Framework For Business Analysis and Valuation Using Financial Statements

Chapter 1: 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 analysis Financial 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 of Business Analysis

We can address quite a few questions by business analysis using financial statements From a security analysts perspective: How well is the firm performing? What is the value of the firms 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.
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 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 current performance and future prospects of the firm.
The role of financial reporting in capital markets

Savings
Net Savers
Financial Intermediaries
Information Intermediaries
Business Ideas
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
From business activities to financial statements

Business Environment Labor markets Capital Markets Product Markets: Suppliers Customers Competitors Business regulations Accounting environment Capital market structure Contracting and governance Accounting conventions and regulations Tax and financial accounting Third-party auditing Legal system for accounting disputes Financial statements Business Strategy Scope of business: Business Activities Operating Investing Financing Degree of diversification Types of diversification Competitive positioning: Cost leadership Product Differentiation
Accounting system
Measures and reports economic consequences of business activities
Key success factors and risks
Accounting strategy Choice of accounting policies Choice of accounting estimates Choice of reporting formats Choice of supplementary disclosures 11
Managers superior information on business activities

Estimation errors Distortion from managers accounting choices
From Business Activities to Financial Statements (cont)

A firms business activities are influenced by its business or economic environment and its own business strategy The business or economic environment includes the firms industry, its input and output markets, and regulations. Business strategy determines how the firm positions itself in its environment to achieve competitive advantage. The firms 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 firms 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 firms business activities and by its accounting system. Understanding the Accounting system is therefore very important!
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.
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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 ANALYSIS TOOLS Business Strategy Analysis Accounting Analysis Evaluate accounting quality by assessing accounting policies and estimates Generate performance expectations thru industry analysis and competitive strategy analysis Financial Analysis Evaluate performance using ratios and cash flow analysis Business Application context Credit analysis, Securities analysis, Merger & Acquisition analysis, Debt/Dividend analysis, Corporate communication strategy analysis, and General business 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 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 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

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Chapter 1: Framework for Business Analysis and Valuation Using Financial Statements

Financial statements to business analysis

Functions and Scope of Business Analysis

Functions of Business Analysis (Contd.)

Importance of financial analysis

The role of financial reporting in capital markets

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

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

From business activities to financial statements

Key success factors and risks

Managers superior information on business activities

From Business Activities to Financial Statements (cont)

From Business Activities to Financial Statements (cont)

A Critical Approach to Institutional Features of Accounting System

Business Analysis using Financial Statements

Steps of Business Analysis

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