UNIVERSITY OF ECONOMICS – THE UNIVERSITY OF DANANG

ACCOUNTING FACULTY

FINANCIAL ANALYSIS

Instructor: Ha Phuoc Vu, Ph.D

University of Economics – The University of Danang

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SYLLABUS

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 SYLLABUS
Chapter Content Period Resources
Chapter 2, 3, 4, 5 – Textbook 1
1 Overview of Financial Analysis Week 1 - 2
Chapter 1 – Textbook 2
2 Capital Structure Analysis Week 3 - 4 Chapter 6, 7 – Textbook 1

Chapter 8 – Textbook 1
3 Business Performance Analysis Week 5 - 7
Chapter 4 – Textbook 2
Chapter 6, 7 – Textbook 1
4 Business Risk Analysis Week 8 - 10
Chapter 5 – Textbook 2
5 Business Valuation Week 11 - 12 Chapter 12, 13, 14 – Textbook 2

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 ASSESSEMENT
No Assessment Description of Assessment Weight
Component
- Class participation and discussion
1 Component 1 20 %
- Activity, homework….

2 Component 2 - Group-work report 20 %

Component 3 - Exam format: essay questions

3 60 %
(Final Exam) - Exam duration: 90 minutes

Total 100%

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 CHAPTER 0

FRAMEWORK FOR BUSINESS ANALYSIS USING

FINANCIAL STATEMENTS

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 FINANCIAL STATEMENTS AND BUSINESS ANALYSIS

• Business intermediaries use financial statements to accomplish four key objectives:

– Business strategy analysis
– Accounting analysis
– Financial analysis
– Prospective analysis
(Palepu & Healy, 2005)

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 THE IMPORTANCE OF STRATEGY ANALYSIS

• Strategy drives the actions of an organization.

• Studying a firm’s strategy provides:
– An understanding of what drives risks, profitability, and competitive advantages
– A basis for future performance to be forecasted
– An idea of how to measure the success of a firm’s actions

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 STRATEGY ANALYSIS (cont)
- Macro-environment analysis: determine direct/indirect influent factors to all enterprises in
all industries.
- PESTLE analysis

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 STRATEGY ANALYSIS (cont)

- Macro-environment analysis: determine direct/indirect influent factors to all enterprises in

all industries. PESTLE
+ Politics: how the government intervenes in the economy. Ex: tax policy, labor law,
environmental law, trade restriction, tariffs, and political stability.
+ Economic: Ex: economic growth, interest rates, exchange rates, the inflation rate,
unemployment rate, …

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 STRATEGY ANALYSIS

• Macro-environment analysis: PEST + 2

+ Social/Cultural: the cultural aspects and health consciousness, population growth
rate, age distribution, career attitudes, emphasis on safety, gender, age, ethnicity,
knowledge of languages, disabilities, home ownership, employment status, religious
belief or practice, culture and tradition, living standards and income level.….
+ Technology: R&D activity, automation, technology incentives and the rate
of technological change

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 STRATEGY ANALYSIS
• Macro-environment analysis: PEST + 2

+ Legal factor : certain laws that affect the business environment in a certain country.
Ex: consumer laws, safety standards, labor laws…

+ Environmental factor: include all those that influence or are determined by the
surrounding environment. This aspect of the PESTLE is crucial for certain industries. Ex:
tourism, farming, agriculture …

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 KEY CONCEPTS IN STRATEGY ANALYSIS

• The importance of industry-level analysis

• Porter’s “five forces” framework for industry analysis
• Competitive strategy analysis of the firm

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 THE IMPORTANCE OF INDUSTRY-LEVEL ANALYSIS

• A firm’s strategy is heavily influenced by the industry it belongs to.

• Understanding the environment and competitive forces within an industry helps with
evaluating the quality of a particular firm’s strategy.
• Porter created a useful framework to evaluate the competitive forces at work in an
industry, as seen in Figure 2-1.

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INDUSTRY STRUCTURE AND PROFITABILITY

Porter’s “five forces” framework for industry analysis

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 COMPETITIVE FORCE 1: RIVALRY AMONG EXISTING FIRMS

• Higher degrees of competition among firms:

– Push prices towards the marginal cost of production.
– Make non-price dimensions of products or services more important.

• Determinants of the intensity of competition among firms:

– Industry growth rate.
– Concentration and balance of competitors.

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 RIVALRY AMONG EXISTING FIRMS

• Determinants of the intensity of competition among firms:

– Degree of differentiation in products and services and switching costs.
– Scale/Learning economies and ratio of fixed to variable costs.
– Excess capacity and exit barriers.

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 COMPETITIVE FORCE 2: THREAT OF NEW ENTRANTS

• The ease with which a new firm can enter an industry will affect the profitability of
other firms within the industry.

• Factors affecting the barriers to entry are:

– Economies of scale

– First mover advantage

– Distribution access

– Relationships with suppliers and customers

– Legal barriers

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 COMPETITIVE FORCE 3: THREAT OF SUBSTITUTE PRODUCTS
• The degree to which substitute products or services exist affects the industry’s
bargaining power with suppliers and customers, and ultimately profitability.
• The degree to which substitutes exist depends upon the relative price and performance
of competing products or services, and the willingness of customers to accept
substitutes.

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 COMPETITIVE FORCE 4: BARGAINING POWER OF BUYERS
• Buyer bargaining power can exert downward pressure on prices.
 Switching cost
 Differentiation
 Importance of product for costs and quality
 Number of buyers
 Volume per buyer
• Factors that can affect this bargaining power are:
 Buyer price sensitivity to product or service
 Relative bargaining power of buyers

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 COMPETITIVE FORCE 5: BARGAINING POWER OF SUPPLIERS

• A mirror image of the bargaining power of suppliers.

 Switching cost

 Differentiation

 Importance of product for costs and quality

 Number of suppliers

 Volume per supplier

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 COMPETITIVE STRATEGY ANALYSIS
• Individual firms must choose appropriate strategies to succeed within their industry
segment.
• Two basic competitive strategies are:
– Cost leadership
– Product / service differentiation
• Figure 2-2 conveniently summarizes aspects of cost leadership and differentiation.

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STRATEGIES FOR CREATING COMPETITIVE ADVANTAGE

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 ACHIEVING AND SUSTAINING COMPETITIVE ADVANTAGE
• Choice of strategy is an important first step for a firm. The likelihood of achieving and
sustaining competitive advantage must be evaluated.
• Factors to evaluate include:
 Resources and capabilities to implement strategies.
 Whether the firm’s activities, infrastructure, and other operating elements consistent
with its competitive strategy.

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 THE IMPORTANCE OF ACCOUNTING ANALYSIS

• Purpose: evaluate the degree to which a firm’s accounting captures its underlying
business reality.
• Understanding accounting allows the business analyst to effectively use the financial
information disclosed by companies.

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 KEY CONCEPTS IN ACCOUNTING ANALYSIS

• Various factors influence the quality of accounting-based financial reports.

• Managers have some discretion in accounting choices used in financial reporting.

Applying accounting principles is the responsibility of management, who has superior
knowledge of a firm’s business.

• Incentives exist for management to distort accounting numbers in their favor. Incentives
for the management of financial reporting items must be considered by the analyst.

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 MANAGER’S ACCOUNTING CHOICES
• Managers have a number of incentives to choose accounting disclosures that are
biased:
– Debt covenants
– Compensation contracts
– Tax considerations
– Regulatory considerations
– Capital market and stakeholder considerations
– Competitive considerations

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS

• Step 1: identify principal accounting policies

• Step 2: assess accounting flexibility
• Step 3: evaluate accounting strategy
• Step 4: evaluate the quality of disclosure
• Step 5: identify potential red flags
• Step 6: undo accounting distortions

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS

• Step 1: Identify Principal Accounting Policies

– Key policies and estimates used to measure risks and critical factors for success
must be identified.

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS

• Step 2: Assess Accounting Flexibility

- Not all firms have equal flexibility in choosing their accounting policies and estimates.
(constrained by accounting standards and conventions)
Ex: R&D cost in biotechnology company, marketing and brand building cost in consumer
goods firm VS bad debt in banks, capitalize cost in software developers
- All firms have some flexibility in choosing several accounting policies: depreciation
policy, inventory accounting policy….

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS
• Step 3: Evaluate Accounting Strategy

- Flexibility in accounting choices allows managers to strategically communicate

economic information or hide true performance..

- Issues to consider include:

– Norms for accounting policies with industry peers

– Incentives for managers to manage earnings

– Changes in policies and estimates and the rationale for doing so (weighted average
→ FIFO: supplier price increase )

– Whether transactions are structured to achieve certain accounting objectives

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS
• Step 4: Evaluate the Quality of Disclosure

- Managers have considerable discretion in disclosing certain accounting information

- Issues to consider include:

– Does the company provide adequate disclosures to access the firm’s business strategy
and its economic consequences? (letter to the shareholders)

– Does the footnotes adequately explain its current performance?

– Does the firm adequately explain its current performance? (accountability report)

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS
• Step 4: Evaluate the Quality of Disclosure

• Issues to consider include: (continued)

– If accounting rules and conventions restrict the firm from measuring its key success
factors appropriately, does the firm provide adequate additional disclosure to help
outsiders understand how these factors are being managed?

– If the firm is in multiple business segment, what is the quality of segment

disclosure?

– How good is the firm’s investor relation program? Is management accessible to

analysts?

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS
• Step 5: Identify Potential Red Flags

-Some issues that warrant gathering more information include:

– Unexplained transactions that boost profits

– Unusual increases in inventory or accounts receivable in relation to sales

– Increases in the gap between net income and cash flows

– Use of R&D partnerships, SPEs or the sale of receivables to finance operations

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS

• Step 5: Identify Potential Red Flags, continued

-More issues that warrant gathering more information:
– Unexpected large asset write-offs
– Large fourth-quarter adjustments
– Qualified audit opinions or auditor changes
– Related-party transactions (lack of objectivity of the marketplace)

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 STEPS IN PERFORMING ACCOUNTING ANALYSIS
• Step 6: Undo Accounting Distortions

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 FINANCIAL ANALYSIS
• Purpose: to assess the performance of a firm in the context of its stated goal and
strategy.

• There are two primary tools in financial analysis:

o Ratio analysis – to assess how various line items in financial statements relate to
each other and to measure relative performance.

o Cash flow analysis – to evaluate liquidity and the management of operating,

investing, and financing activities as they relate to cash flow.

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 PROSPECTIVE ANALYSIS: FORECASTING AND VALUATION

• Purpose: to make prediction about a firm’s future

• Two commonly used techniques in prospective analysis:
o Financial statement forecasting
o Business valuation
 Future cash flow performance
 Current book value of equity, future ROE and growth

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BUSINESS ANALYSIS USING FSS

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