FINANCIAL Economic

STATEMENT - Identifying the economic characteristics of the industries in which a firm

ANALYSIS competes and mapping those characteristics into determinants of profitability
and risk
Strategies
- Describing the strategies that a firm pursues to differentiate itself from
competitors as a basis for evaluating a firm’s competitive advantages, the
sustainability and potential growth of a firm’s earnings, and its risks
Financial statement
- Evaluating the firm’s financial statements, including the accounting concepts
and methods that underlie them and the quality of the information they provide

SIX Step 1: Identify Economic Characteristics and Competitive Dynamics in the

INTERRELATED Industry
SEQUENTIAL The economic characteristics and competitive dynamics of an industry play a key role
STEPS IN in influencing the strategies firms in the industry employ, their profitability and risk
FINANCIAL factors, and therefore the types of financial statement relations you should expect to
STATEMENT observe.
ANALYSIS
TOOLS FOR STUDYING INDUSTRY ECONOMICS
1. Value Chain Analysis
- The value chain for an industry sets forth the sequence or chain of activities
involved in the creation, manufacture, and distribution of its products and
services. You also can use the value chain to identify the strategic positioning
of a particular firm within the industry
2. Porter’s Five Forces
- Porter suggests that five forces influence the level of competition and the
profitability of firms in an industry. Three of the forces—rivalry among existing
firms, potential entry, and substitutes—represent horizontal competition
among current or potential future firms in the industry and closely related
products and services. The other two forces—
- buyer power and supplier power—depict vertical competition in the value
chain, from the suppliers through the existing rivals to the buyers.
3. Economic Attributes Framework
- Demand
- Supply
- Manufacturing
- Marketing
- Investing and Financing

Step 2: Identify the Company Strategies

Firms establish business strategies to differentiate themselves from competitors, but an
industry’s economic characteristics affect the flexibility that firms have in designing
those strategies.
In many industries, however, products and ideas quickly get copied. Consider the
following examples: cell phones, tablets, and computer hardware; chicken, pizza, and
hamburger restaurant chains; and financial services. In these cases, firms may achieve
competitive advantage by being the first with a new concept or idea (referred to as first
mover advantage) or by continually investing in product development to remain on the
leading edge of change in an industry. Such competitive advantages are difficult (but not
impossible) to sustain for long periods of time.

Step 3: Assess the Quality of the Financial Statements

ACCOUNTING PRINCIPLES
In the Philippines, the Philippine Financial Reporting Standards (PFRS)/Philippine
Accounting Standards (PAS) are the new set of Generally Accepted Accounting
Principles (GAAP) issued by the Accounting Standards Council (ASC) to govern the
preparation of financial statements. These standards are patterned after the revised
International Financial Reporting Standards (IFRS) and International Accounting
Standards (IAS) issued by the International Accounting Standards Board (IASB).
Global harmonization in accounting standards should facilitate better financial
statement analysis, enabling analysts to evaluate and compare financial
statements from firms across many countries, prepared under similar accounting
principles. Accordingly, increasing comparability should make allocation of capital
more efficient worldwide.

BALANCE SHEET
- ASSET
Assets are probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events
- LIABILITIES
Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other entities in
the future as a result of past transactions or events.3
- EQUITY
The shareholders’ equity in a firm is a residual interest or claim. That is, the owners
have a claim on all assets not required to meet the claims of creditors. Therefore, the
valuation of assets and liabilities on the balance sheet determines the valuation of total
shareholders’ equity
 - INCOME STATEMENT
The second principal financial statement, the income statement, provides information
about the profitability of a firm for a period of time. As is common among analysts and
investors, we use the terms net income, earnings, and profit interchangeably when
referring to the bottom-line amount on the income statement.

Net income equals revenues and gains minus expenses and losses. Revenues
measure the inflows of assets and the settlements of obligations from selling goods and
providing services to customers. Expenses measure the outflows of assets that a firm
consumes and the obligations it incurs in the process of operating the business to
generate revenues. As a measure of performance for a period, revenues represent the
resources generated by a firm and expenses represent the resources consumed during
that period. Gains and losses result from selling assets or settling liabilities for more or
less than their book values in transactions that are only peripherally related to a firm’s
central operations.

Statement of cash flows

The third principal financial statement is the statement of cash flows. The purpose of
the statement of cash flows is important but simple: to inform financial statement
users about the sources and uses of cash, partitioned into its three business
activities: operating, investing, and financing.

CLASSIFICATION OF CASH FLOWS

1. Operating. Selling goods and providing services are among the most
important ways a financially healthy company generates cash. Assessing cash
flow from operations over several years indicates the extent to which operating
activities have provided the necessary cash to maintain operating capabilities (and
the extent to which firms have had to rely on other sources of cash)
2. Investing. The acquisition of long-lived productive assets, particularly
property, plant, and equipment, usually represents major ongoing uses of cash.
Firms must replace such assets as they wear out. If firms are to grow, they must
acquire additional long-lived productive assets. Firms obtain a portion of the cash
needed to acquire long-lived productive assets from sales of existing assets.
However, such cash inflows are seldom sufficient to cover the cost of new
acquisitions.
3. Financing. A firm obtains cash from short- and long-term borrowing and from
issuing preferred and common stock. It uses cash to repay short- and
long-term borrowing, to pay dividends, and to reacquire shares of outstanding
preferred and common stock.

Step 4: Analyze Profitability and Risk

Most financial statement analysis aims to evaluate a firm’s profitability and risk. This
twofold focus stems from the emphasis of investment decisions on returns and risk.

TOOLS OF PROFITABILITY AND RISK ANALYSIS

1. Common-Size Financial Statements - a tool that is helpful in highlighting
relations in a financial statement. Common-size income statements and
balance sheets express all items in the statement as a percentage of a common
base. Common-size balance sheets often use total assets as the base. Sales
 revenue is a common base in a common-size income statement
2. Percentage Chance Financial Statements - a tool that is helpful in highlighting
the relative rates of growth in financial statement amounts from year to year
and over longer periods of time. These statements present the percentage
change in the amount of an item relative to its amount in the previous period or
the compounded average percentage change over several prior periods.
3. Financial Statement Ratios - Financial statement ratios express relations
among various items from the three financial statements. Researchers and
analysts have found that such ratios are effective indicators of various dimensions
of profitability and risk and serve as useful signals of future profitability and risk.

Step 5: Prepare Forecasted Financial Statements and Step 6: Value the Firm
Each of the steps in our six-step analysis and valuation framework is important, but the
crucial (and most difficult) step is forecasting future financial statements. Such
forecasts are the inputs into valuation models or other financial decisions, and the
quality of the decisions rests on the reliability of the forecasts. The primary reason for
the analysis of a firm’s industry, strategy, accounting quality, and financial statement
ratios is to use them as the starting point for deriving forecasts of future
performance. Forecasted financial statements rely on assumptions you make about
the future.
To develop reliable estimates of firm value, and therefore to make intelligent investment
decisions, you must rely on well-reasoned and objective forecasts of the firm’s
future profitability and risk. Forecasts of future dividends, earnings, and cash flows form
the basis for the most frequently used valuation models.

SOURCES OF In the Philippines, business organizations are expected to have their financial
FINANCIAL statements available for the public’s eye. Majority of the businesses and even
STATEMENT government agencies have their financial statements posted on their websites.
INFORMATION However, some portions are kept hidden as respect to Republic Act No. 10173 or
better known as the “Data Privacy Act of 2012”

Richard Branson “BUSINESS OPPORTUNITIES ARE LIKE BUSES. THERE'S ALWAYS ANOTHER
ONE COMING.”

Mixed Attribute • To simplify the complexity of valuation of assets and liabilities in real companies.
Accounting
Model • Proposes application of a standardized framework to analyze the impact of events
and transactions on the financial statements.
• Characterizes most accounting standards implies that there is a mix of emphases
on balance sheet versus income statement accounts.

Double-Entry • Double-entry bookkeeping views transactions as having two equal sides, which
Bookkeeping requires that at least two accounts be affected when transactions and events are
recorded. That is, the ‘‘double’’ in double-entry bookkeeping refers to the fact that
there must be at least one debit to some account and at least one credit to
another.

Asset and Relevance and Representational Faithfulness

Liability Valuation
Relevant financial information is capable of making a difference in the decisions made
by users. Information may be capable of making a difference in a decision even if some
users choose not to take advantage of it or already are aware of it from other sources.
Financial reports represent economic phenomena in words and numbers. To be useful,
financial information not only must represent relevant phenomena, but it also must
faithfully represent the phenomena that it purports to represent. To be a perfectly faithful
representation, a depiction would have three characteristics. It would be complete,
neutral, and free from error. Of course, perfection is seldom, if ever, achievable. The
Board’s objective is to maximize those qualities to the extent possible
Valuations of assets and liabilities reflect
• Historical data
• Current information
• Expectations of future outcomes
Mixed Attribute Accounting Model is used to
• Provide an optimal mix of relevant and reliable information in the financial
statements.
• Help users better translate the information into
• Assessments of the risk
• Timing
• Amounts of future cash flows
• The conventional accounting model uses historical, or acquisition, costs to value
assets and liabilities and delays the recognition of value changes until external
market transactions validate their amounts. Use of acquisition costs generally
results in more representationally faithful asset and liability valuations than do
current values, but such valuation can lose relevance, especially as the time from
the initial transaction passes and historical values diverge from current values.
Income • Reporting cash inflows and outflows is representationally faithful but is often not
Recognition relevant for predicting future cash flows.
• Reporting income under accrual accounting procedures provides a measure of
financial performance that is more relevant for users interested in predicting the
ultimate payoff of cash flows, albeit with a potential for information to be less
representationally faithful
• The traditional accounting model relies mostly on historical values for assets and
liabilities and delays income recognition until realization (Approach 1). Under this
approach:
• asset and liability valuation directly link to income recognition.
• changes in the economic value of assets and liabilities are recognized in net
income when some market transaction triggers realization of the economic
value changes.

• However, the FASB and IASB are more often requiring the use of fair values for
certain assets and liabilities. Using the fair value approach for assets and liabilities
generally translates into Approach 3, which recognizes such economic value
changes in income immediately.

• As a hybrid of these approaches, some economic value changes are recognized on

the balance sheet and in comprehensive income before they are recognized in net
income on the income statement (Approach 2).
• In the intervening time, firms use accumulated other comprehensive income
(in shareholders’ equity) as a temporary ‘‘holding tank’’ for unrealized gains
and losses for which the assets and liabilities have been marked to fair value
but the gains and losses are yet to be realized in a market transaction.
• When the change in economic value is realized, the firm formally recognizes
the gains and losses by removing them from accumulated other
comprehensive income and reporting them within net income.

Purpose of the The objective of providing a statement of cash flows is to assist users in
Statement of understanding the cash inflows and outflows that support a firm’s primary activities. This
Cash Flows information is sometimes difficult to extract from the accrual accounting information on
the balance sheet and income statement.

The statement of cash flows gives you an understanding of how the business changed
during the period through the lens of the Cash account
The statement of cash flows provides numerous insights not available from either the
balance sheet or the income statement. Namely:
- It reconciles the change in cash on the balance sheet and net income reported in
the income statement.
- is logically organized in three sections (operating activities, investing activities,
and financing activities), which correspond to the primary pursuits necessary to
generate profits. Provides information about cash flows to and from entities,
 such as customers, suppliers, creditors, and investors, with whom the firm
conducts business.
- assists analysts with numerous other tasks, such as uncovering accounting
discretion, calculating free cash flows and identifying other information
unavailable elsewhere in the financial reports.

Firm’s Life Cycle The figure shows the usual life cycle of a firm in terms of:

1. Revenue - usually sa simula mababa talaga ang kita mo, yun ang nasa introduction
stage / introduction of your company and products; eventually it will increase once and
reach a certain peak (maturity) then will also decline (ito po yung stage na naluluge ka
kasi may product or service errors na or maaaring napagsawaan na ng consumers ang
products mo. Often, you must create interventions para kahit mag-decline ay
makasurvive pa din ang business mo)

2. Net Income – nagsisimula as negative kasi maaaring marami ka pang expenses

kesa sa revenue mo but unti-unti pa din itong mag-gogrow and will also reach a peak of
maturity. The difference lang ng curve na ito kesa sa curve ng revenue is it usually
starts negative and has more sudden effect of increase (hindi gaya ng sa revenue na
gradual ang pag-increase) This sudden increase is because usually you have more
stocks on hand and pag nasikat na ang business mo, you also increase your prices.
Therefore same lang ang level of expenses mo pero mas malaki na ang natatanggap
mong revenue kaya greater income na

3. Cash Flows

(a) operating – starts negative again since majority involves expenses but eventually
increases because of inflows from operations
(b) investing – also starts negative kasi madalas gagastos ka pa talaga sa una to buy
all necessary equipment and machineries or properties then saka ka pa naman kukuha
ng return on investment once nasa peak of maturity na ikaw.

(c) Financing – starts very high kasi inflow yan, meaning hindi sariling pera mo ang
ginamit mo. Maaaring nangutang ka sa iba so technically nadagdagan ang iyong cash
sa organization
Main points in
Cash Flow
Activities