Understanding the Significance of Financial Statements in Stock Valuation

This article discusses the significance of financial statements in stock valuation. It explains the role of income statement, balance sheet, cash flow statement and change in equity statement in stock valuation. It also highlights the importance of considering future growth and sustainability of the business while estimating stock prices.

COMMUNICATION ACCOUNTING
Chapter 4- Financial Statements
STUDENT ID:
[Pick the date]

To be honest, I have always considered investing into stocks similar to the experience of a
fish market. However, I was amazed and fascinated when a basic yet powerful difference was
pointed between fish and stock. Fish are essentially dead when they are sold and would be
consumed. However, the same is not true about stocks which tend to reflect the firms which
are very much operating. This revelation was quite an eye opener and from that point, I was
quite sure that the financial statements would play a more crucial role that I previously
thought.
With regards to the utility of the financial statements also, I was only partially right since I
was under the impression that the stock prices tend to vary in accordance with the profits
generated by the business as reported in the income statement. However, it was quite
surprising to be honest that stock price are not reactive but proactive in the sense that they
tend to price in the futuristic growth of the company. As I was reading through the chapter, I
could partially understand why businesses having similar profits tend to have so different
valuation. This might be on account of the future expectations in terms of growth and profits.
Further, the role of financial statements was also different from my expectation considering
that they enable understanding of the past of the company which is a key for estimating the
future performance. It make sense that the past performance must be considered while
projecting the future growth as the past serves as a base model in which modifications can be
made based on the current and future variations in the key variables. Thus, I realised that
investing in stocks is not a straight forward science but rather involves prudent estimation
based on future estimates. Considering the subjectivity involved with estimation of likely
future growth, it does not come as a surprise that it is difficult to reach a fair price. Thus, we
can always find some market participants who are buying and others selling based upon their
difference in future expectations.
A fascinating concept highlighted in the chapter related to the concept of free cash flow and
its relational with the operational and financial aspects of the business. Through the
comparison between two firms, it has been explained how during evaluation not only the cash
flow from operations must be considered but also the cash invested in the business is to be
also considered. Hence, it helped me in understanding that decision making should not be
made on the current profits or operational cash flow being generated but the overall
sustainability of the same is considered to be critical. This is significant as the valuation of

the stock considers not only the present value of the profits or operational cash flow
generated but also the likely ability of the company to generate the same in the future.
Before studying this chapter, the only financial aspect that I considered to be vital was the
profit generated. But to my utter dismay, there are four components of financial statements
namely the income statement, balance sheet, cash flow statement and change in equity
statement. The income statement highlights the profitability of the business. However, the
balance sheet is also considered to be significant as it reflects the health of the business. This
is critical considering that the interest of the creditors and lenders that have extended
financial help and have pending payments from the business. As a result, it is imperative that
the business should be financially sound which provides the various stakeholders that the
business would continue to operate in the future. From an investor point of view also the
balance sheet would be important considering that the prevailing share price tends to reflect
future earnings which are possible only when the firm continues to operate.
Additionally, a pivotal role would be played by the cash flow statement considering the
income statement is prepared on accrual basis. This was quite interesting as I previously
considered the profit figure as sacrosanct and did not previously consider the need to
supplement the same with cash flow statement. I never considered that sales were made on
credit and hence there could be issue of bad collectibles, Also, the possibility of manipulation
of the statements to jack up profit did not ever occur to me. However, having read this
chapter has provided me valuable insights with regards to stock valuation and the need of
financial statements.