1.3 Financial Statements and Analysis
The first step for implementing valuation is to understand exactly what we are trying to value. From a conceptual standpoint, it helps to have a couple of diagrams in mind when doing any type of valuation activity: the financial statements for the project. Figure 1.3 shows a balance sheet for a possible project that a firm is considering undertaking. For the purpose of valuation, all economic agents/quantities, whether they are companies, people, or assets (tangible or intangible), can be represented by balance sheets and income statements. We use this concept throughout this book. So, if you are unsure how to do this or find it hard to think about this conceptually, the book will provide many examples. Figure 1.3 is our first example of this. It denotes the balance sheet representation (as well as its associated income statement representation) of a project (in this case, the construction of a manufacturing plant). As with any balance sheet, the left-hand side represents the assets (in this case, the manufacturing plant), and the right-hand side represents the liabilities and the owners’, or shareholders’, equity.4 When we are doing a valuation, we are always valuing some part of this balance sheet. The income statement is a representation of the various cash flows produced by (or operating) the asset on the left-hand side of the balance sheet.
Figure 1.3 ABC Company project balance sheet and income statement
Before we do a valuation, we want to make sure that we analyze all aspects of this balance sheet and its associated income statement. This is precisely the goal of Chapter 2, “Financial Statement Analysis.” Chapter 2 discusses a few of the concepts and techniques to analyze this balance sheet and income statement. We will go through important linkages within the balance sheet, within the income statement, and across these two financial statements. We will also demonstrate some techniques to tease out what are the sensitive factors for success in these financial statements and how to figure these out. The goal of Chapter 2 is not to teach accounting; instead, we want to build on your existing foundation of knowledge in accounting to emphasize certain concepts and to introduce some new concepts that will prove particularly useful for valuation.