Financial Analysis

F- 401
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 of business 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?”
 A loan officer may be interested in knowing the credit risk
of the firm
 A management consultant might be interested in the
structure of the industry to which the firm belongs
 A corporate manager may ask whether the firm is a
potential take over target and so on
Functions of business analysis (cont….)
 Financial statement analysis is a valuable tool since it
enables the outside analysts create ‘inside information’ there
by gaining valuable insights about current performance and
future prospects.

 The assumption is managers have complete information on

a firm’s strategies and current state of the art.
Functions of business analysis (cont….)
Question is: how much information can one garner from FSA?

In order to answer this question, we need to understand the

role of financial reporting in the functioning of capital
markets and the institutional forces that shape financial
statements.

That takes us to the next section…

 The role of financial reporting in capital
markets
Capital Markets

Savings

Financial Information
Intermediaries Intermediaries

Business Ideas
 The role of financial reporting in
capital markets
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 classic “lemon” problem

 The role of financial reporting in
capital markets
Intermediaries can prevent the market breakdown which
resulted from the lemon problem since they provide
independent certification.
Intermediaries can be:
 Financial: VC firms, Banks, Mutual funds
 Information: Auditors, Financial analysts, Bond rating
agencies
Both types add value by help distinguishing bad ideas from
good ones
 The role of financial reporting in
capital markets
Financial reporting plays a critical role in the
functioning of both types
 Information Intermediaries add value by either
enhancing the credibility or by analyzing the
information in the FS
 Financial intermediaries rely on FS information to
analyze investment opportunities.
 From business activities to financial
statements
Business Environment Business Strategy
Labor markets Scope of business:
Capital Markets Degree of diversification
Product Markets: Business Activities Types of diversification
Suppliers Operating Competitive positioning:
Customers Investing Cost leadership
Competitors Financing Differentiation
Business regulations Key success factors and risks

Accounting system
Accounting environment Accounting strategy
Measures and reports
Capital market structure economic consequences Choice of accounting policies
Contracting and governance of business activities
Choice of accounting
Accounting conventions and estimates
regulations
Choice of reporting formats
Tax
Choice of supplementary
Third party auditing Financial statements
disclosures
Legal system for accounting Managers’ superior
disputes 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
economic environment and its own business
strategy
 The 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.
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.
 A firm’s accounting system provides a mechanism through
which business activities are selected, measured and
aggregated into financial statement data.
 Thus FS data are influenced by both the firm’s business
activities and by its accounting system
Understanding the Accounting system is therefore very
important!!!
From Business Activities to Financial
Statements (cont…)
AS Feature 1: Accrual system
 Accrual accounting distinguishes between the recording of costs and
benefits associated with economic activities and the actual payment and
receipt of cash
 The effects of economic transactions are recorded on the basis of
expected not necessarily actual cash receipts and payments.
 The need for accrual accounting arises from investors’ demand for FR on
a periodic basis. Firms undertake economic transactions on a continual
basis and the arbitrary closing of accounting books a the the end of a
reporting period leads to a fundamental measurement problem. Accrual
accounting, as opposed to cash accounting, is designed to provide more
complete information about a firm’s periodic performance.
From Business Activities to Financial
Statements (cont…)
AS Feature 2: Accounting standards and auditing
 Because accrual accounting deals with expectations of future cash
consequences of current events, it is subjective and relies on a variety of
assumptions. The management of a firm is responsible for making those
estimates and assumptions since they have intimate knowledge of their
firm’s business.

 The delegation of financial reporting decisions to corporate managers

has both costs and benefits. On the one hand, the decisions allow the
manager to reflect inside information to FS. On the other hand, they have
an incentive to distort the numbers for their own advantage.
From Business Activities to Financial
Statements (cont…)
AS Feature 2: Accounting standards and auditing

 A number of conventions have evolved to ensure that

mangers use their accounting flexibility wisely. For example,
cost and conservatism conventions.

 Accounting standards ( GAAPs like FAS, IAS, BAS for

example) also limit potential distortions that managers can
introduce into reported numbers. Uniform accounting
standards attempt to reduce managers’ ability to influence
accounting numbers.
From Business Activities to Financial
Statements (cont…)
AS Feature 2: Accounting standards and auditing
 Increased uniformity from accounting standards comes at the expense
of reduced flexibility for mangers to reflect genuine business differences
in their firms’ FS.
 Auditing ensures that mangers use accounting rules and conventions
consistently over time. Therefore, auditing improves the quality of
accounting data.
Third party auditing, however, may also reduce the quality of FR
because it constrains the kind of accounting rules and conventions that
evolve over time.
 Legal environment may also have a significant effect on the quality of
reported numbers.
From Business Activities to Financial
Statements (cont…)
AS Feature 3: Managers’ reporting strategy
 A firm’s reporting strategy has an important influence on the firm’s FS
since managers have considerable discretion.
 Managers can choose accounting and disclosure policies that make it
more or less difficult for external users of FR . Accounting regulations
usually prescribe minimum disclosure requirements, but they do not
restrict the mangers from voluntarily providing additional disclosures.
 A superior disclosure strategy will enable managers to communicate
the underlying business reality to outside investors. Only constraining
factor would be competitive dynamics in the product market.
From Business Activities to Financial
Statements (cont…)
AS Feature 3: Managers’ reporting strategy
 Managers can use FR strategies to manipulate investors’ perceptions.
They can make it difficult for investors to identify poor performance on a
timely basis e.g. optimistic assessment

 Information content of FS about the underlying business varies across

firms and time, which provides for both opportunity and challenge in
business analysis.

We next discuss the process thru which we can separate ‘noise’ from
information in FS.
From Financial Statements to Business
Analysis
 Since Financial Statements may be subject to
manipulations by the management, investors discount a
firm’s reported accounting performance.

 Financial and information intermediaries can add value by

improving investors’ understanding of current performance
and future prospects.

 For our analysis, we would use the following framework.

 Analysis using Financial Statements

Financial Statements
Managers’ superior Business Application
information on business context
activities Credit analysis
Noise from estimating errors Securities analysis
Distortions from managers’ M&A analysis
accounting choices
Debt/Dividend analysis
Other public Data
Corporate communication
Industry and Firm data strategy analysis
Outside Financial Statements General business analysis

ANALYSIS TOOLS
Business Strategy
Analysis
Generate performance
expectations thru industry
analysis and competitive
strategy analysis

Accounting Analysis Financial Analysis Prospective Analysis

Evaluate accounting quality by
Evaluate performance using Make forecasts and value
assessing accounting policies
ratios and cash flow analysis business
and estimates
From Financial Statements to Business
Analysis
Essentially four steps to follow:
 Step 1: Business Strategy Analysis

 Step 2: Accounting Analysis

 Step 3: Financial Analysis

 Step 4: Prospective Analysis