Financial analysis is an information processing system used to provide relevant information for decision making. The main source of information is published financial statements. Basically, various accounts from published financial statements are evaluated in relation to each other to form performance indicators, which are then compared to ‘‘established’’ standards. These performance indicators are better known as ratios, and constitute the main tools of conventional financial analysis. Some of the ratios are particularly relevant to the prediction of economic events. It is therefore the purpose of this chapter to elaborate on financial analysis and the predictive approach.
The financial statements included in annual reports generally include a balance sheet, an income statement, a statement of changes in the financial position, notes to the financial statements, a reconciliation of retained earnings, an auditor’s opinion, and supplementary information on the effects of changing prices. These reports are discussed next.
The balance sheet, or statement of financial position, expresses the financial position of a firm at the end of the accounting period, a moment in time. More precisely, it presents both the assets of a firm and claims on those assets (liabilities and owner’s equity) at a point in time. Two major questions of interest