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Firms with publicly-traded securities must submit certain financial statements to the Securities Exchange Commission (SEC). Companies must submit a 10-K, which is a summary of the firm’s financial performance using specific data following detailed rules. The 10-K includes the balance sheet, the statement of cash flows, and the income statement. Firms also must submit an annual report to their shareholders, which is a slightly different version of the firm’s performance, as mangers have a bit more flexibilty in conveying the information. Financial statements are typically constructed by internal employees and then audited by an outside body. A quick review of the construction of financial statements will be helpful before we analyze and interpret these statements.
For those who like to cook, financial statements share some attributes with recipes. A lasagna recipe might list the ingredients and detail the steps involved, but it might not explain how to know exactly when the noodles were done (but not overdone) and how to know when the cheese has melted to perfection, opting instead for “cook for about 35 minutes.” In order to better understand what makes a delicious lasagna, we need to know not only the ingredients and steps, but how to interpret the recipe and a basic understanding of cooking in general. In finance, a fundamental analysis of financial statements would be to review them and then perform some type of analysis of them. A fundamental analysis combines economics and accounting. The accounting provides the data on the financial statements; the economics provides the tools to analyze these statements. A successful analysis includes both the quantitative data (the financial statements) and analysis of this data (using, for example, ratio analysis). In this chapter we review the basic financial statements provided to us by the accountants and use economic analysis to analyze these statements.