CHAPTER 3 UNDERSTANDING FINANCIAL STATEMENTS

11 CHAPTER 3 UNDERSTANDING FINANCIAL STATEMENTSF inancial STATEMENTS provide the fundamental information that we use to analyze andanswer valuation questions. It is important, therefore, that we understand the principlesgoverning these STATEMENTS by looking at four questions: How valuable are the assets of a firm? The assets of a firm can come in several forms assets with long lives such as land and buildings, assets with shorter lives suchinventory, and intangible assets that still produce revenues for the firm such as patentsand trademarks. How did the firm raise the funds to finance these assets? In acquiring these assets, firmscan use the funds of the owners (equity) or borrowed money (debt), and the mix islikely to change as the assets age. How profitable are these assets? A good investment, we argued, is one that makes areturn greater than the hurdle rate. To evaluate whether the investments that a firm hasalready made are good investments, we need to estimate what returns we are making onthese investments.

statements do a reasonably good job of categorizing the assets owned by a firm, a partial job of assessing the values of these assets and a poor job of reporting uncertainty about asset values. In this section, we will begin by looking at the accounting principles underlying

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