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Analysis of Financial Statements, 3rd Edition


There is no doubt that the financial crises and scandals of the past few years, as well as the resulting legislation, regulation, and rulemaking, have changed financial analysis. That's why Pamela Peterson Drake and Frank Fabozzi decided to create the Third Edition of Analysis of Financial Statements.

Written to reflect current market conditions—but remaining true to the structure of previous editions—this reliable resource addresses the changing complexities of this discipline and provides an up-to-date perspective of what it really takes for an analyst or investor to assess a company's financial health and risks.

Throughout this new edition, the authors demonstrate the nuts and bolts of financial analysis by applying the techniques to actual companies. They set the stage for financial analysis in Part One with discussions of financial statements and the quality of available financial information. In Part Two, they walk you through how to judge a company's financial health using financial statement information in financial ratio analysis, earnings analysis, and cash flow analysis. In Part Three, the authors take analysis a step further by discussing how you can apply what you've learned to equity valuation, credit analysis, and fundamental factor models.

Filled with in-depth insights and expert advice, the Third Edition of Analysis of Financial Statements will help you excel at interpreting today's financial statements and enable you to use this information to make better investment decisions.

PAMELA PETERSON DRAKE, PhD, CFA, is the J. Gray Ferguson Professor of Finance and Head of the Department of Finance and Business Law in the College of Business at James Madison University. Prior to joining James Madison, she was an associate dean and professor of finance at Florida Atlantic University and, previous to that, a professor at Florida State University. She has published articles in numerous journals and collaborated with Frank Fabozzi on the previous edition of this book as well as Foundations and Applications of the Time Value of Money, Capital Budgeting, and Financial Management and Analysis, all published by Wiley. She received a BS in accountancy from Miami University and her PhD in finance from The University of North Carolina at Chapel Hill.

FRANK J. FABOZZI, PhD, CFA, CPA, is Professor of Finance at EDHEC Business School and a member of the EDHEC-Risk Institute. Prior to joining EDHEC in August 2011, he held various professorial positions in finance at Yale University's School of Management from 1994 to 2011 and was a visiting professor of finance and accounting at MIT's Sloan School of Management from 1986 to 1992. He is also editor of the Journal of Portfolio Management.

Preface xi

About the Authors xiii


The Basics 1


Introduction 3

What Is Financial Analysis? 4

Where Do We Find the Financial Information? 8

Who Gets What Type of Information and When? 10

What Does Sarbanes-Oxley Mean to Companies and Investors? 28

What Does the Dodd-Frank Act Mean for Companies and Investors? 32

Summary 34

Review 35


Financial Statements 37

Accounting Principles: What Are They? 37

What Do the Basic Financial Statements Tell Us? 39

Accounting Flexibility 56

How Does Accounting in the United States Differ from Accounting Outside of the United States? 58

Summary 59

Review 60


The Quality of Financial Information 63

It’s All in the Timing 65

Too Many Choices? 76

So What’s Their Business? 86

Restatements and Financial Analysis 87

Tell-Tale Signs 90

Summary 92

Review 95


Analysis of Financial Statements 99


Financial Analysis 101

What Are Financial Ratios and How Do We Use Them? 102

What Are the Different Types of Financial Ratios? 105

Analysis of Return-on-Investment Ratios 122

How Can We Use Common-Size Analysis to Analyze Financial Statements? 127

Integrated Ratio Analysis 130

What Are the Pitfalls and Pratfalls of Financial Ratio Analysis? 137

Summary 143

Review 144


Equity Analysis 147

Earnings 147

Price-Earnings Ratio 158

Dividends 161

Other Fundamentals 173

Book-to-Market Ratio 175

Summary 178

Review 179


Cash Flow Analysis 181

Measures of Cash Flow 181

Cash Flows and the Statement of Cash Flows 184

Free Cash Flow 189

The Usefulness of Cash Flows in Financial Analysis 196

Summary 202

Review 203


Applying Financial Analysis 205


Measuring Company Performance 207

Traditional Performance Measures 210

Measures of Value Added 212

Summary 237

Review 238


Corporate Credit Analysis 241

Types of Credit Risk 241

Factors to Consider in Corporate Credit Analysis 252

Summary 263

Review 264


Analysis of Equity Risk Using Fundamentals Factor Models 267

Measuring Risk 267

Asset Pricing Model 271

Factor Models 275

Fundamental Factor Models 276

Summary 280

Review 281


The Lessons We Learn 283

The Lessons 288

The Future of Financial Analysis in the Post-Crisis Era 298

Review 299

Answers to End-of-Chapter Questions 301

Index 305