Fin Analysis Chap1 (2010)
Transcript of Fin Analysis Chap1 (2010)
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Chapter 1:Framework
for Business
Analysis andValuation
Using
Financial
Statements
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Chapter 1:A framework for Business Analysis and
Valuation Using Financial Statements
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Learning Objectives
To outline a comprehensive framework forfinancial statement analysis
Financial statements provide the most
widely available data on publiccorporations economic activities
So, investors and other stakeholders rely onfinancial reports to assess the plans and
performance of firms and corporatemanagers.
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Agenda Functions of business analysis
Role of financial reporting in capital market
From business activities to financial statements
Financial statements to business analysis
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Functions and Scope of
Business Analysis
We can address quite a few questions by businessanalysis using financial statements
From a security analystsperspective: How well isthe firm performing? What is the value of the firms
stock given its current and future performance? (Goalof Wealth-maximization vs. profit maximization)
A loan officermay be interested in knowing the creditrisk of the firm, liquidity-solvency status, risk status, and
so on. (Liquidity vs. profitability principle)A management consultantmight be interested in thestructure of the industry in which the firm is operating,strategies of different players and their relativeperformances.
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Functions of Business Analysis
(Contd.)
A corporate managerrelates the performances ofthe firm with the stock price. He may be interestedin the state of communication between the firm and
investors. In cases, the corporate managermay like to know if
the firm is a potential take over target, the amount ofvalue addition in case of acquisitions, and so on.
An independent auditormay like to know whetherthe accounting policies and accrual estimates areconsistent with the business policy of the firm.
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Importance of financial analysis
Financial statement analysis is a valuable
activity when managers have complete
information on a firms 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 currentperformance and future prospects of the firm.
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The role of financial reporting in
capital markets
Savings
Business
Ideas
Financial
Intermediaries
Information
Intermediaries
Net Savers
Net Borrowers
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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 optimisticThese two reasons result in a classic lemons problem,e.g., bad ideascrowd out good ideas and investors lose confidence in this market.Suppose, initially there are 50% good firms and 50% bad firms. Both thetypes claim high prospect for the next year. Investors fail to distinguish the
two types and give them average credibility. For example, 50% credibilityturns up correct because 50% told lies. This demotivates the good firmsand they quit the market. The market now becomes full of bad firms. Inturn, among the bad firms, relatively good ones lose credibility because ofbad firms, and quit the market. At the end, it turns up that firms do notdeserve perfect credibility, that essentially leads to market break-down.
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The role of financial reporting in
capital markets (Contd.)
Intermediaries can prevent the market breakdown which resultedfrom the lemons problem since they provide independentcertification.
Intermediaries can be:
Financial Intermediaries:Venture capital firms, investmentbanks, merchant banks, banks, mutual funds, and insurancecompanies. These institutions rely on information of financialstatements and supplement this with other sources of informationto analyze investment opportunities.
Information Intermediaries: Auditors, financial analysts, bondrating agencies and financial press. These firms add value byenhancing the credibility of financial reports (as audit firms do) andby analyzing the information in the financial statements (asanalysts do).
Both types add value by distinguishing bad ideas from good ones
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From business activities to
financial statementsBusiness Environment
Labor markets
Capital Markets
Product Markets:
Suppliers
Customers
Competitors
Business regulations
Business Activities
Operating
Investing
Financing
Business Strategy
Scope of business:
Degree of diversification
Types of diversification
Competitive positioning:
Cost leadership
Product Differentiation
Key success factors andrisks
Accounting
environment
Capital market structure
Contracting and governance
Accounting conventions andregulations
Tax and financial accounting
Third-party auditing
Legal system for accountingdisputes
Accounting system
Measures and reportseconomic consequences of
business activities
Accounting strategy
Choice of accounting policies
Choice of accountingestimates
Choice of reporting formats
Choice of supplementarydisclosures
Financial statements
Managers superior informationon business activities
Estimation errors
Distortion from managersaccounting choices
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From Business Activities to
Financial Statements (cont)A firms business activities are influenced by its business oreconomic environment and its own business strategy
The business or economic environment includes thefirms industry, its input and output markets, andregulations.
Business strategy determines how the firm positionsitself in its environment to achieve competitive advantage.
The firms accounting system provides a mechanismthrough which business activities are selected, measured,and aggregated into financial statement data. Thus, in itsturn depends on accounting environment and accounting
strategy.
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From Business Activities to
Financial Statements (cont)
A firms financial statements summarize the economicconsequence of its business activities. However, the firmcannot report everything either because they are too
numerous or because they fear losing competitiveadvantage.
Thus Financial Statement data are influenced by boththe firms business activities and by its accountingsystem.
Understanding the Accounting system is therefore veryimportant!
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A Critical Approach to
Institutional Features of Accounting System
Accounting System (AS) Feature 1: Accrual system
Accrual system against cash based one
Investors preference for calendar basedperformance against function based one
Accounting System (AS) Feature 2 (a): Delegation tocorporate management
Regarding future consequence of current activities(expected realization of credit sales). This might berealistic (benefit) or fabricated (cost)
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A Critical Approach toInstitutional Features of Accounting System
(Contd)
AS Feature 2 (b): Conservatism and Uniformaccounting standard
Accounting standard limits the freedom ofmanagement by cost and conservatism principle
Accounting standards ( GAAPs like FASB, IAS,BAS for example) limit the freedom throughuniform accounting standard for differentorganizations.
AS Feature 2 (c): Role of auditing and law External auditing may curtail the freedom
Legal environment may curtail the freedom
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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.
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Business Analysis using Financial Statements
Financial Statements
Influenced by managers superior information onbusiness activities, noise from estimating errors, and
Distortions from managers accounting choices
Other Public Data
Like Industry and Firm data outside Financial
Statements
Business Application context
Credit analysis, Securitiesanalysis, Merger & Acquisition
analysis, Debt/Dividend
analysis, Corporate
communication strategy
analysis, and General business
analysis
ANALYSIS TOOLS
Business Strategy Analysis
Generate performance expectationsthru industry analysis and competitive
strategy analysis
AccountingAnalysis
Evaluate accounting
quality by assessing
accounting policies
and estimates
Financial Analysis
Evaluate performance using
ratios and cash flow analysis
Prospective
Analysis
Make forecasts and
value business
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Steps of Business AnalysisStep 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 firms 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 currentperformances 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