Reading: Accounting Framework

The financial statements we use for financial analysis should provide a fair account of the asset structure, financing policy, and earnings capacity that are relevant for the firm's business activities. If the account these statements provide is biased, the resulting financial analysis will most likely also be biased.

There are various reasons why such bias could arise (especially when looking at firms that are not listed on a stock exchange and, therefore, governed by less strict accounting and disclosure rules). Three of the most common sources are:

• Depreciation policy: Often, depreciation charges reflect tax considerations instead of the actual use of the firm's assets. The book value of assets therefore often understates the acutal (replacement) value of these assets. If possible, financial analysis shold be based on depreciation charges that reflect the actual use of the assets.
• Research and development (R&D): Very often, money spent for R&D is included in the firm's SG&A expenses and, therefore, fully charged to the income statement in the year the money was spent. Economically, one could argue that R&D generates an asset with a useful life longer than 1 year. Therfore, for financial analysis, R&D should be activated on the balance sheet and depreciated over it's useful life (that is, it sould be treated as an investment, similar to property, plant, and equipment).
• Operating leasing: Historically, cash flows arising from operating leases were treated as operating expenses and charged to the income statement. Economically, a lease (regardless of whether it is an operating or a financial lease) constitutes a purchase of an asset on credit. Therefore, the lessee should recognize the associated assets and liabilities on the balance sheet. Note that, in early 2016, the FASB has decided to make this adjustment to the accounting standards. 

A detailed discussion of these items goes beyond the scope of this introductory course.

A quick check that we should always run, however, fefers to the presence of non-operating assets!

Since the main purpose of financial analysis is to assess the financial health and performance of the firm's core business activities, the financial statements we use should only include the assets, liabilities, equities, reveneues, and expenses that are actually relevant for these business activities. That is not always the case.

An excellent case in point is Apple:

• At the end of their 2015 business year, the firm's balance sheet reported total assets of USD 290 billion (see, for example, here). 
• For this business year, the firm's income statement reported an operating income (EBIT) of 71 billion (see, for example, here). 
• One could therefore conclude that the firm's Return on Asset (ROA) was roughly 24% [= 71/290].

Is the ROA of 24% a fair assessment of the Apple's operating profitability? 

Probably not. The reason is that Apple's balance sheet contains a lot of assets that are not direclty required for it's operating business: It holds financial investments of rougly 185 billion. 

Arguably, these financial investments are the result of a highly successful and profitable business in the past. However, they do not contribute to the firm's operating profit of 71 billion. To get a less biased view on the financial performance of the company, we should, therefore exclude them from the analysis.

If we exclude these assets from the balance sheet, total assets drop to 105 billion [= 290 - 185]. Consequently, the "operating" return on assets (ROA) would increase to approximately 68% [= 71/105]!

This simple illustration shows how important it is to make sure that our analysis is not affected by positions and activities that are not directly relevant for the firm's business. Before doing financial analysis, we should therefore have a critical look at the financial statements and try to filter out items that are not business relevant. Very often, this means:

• Take a critical look at the position Cash and equivalents. Only include the part of cash that is actually relevant. Treat the rest as "Excess cash" and exclude it from the analysis.
• Take a critical look at financial investments. Most operating firms do not need financial investments to run their business.
• Take a critical look at real estate.