fin analysis chap1 (2010)

8/12/2019 Fin Analysis Chap1 (2010)

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Chapter 1:Framework

for Business

Analysis andValuation

Using

Financial

Statements


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Chapter 1:A framework for Business Analysis and

Valuation Using Financial Statements


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Learning Objectives

To outline a comprehensive framework forfinancial statement analysis

Financial statements provide the most

widely available data on publiccorporations economic activities

So, investors and other stakeholders rely onfinancial reports to assess the plans and

performance of firms and corporatemanagers.


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Agenda Functions of business analysis

Role of financial reporting in capital market

From business activities to financial statements

Financial statements to business analysis


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Functions and Scope of

Business Analysis

We can address quite a few questions by businessanalysis using financial statements

From a security analystsperspective: How well isthe firm performing? What is the value of the firms

stock given its current and future performance? (Goalof Wealth-maximization vs. profit maximization)

A loan officermay be interested in knowing the creditrisk of the firm, liquidity-solvency status, risk status, and

so on. (Liquidity vs. profitability principle)A management consultantmight be interested in thestructure of the industry in which the firm is operating,strategies of different players and their relativeperformances.


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Functions of Business Analysis

(Contd.)

A corporate managerrelates the performances ofthe firm with the stock price. He may be interestedin the state of communication between the firm and

investors. In cases, the corporate managermay like to know if

the firm is a potential take over target, the amount ofvalue addition in case of acquisitions, and so on.

An independent auditormay like to know whetherthe accounting policies and accrual estimates areconsistent with the business policy of the firm.


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Importance of financial analysis

Financial statement analysis is a valuable

activity when managers have complete

information on a firms strategies and more

importantly, the managers like the information

reflected in the financial statement. In reality,this is not often true. It enables the outside

analysts create inside information from

analyzing financial statement and thereby

gaining valuable insights about currentperformance and future prospects of the firm.


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The role of financial reporting in

capital markets

Savings

Business

Ideas

Financial

Intermediaries

Information

Intermediaries

Net Savers

Net Borrowers


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capital markets (Contd.)

What is the problem?

Matching savings to business ideas is complicated..

Entrepreneurs have better information

Entrepreneurs lack credibility because they have the incentives

to be over optimisticThese two reasons result in a classic lemons problem,e.g., bad ideascrowd out good ideas and investors lose confidence in this market.Suppose, initially there are 50% good firms and 50% bad firms. Both thetypes claim high prospect for the next year. Investors fail to distinguish the

two types and give them average credibility. For example, 50% credibilityturns up correct because 50% told lies. This demotivates the good firmsand they quit the market. The market now becomes full of bad firms. Inturn, among the bad firms, relatively good ones lose credibility because ofbad firms, and quit the market. At the end, it turns up that firms do notdeserve perfect credibility, that essentially leads to market break-down.


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capital markets (Contd.)

Intermediaries can prevent the market breakdown which resultedfrom the lemons problem since they provide independentcertification.

Intermediaries can be:

Financial Intermediaries:Venture capital firms, investmentbanks, merchant banks, banks, mutual funds, and insurancecompanies. These institutions rely on information of financialstatements and supplement this with other sources of informationto analyze investment opportunities.

Information Intermediaries: Auditors, financial analysts, bondrating agencies and financial press. These firms add value byenhancing the credibility of financial reports (as audit firms do) andby analyzing the information in the financial statements (asanalysts do).

Both types add value by distinguishing bad ideas from good ones


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From business activities to

financial statementsBusiness Environment

Labor markets

Capital Markets

Product Markets:

Suppliers

Customers

Competitors

Business regulations

Business Activities

Operating

Investing

Financing

Business Strategy

Scope of business:

Degree of diversification

Types of diversification

Competitive positioning:

Cost leadership

Product Differentiation

Key success factors andrisks

Accounting

environment

Capital market structure

Contracting and governance

Accounting conventions andregulations

Tax and financial accounting

Third-party auditing

Legal system for accountingdisputes

Accounting system

Measures and reportseconomic consequences of

business activities

Accounting strategy

Choice of accounting policies

Choice of accountingestimates

Choice of reporting formats

Choice of supplementarydisclosures

Financial statements

Managers superior informationon business activities

Estimation errors

Distortion from managersaccounting choices


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From Business Activities to

Financial Statements (cont)A firms business activities are influenced by its business oreconomic environment and its own business strategy

The business or economic environment includes thefirms industry, its input and output markets, andregulations.

Business strategy determines how the firm positionsitself in its environment to achieve competitive advantage.

The firms accounting system provides a mechanismthrough which business activities are selected, measured,and aggregated into financial statement data. Thus, in itsturn depends on accounting environment and accounting

strategy.


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From Business Activities to

Financial Statements (cont)

A firms financial statements summarize the economicconsequence of its business activities. However, the firmcannot report everything either because they are too

numerous or because they fear losing competitiveadvantage.

Thus Financial Statement data are influenced by boththe firms business activities and by its accountingsystem.

Understanding the Accounting system is therefore veryimportant!


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A Critical Approach to

Institutional Features of Accounting System

Accounting System (AS) Feature 1: Accrual system

Accrual system against cash based one

Investors preference for calendar basedperformance against function based one

Accounting System (AS) Feature 2 (a): Delegation tocorporate management

Regarding future consequence of current activities(expected realization of credit sales). This might berealistic (benefit) or fabricated (cost)


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A Critical Approach toInstitutional Features of Accounting System

(Contd)

AS Feature 2 (b): Conservatism and Uniformaccounting standard

Accounting standard limits the freedom ofmanagement by cost and conservatism principle

Accounting standards ( GAAPs like FASB, IAS,BAS for example) limit the freedom throughuniform accounting standard for differentorganizations.

AS Feature 2 (c): Role of auditing and law External auditing may curtail the freedom

Legal environment may curtail the freedom


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A Critical Approach toInstitutional Features of Accounting System (Cont)

AS Feature 3: Managers reporting strategy

The strategy may be to make either more or less

difficult for external users

Makes voluntary disclosure when accounting regulation

restricts certain disclosure

Competitive dynamic might hinder superior disclosure

Optimistic assessment of performances or hiding the

weakness of the firm may be necessary to influence

investors perceptions.

Information content of Financial Statements about the

business varies across firms and time, which provides

for both opportunity and challenge in business analysis.


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Business Analysis using Financial Statements

Financial Statements

Influenced by managers superior information onbusiness activities, noise from estimating errors, and

Distortions from managers accounting choices

Other Public Data

Like Industry and Firm data outside Financial

Statements

Business Application context

Credit analysis, Securitiesanalysis, Merger & Acquisition

analysis, Debt/Dividend

analysis, Corporate

communication strategy

analysis, and General business

analysis

ANALYSIS TOOLS

Business Strategy Analysis

Generate performance expectationsthru industry analysis and competitive

strategy analysis

AccountingAnalysis

Evaluate accounting

quality by assessing

accounting policies

and estimates

Financial Analysis

Evaluate performance using

ratios and cash flow analysis

Prospective

Analysis

Make forecasts and

value business


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Steps of Business AnalysisStep 1: Business Strategy Analysis

Identifies the key profit drivers and business risks, and makes an

Assessment of profit potentials at a qualitative level

Industry analysis to evaluate the sustainability of competitive

advantage

Step 2: Accounting Analysis

Evaluates the degree to which a firms accounting captures the

underlying business reality

Identifies the sources of distortion in accounting data, and makes

a revision

Step 3: Financial Analysis

Systematic and efficient analysis of sustainability of currentperformances by using financial data

Ratio analysis makes time series and cross section study, and

Cash flow analysis evaluates the cash management and liquidity

Step 4: Prospective Analysis:

Synthesis of all 3 above to predict future

fin analysis chap1 (2010)

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