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Chapter19: Financial Statement AnalysisChapter Openerp. 627PART??VIN THE PREVIOUS chapter, we explored equity valuation techniques. These techniques take the firms dividends and earnings prospects as inputs. Although the valuation analyst is interested in economic earnings streams, only financial accounting data are readily available. What can we learn from a companys accounting data that can help us estimate the intrinsic value of its common stock? In this chapter, we show how investors can use financial data as inputs into stock valuation analysis. We start by reviewing the basic sources of such data—the income statement, the balance sheet, and the statement of cash flows. We next discuss the difference between economic and accounting earnings. Although economic earnings are more important for issues of valuation, we examine evidence suggesting that, whatever their shortcomings, accounting data still are useful in assessing the economic prospects of the firm. We show how analysts use financial ratios to explore the sources of a firms profitability and evaluate the “quality” of its earnings in a systematic fashion. We also examine the impact of debt policy on various financial ratios. Finally, we conclude with a discussion of the challenges you will encounter when using financial statement analysis as a tool in uncovering mispriced securities. Some of these issues arise from differences in firms accounting procedures. Others are due to inflation-induced distortions in accounting numbers.The Income StatementThe income statement A financial statement showing a firms revenues and expenses during a specified period.is a summary of the profitability of the firm over a period of time, such as a year. It presents revenues generated during the operating period, the expenses incurred during that same period, and the companys net earnings or profits, which are simply the difference between revenues and expenses.???It is useful to distinguish four broad classes of expenses: c