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

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

2. Chapter 1:A framework for Business Analysis and Valuation Using Financial Statements

3. 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.

4. Agenda • Functions of business analysis • Role of financial reporting in capital market • From business activities to financial statements • Financial statements to business analysis

5. Functions and Scope ofBusiness 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?” (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.

6. 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.

7. Importance of financial analysis • Financial statement analysis is a valuable activity when managers have complete information on a firm’s 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.

8. The role of financial reporting in capital markets Savings Net Savers Financial Intermediaries Information Intermediaries Business Ideas Net Borrowers

9. 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.

10. 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

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

12. From Business Activities to Financial Statements (cont…) A firm’s business activities are influenced by its business or economic environment and its own business strategy • The business or 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. • The firm’s 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.

13. 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. • Thus Financial Statement data are influenced by both the firm’s business activities and by its accounting system. Understanding the Accounting system is therefore very important!

14. A Critical Approach toInstitutional 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)

15. A Critical Approach toInstitutional 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

16. A Critical Approach toInstitutional 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.

17. Business Analysis using Financial Statements Business Application context Credit analysis, Securities analysis, Merger & Acquisition analysis, Debt/Dividend analysis, Corporate communication strategy analysis, and General business analysis 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 Generate performance expectations thru industry analysis and competitive strategy analysis Accounting Analysis Evaluate accounting quality by assessing accounting policies and estimates Prospective Analysis Make forecasts and value business Financial Analysis Evaluate performance using ratios and cash flow analysis

18. 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 firm’s 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