of financial reports (as auditors do), or by analyzing the information in the financial statements (as analysts and the rating agencies do). Financial intermediaries rely on the information in the financial statements, and supplement this information with other sources of information, to analyze investment opportunities. In the following section, we discuss key aspects of the financial reporting system design that enable it to play effectively this vital role in the functioning of the capital markets.

The purpose of this chapter is to outline a comprehensive framework for financial statement analysis. Because financial statements provide the most widely available data on public corporations’ economic activities, investors and other stake-holders rely on financial reports to assess the plans and performance of firms and corporate managers.

A variety of questions can be addressed by business analysis using financial statements, as shown in the following examples:

• A security analyst may be interested in asking: “How well is the firm I am following performing? Did the firm meet my performance expectations? If not, why not? What is the value of the firm’s stock given my assessment of the firm’s current and future performance?”

• A loan officer may need to ask: “What is the credit risk involved in lending a certain amount of money to this firm? How well is the firm managing its liquidity and sol-vency? What is the firm’s business risk? What is the additional risk created by the firm’s financing and dividend policies?”

• A management consultant might ask: “What is the structure of the industry in which the firm is operating? What are the strategies pursued by various players in the industry? What is the relative performance of different firms in the industry?”

• A corporate manager may ask: “Is my firm properly valued by investors? Is our investor communication program adequate to facilitate this process?”

• A corporate manager could ask: “Is this firm a potential takeover target? How much value can be added if we acquire this firm? How can we finance the acquisition?”

• An independent auditor would want to ask: “Are the accounting policies and accru-al estimates in this company’s financial statements consistent with my understanding of this business and its recent performance? Do these financial reports communicate the current status and significant risks of the business?”

Financial statement analysis is a valuable activity when managers have complete in-formation on a firm’s strategies and a variety of institutional factors make it unlikely that they fully disclose this information. In this setting, outside analysts attempt to create “in-side information” from analyzing financial statement data, thereby gaining valuable in-sights about the firm’s current performance and future prospects.

To understand the contribution that financial statement analysis can make, it is important to understand the role of financial reporting in the functioning of capital markets and the institutional forces that shape financial statements. Therefore, we present first a brief description of these forces; then we discuss the steps that an analyst must perform to extract information from financial statements and provide valuable forecasts.

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