5.2 Financial Ratios and Forecasting
Now that we are done, for now, with reading and interpreting financial statements, let’s discuss why these accounting data are so important and what can be done to make the interpretive process more effective. Keep in mind that the purpose of releasing Financial Statements is to enable effective credit and investment decisions, i.e., decisions regarding the future prospects of a business entity.
Potential and current lenders wish to assess the creditability of the firm and shareholders wish to assess the returns their investments will earn. Will the borrowing corporation be able to make timely interest payments on its debt? Will shareholders receive sufficient dividends and growth in their capital investments, i.e., increases in share prices, to justify owning a portion of this corporation after considering the risks involved?
A good predictor of stock price performance may be book value – assets less liabilities, and earnings. A recent study[1] has found that the usefulness of these predictor variables has become attenuated in recent years, more particularly since the crisis of 2000-2001. A more useful predictor is cash flow. Cash flows are easier to predict than earnings and book values and have greater impact on price than the others.
Yet, regulators and the accounting profession continue producing rulings that make reading statements more complex and therefore opaque. Accrual accounting, despite its flagrant flaws, has become a faith, rather than a science, that sufficiently describes a certain reality. Does one really need to pore through two hundred pages of arcane financial statement information in order to make an investment decision? Isn’t the purpose of a statement to simplify and clarify the financial condition and productivity of the corporation and its management?
Much has changed in recent decades. We now live in a much more technological world. Communications are faster. Investment analysis and its implementation are speedier. When we look at financial statements, little, if anything, has changed for the last one hundred years. Statements look the same; the accounts are the same. Double-entry bookkeeping has not advanced since it was developed in Italy by Luca Pacioli in 1494! Intangibles, including brand names, patents, customer lists, R&D-in-process, training, and information systems, are not carried on the balance sheet, but usually expensed only as incurred. More and more, investment decisions are made using data outside of the accounting sphere. Clearly, accounting reporting methods need updating[2].
On Achievement
The secret to getting ahead …is getting started.
-Mark Twain
The secret of achievement is to hold a picture of a successful outcome in the mind.
–Henry David Thoreau
Ninety-nine percent of the failures come from people…
who are in the habit of making excuses.
-George Washington Carver
Scientist and Inventor
Success is the ability to go from failure to failure without losing your enthusiasm.
–Winston Churchill