Chapter 1: Framework for Business Analysis and

Valuation Using

Financial

Statements

Chapter 1:A framework for Business Analysis and Valuation Using Financial Statements

Chapter 1:A framework for Business Analysis and Valuation Using Financial Statements

Learning Objectives

• To outline a comprehensive framework for financial statement analysisFinancial statements provide the most

widely available data on public corporations’ economic activities

So, investors and other stakeholders rely on financial reports to assess the plans and performance of firms and corporate managers.

Agenda

Functions of business analysis

Role of financial reporting in capital market

From business activities to financial statements

Financial statements to business analysis

Functions and Scope ofBusiness Analysis

We can address quite a few questions by business analysis using financial statements… From a security analyst’s perspective: “ How well is the firm performing? What is the value of the firm’s stock given its current and future performance?” (Goal of Wealth-maximization vs. profit maximization) A loan officer may be interested in knowing the credit risk of the firm, liquidity-solvency status, risk status, and so on. (Liquidity vs. profitability principle) A management consultant might be interested in the structure of the industry in which the firm is operating, strategies of different players and their relative performances.

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Functions of Business Analysis (Contd.)

A corporate manager relates the performances of the firm with the stock price. He may be interested in the state of communication between the firm and investors.

In cases, the corporate manager may like to know if the firm is a potential take over target, the amount of value addition in case of acquisitions, and so on.

An independent auditor may like to know whether the accounting policies and accrual estimates are consistent with the business policy of the firm.

Importance of financial analysis

Financial statement analysis is a valuable activity when managers have complete information on a firm’s 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 current performance and future prospects of the firm.

The role of financial reporting in capital markets

Savings

Business Ideas

Financial Intermediaries

Information Intermediaries

Net Savers

Net Borrowers

The role of financial reporting in 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 optimistic

These two reasons result in a classic “lemons” problem, e.g., bad ideas “crowd out” good ideas and investors lose confidence in this market. Suppose, initially there are 50% good firms and 50% bad firms. Both the types claim high prospect for the next year. Investors fail to distinguish the two types and give them average credibility. For example, 50% credibility turns up correct because 50% told lies. This demotivates the good firms and they quit the market. The market now becomes full of ‘bad firms’. In turn, among the bad firms, relatively good ones lose credibility because of bad firms, and quit the market. At the end, it turns up that firms do not deserve perfect credibility, that essentially leads to market break-down.

The role of financial reporting in capital markets (Contd.)

Intermediaries can prevent the market breakdown which resulted from the lemons problem since they provide independent certification.Intermediaries can be: Financial Intermediaries: Venture capital firms, investment banks, merchant banks, banks, mutual funds, and insurance companies. These institutions rely on information of financial statements and supplement this with other sources of information to analyze investment opportunities. Information Intermediaries: Auditors, financial analysts, bond rating agencies and financial press. These firms add value by enhancing the credibility of financial reports (as audit firms do) and by analyzing the information in the financial statements (as analysts do).Both types add value by distinguishing bad ideas from good ones

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From business activities to financial statements

Business Environment

Labor marketsCapital MarketsProduct Markets: Suppliers Customers CompetitorsBusiness regulations

Business ActivitiesOperatingInvestingFinancing

Business Strategy

Scope of business:

Degree of diversification

Types of diversification

Competitive positioning:

Cost leadership

Product Differentiation

Key success factors and risks

Accounting environment

Capital market structure

Contracting and governance

Accounting conventions and regulations

Tax and financial accounting

Third-party auditing

Legal system for accounting disputes

Accounting system

Measures and reports economic consequences of

business activities

Accounting strategy

Choice of accounting policies

Choice of accounting estimates

Choice of reporting formats

Choice of supplementary disclosures

Financial statements

Managers’ superior information on business activities

Estimation errors

Distortion from managers’ accounting choices

From Business Activities to Financial Statements (cont…)

A firm’s business activities are influenced by its business or economic environment and its own business strategyThe business or economic environment includes the firm’s industry, its input and output markets, and regulations. Business strategy determines how the firm positions itself in its environment to achieve competitive advantage.The firm’s accounting system provides a mechanism through which business activities are selected, measured, and aggregated into financial statement data. Thus, in its turn depends on accounting environment and accounting strategy.

From Business Activities to Financial Statements (cont…)

A firm’s financial statements summarize the economic consequence of its business activities. However, the firm cannot report everything either because they are too numerous or because they fear losing competitive advantage. Thus Financial Statement data are influenced by both the firm’s business activities and by its accounting system. Understanding the Accounting system is therefore very important!

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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 based

performance against function based one

Accounting System (AS) Feature 2 (a): Delegation to corporate management

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

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A Critical Approach to Institutional Features of Accounting System

(Contd)

AS Feature 2 (b): Conservatism and Uniform accounting standard

• Accounting standard limits the freedom of management by cost and conservatism principle

• Accounting standards ( GAAPs like FASB, IAS, BAS for example) limit the freedom through uniform accounting standard for different organizations.

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 to Institutional 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.

Business Analysis using Financial Statements

Financial Statements

Influenced by managers’ superior information on business 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, Securities analysis, Merger & Acquisition analysis, Debt/Dividend analysis, Corporate communication strategy analysis, and General business analysis

ANALYSIS TOOLS

Business Strategy Analysis

Generate performance expectations thru industry analysis and competitive

strategy analysis

Accounting Analysis

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

Steps of Business Analysis Step 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 AnalysisEvaluates the degree to which a firm’s 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 current performances 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