A Framework for Business Analysis and Valuation Using Financial Statements

The Role of Financial Reporting in Capital Markets

• Financial reporting plays a critical role in the functioning of both information intermediaries and finan
cial intermediaries.
• Information intermediaries add value by either enhancing the credibility of financial reports (such as
external auditors), or by analyzing the information in the financial statements (such as analysts).
• Financial intermediaries rely on the information with other sources of information.

CAPITAL MARKETS

Savings

FINANCIAL INFORMATION
INTERMEDIARIES INTERMEDIARIES

Business
Ideas

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 A Framework for Business Analysis and Valuation Using Financial Statements
From Business Activities to Financial Statements

• Corporate managers are responsible for acquiring physical and financial resources from the firm’s environ-
ments and using them to create value for the firm’s investors. Value is created when the firm earns return
on investment in excess of the cost of capital.
• Managers formulate business strategies to achieve this goal, and they implement them through business
activities. A firm’s business activities are influenced by its economic environment and its own business
strategy.
• The economic environments includes the firm’s industry, its input and output markets; and the regulations
under which the firm operates. The firm’s business strategy determines how the firm positions itself in its
environment to achieve a competitive advantage.
• A firm’s financial statements summarize the economic consequences of its business activities. The firm’s
business activities in any time period are too numerous to be reported individually to outsiders. Further,
some of the activities undertaken by the firm are proprietary in nature, and disclosing these activities in
detail could be a detriment to the firm’s competitive position.
• The firm’s accounting system provides a mechanism through which business activities are selected, and
aggregated into financial statement data.
• Intermediaries using financial statement data to do business analysis have to be aware that financial
reports are influenced both by the firm’s business activities and by its accounting system.
• A key aspect of financial statement analysis, therefore, involves understanding the influence of accounting
system on the quality of the financial statement data being used in the analysis, that consists of:
– Accrual Basis Accounting
– Accounting Standards and Auditing
– Managers’ Reporting Strategy

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 A Framework for Business Analysis and Valuation Using Financial Statements
From Business Activities to Financial Statements

Accrual Accounting
• Corporate financial reports is prepared using accrual basis accounting rather than cash basis accounting.
Accrual basis accounting distinguishes between the recording of costs and benefits associated with
economic activities and the actual payment and receipt of cash. Net income is the primary periodic
performance index under accrual basis accounting.
• To determine net income, the effects of economic transactions are recorded on the basis of expected, not
necessarily actual, cash receipts and disbursements. Expected cash receipts from the delivery of products
and services are recognized as revenue, and expected cash outflows associated with these revenues are
recognized as expenses.
• The need for accrual basis accounting arises from investors’ demand for financial reports on a periodic
basis. Firms undertake economic transactions on a continual basis, so that the arbitrary closing of
accounting books at the ends of reporting period leads to a fundamental measurement problem. Cash basis
accounting does not report the full economic consequence of the transactions undertaken in a given period.
Accrual basis accounting is designed to provide more complete information on a firm’s periodic performance.
Accounting Standards and Auditing
• Accrual basis with expectations of future cash consequence of current events, it is subjective and relies on
a variety of assumptions. A firm’s managers are entrusted with the task of making the appropriate
estimates and assumptions to prepare the financial statements because they have intimate knowledge of
their firm’s business.
• The accounting discretion granted to managers is potentially valuable because it allows them to reflect
inside information in reported financial statements. However, since investors view profits as a measure of
managers’ performance, managers have incentives to use their accounting discretion to distort reported
profit by making biased assumptions. The use of accounting numbers in contracts between the firm and
outsiders, is also provides another motivation for management manipulation of accounting numbers. Earnings
management distorts financial accounting data, making them less valuable to external users of financial
statements. Therefore, the delegation of financial reporting decisions to corporate managers has both
costs and benefits.

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 A Framework for Business Analysis and Valuation Using Financial Statements
From Business Activities to Financial Statements

• A number of accounting conventions have evolved to ensure that managers use their accounting flexibility
to summarize their knowledge of the firm’s business activities, and not to disguise reality for self-serving
purposes. For example, the measurability and conservatism conventions are accounting responses to
concerns about distortion form managers’ potentially optimistic bias. Both these conventions attempt to
limit managers’ optimistic bias by imposing their own pessimistic bias.
• Accounting standards, called GAAP, promulgated by FASB and similar standard-setting bodies in other
countries, also limit potential distortions that managers can introduce into reported numbers. Uniform
accounting standards attempt to reduce manager’s ability to record similar economic transaction in
dissimilar ways, either over time or across firms.
• Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility for
managers to reflect genuine business differences in their firm’s financial statements. Rigid accounting
standards work best for economic transactions whose accounting treatment is not predicated on managers’
proprietary information. However, when there is significant business judgment involved in assessing a
transaction’s economic consequences, rigid standards which prevent managers from using their superior
business knowledge would be dysfunctional. Further, if accounting standards are too rigid, they may induce
managers to expend economic resources to restructure business transactions to achieve s desired
accounting result.
• Auditing is a verification of integrity of the reported financial statements by someone other than the
preparer, ensures that managers use accounting rules and conventions consistently over time, and that their
accounting estimates are reasonable. Therefore, auditing improves the quality of accounting data.
• Third-party auditing may also reduce the quality of financial reporting because it constraints the kind of
accounting rules and conventions that evolve over time. For example, the FASB considers the views of
auditors in the standard-setting process. Auditors are likely to argue against accounting standards
producing numbers that are difficult to audit, even if the proposed rules produce relevant information for
investors.

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 A Framework for Business Analysis and Valuation Using Financial Statements
From Business Activities to Financial Statements

Managers’ Reporting Strategy

• The mechanisms that limit managers’ ability to distort accounting data add noise, it is not optimal to use
accounting regulations to eliminate managerial flexibility completely. Real world accounting systems,
therefore, leave considerable room for managers to influence financial statement data. A firm’s reporting
strategy, that is, the manner in which managers use their accounting discretion, has an important influence
on the firm’s financial statements.
• Corporate managers can choose accounting and disclosure policies that make it more or less difficult for
external users of financial reports to understand the true economic picture of their business. Accounting
rules often provide a broad set of alternatives from which managers can choose. Further, managers are
entrusted with making a range of estimates in implementing these accounting policies. Accounting
regulations usually prescribed minimum disclosure requirements, but they do not restrict managers from
voluntary providing additional disclosures.
• A superior disclosure strategy will enable managers to communicate the underlying business reality to
outside investors. One important constraint on a firm’s disclosure strategy is the competitive dynamics in
product markets. Disclosure of proprietary information about business strategies and their expected
economic consequences may hurt the firm’s competitive position. Subject to this constraint, managers can
use financial statements to provide information useful to investors in assessing their firm’s true economic
performance.
• Managers can also use financial reporting strategies to manipulate investors’ perceptions. Using the
discretion granted to them, managers can make it difficult for investors to identify poor performance on a
timely basis. For example, managers can choose accounting policies and estimates to provide an optimistic
assessment of the firm’s true performance by controlling the extent of information that is disclosed
voluntarily.
• The extent to which financial statements are informative about the underlying business reality varies
across the firms and across time for a given firm. This variation in accounting quality provide both an
important opportunity and a challenge in doing business analysis.

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 A Framework for Business Analysis and Valuation Using Financial Statements
From Business Activities To Financial Statements

From Business Activities to Financial Statements

Business Strategy
Business Environment Business Activities
Scope of business; Degree of diversifi-
cation; Type of diversification; Compe-
Labor markets; Capital markets; Product markets Operating;
titive positioning; Cost leadership;
-suppliers, consumers, competitors; Investing;
Differentiaton; Key success factors
Business Regulations Financing
and risks

Accounting Environment Accounting System Accounting Strategy

Capital market structure; Contracting and Measure and report Choice of accounting policies;
Governance; Accounting conventions; economic Choice of accounting estimates
Tax and Financial accounting consequences of Choice of reporting format;
linkages; Third-party auditing; business activities Choice of supplementary disclosures
Legal system for accounting disputes

Financial Statements

Manager’s’ superior
information on business
activities; Estimation
errors; Distortions from
managers’accounting
choices

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 A Framework for Business Analysis and Valuation Using Financial Statements
From Financial Statements to Business Analysis

Analysis Using Financial Statements

Financial Statements
Business Application Context
Managers’ superior information on business
Credit analysis; Securities analysis;
activities; Noise from estimation errors;
Merger and acquisition analysis;
Distortion from managers’ accounting choices
Debt/Dividend analysis; Corporate
Other Public Data
communication strategy analysis;
Industry and firm data;
General business analysis
Outside financial statements
ANALYSIS
TOOLS

Business Strategy
Analysis
Generate performance
Expectations through
Industry analysis and
Competitive strategy analysis

Accounting Analysis Financial Analysis Prospective Analysis

Evaluate accounting quality Evaluate performance using Make forecast
by assessing accounting ratios and and
policies and estimates cash flow analysis Value business

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 STRATEGY ANALYSIS

• Strategy analysis is an important starting point for the analysis of financial statements: (i) it allows the
analyst to probe the economics of a firm at a qualitative level so that the subsequent accounting and
financial analysis is grounded in business reality; (ii) it allows the analyst to identify the firm’s profit
drivers and key risks; (iii) it allows the analyst to assess the sustainability of the firm’s current
performance and make realistic forecasts of future performance.
• A firm’s value is determined by its ability to earn a return on its capital in excess of the cost of capital. A
firm’s cost of capital is determined by the capital markets, while its profit potential is determined by its
own strategic choices: (1) the choice of an industry or a set of industries in which the firm operates
-industry choice; (2) the manner in which the firm intends to compete with other firms in its chosen indus-
try or industries -competitive positioning; and (3) the way in which the firm expects to create and exploit
synergies across the range of business in which it operates –corporate strategy. Strategy analysis involves:
(i) industry analysis; (ii) competitive strategy analysis; and (iii) corporate strategy analysis.
• Industry Analysis
– Degree of Actual and Potential Competition
• Rivalry Among Existing Firm
• Threat of New Entrants
• Threat of Substitute Products
– Industry Profitability
• Bargaining Power of Buyers
• Bargaining Power of Supplier
• Competitive Strategy Analysis
– Sources of Competitive Advantage
– Achieving and Sustaining Competitive Advantage
• Corporate Strategy Analysis
– Sources of Value Creation at the Corporate Level

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 STRATEGY ANALYSIS
Industry Analysis

Industry Structure and Profitability

Degree of Actual and Potential Competition

Rivalry Among Existing Firms Threat of New Entrants

Threat of Substitute Products
Industry growth; Concentra- Scale economies;
Relative price and performance;
tion; Differentiation; Switching First mover advantage;
Buyers’ willingness to switch
cost; Scale/Learning economies; Distribution access;
Fixed-Variable costs; Excess Relationships;
capacity; Exit barrires Legal barriers

Industry
Profitability

Bargaining Power in Input and Output Markets

Bargaining Power of Buyers Bargaining Power of Suppliers

Switching costs; Differentiation; Switching costs; Differentiation;
Importance of product for costs and quality; Importance of product for costs and quality;
Number of buyers; Number of suppliers;
Volume per buyer Volume per supplier

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 STRATEGY ANALYSIS
Competitive Strategy Analysis

Strategy for Creating Competitive Advantage

Cost Leadership Differentiation

Supply a product or service at a lower cost Supply a unique product or service at a cost
lower than the price premium customers
will pay

Economies of scale and scope; Superior product quality

Efficient production Superior product variety
Simpler product designs Superior customer service
Lower input costs More flexible delivery
Low-cost distribution Investment in brand image
Little research and development or brand Investment in research and development
advertising Control system focus on creativity and
Tight cost control system innovation

Competitive Advantage

Match between fir’s core competence and KSF to execute strategy

Match between firm’s value chain and activities required to execute strategy
Sustainability of competitive advantage

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 STRATEGY ANALYSIS
Corporate Strategy Analysis

• Some companies focus on only one business, many companies operate in multiple business. In recent years,
there has been an attempt to reduce the diversity of their operations and focus on a relatively few “core”
business, in the US. However, multibusiness organizations continue to dominate the economic activity in
most countries in the world.
• When analyzing a mutibusiness organization, an analyst has to not only evaluate the industries and
strategies of the individual business units but also the economic consequences –either positive or negative-
of managing all the different business under one corporate umbrella.
• Sources of Value Creation at the Corporate Level
– Economic theory suggests that the optimal activity scope of a firm depends on the relative transact-
ion cost of performing a set of activities inside the firm versus using the market mechanism. Trans-
action cost economics implies that the multiproduct firm is an efficient choice of organizational form
when coordination among independent, focused firm is costly due to the market transaction costs.
– Transaction costs can arise out of several sources: (i) if the production process involves specialized
assets such as human capital skill; (ii) proprietary technology; (iii) other organizational know-how that
is not easily available in the marketplace; (iv) market imperfections-such as information and incentive
problems. If buyers and sellers cannot solve these problems through standard mechanisms such as
enforceable contracts, it will be costly to conduct transactions through market mechanisms.
– Transactions inside an organization may be less costly than market-based transactions for several
reasons: (i) communication costs inside an organization are reduced because confidentiality can be
protected and credibilty can be assured through internal mechanisms; (ii) the headquarter office can
play a critical role in reducing costs of enforcing agreements between organization subunits; (iii) orga-
nizational subunits can share valuable nontradeable assets (organizational skills, systems, and
process) or nondivisible assets (brand names, distribution channels, and reputation).
– There are also forces that increase transaction costs inside organizations: (i) lack the specialized
information and skills necessary to manage business across several different industries; (ii)
decentralization will decrease goal conqruence among subunits managers, making it difficult to realize
economies scope.

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 STRATEGY ANALYSIS
Corporate Strategy Analysis

THE VALUE CYCLE

Market4 value of External

securities Financing
3

2 Retained funds

Internal
Cash Flow Total investment funds
internal plus
external sources

Resources for growth

Profitability or defense
Comp. Position

1 Competitive
Position

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 STRATEGY ANALYSIS
Corporate Strategy Analysis

Key Relationships in the Value Cycle

1 The relationship between underlying economic principles and cash flows

2 The relationship between the generation of cash flow and its internal use

3 The relationship between profitability, cash flow, and market valuation of

the firm’s securities

4 The relationship between external capital markets and the company’s

access to those markets

5 The relationship between available investment opportunities and the future

competitive position

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 STRATEGY ANALYSIS
Corporate Strategy Analysis

The Value Cycle Spiral

etc.

Increased in market value

of securities

Greater Improved access

internal to capital market
cash flow
Improved
Competitive
Position

Greater
profitability

Market value
of securities

Internal Access to capital

cash flow markets
Improved
Competitive
position

Profitability

Competitive
Position

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