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1 A F r am e w o rk fo r B us i ne s s An al ys i s a n d
Va lu a t ion U s in g F i na n c ial S t a te m e n t s
chapter




T he purpose of this chapter is to outline a comprehensive framework
for ¬nancial statement analysis. Because ¬nancial statements provide the most widely
available data on public corporations™ economic activities, investors and other stake-
holders rely on ¬nancial reports to assess the plans and performance of ¬rms and corpo-
1
rate managers.
Framework
A variety of questions can be addressed by business analysis using ¬nancial state-
ments, as shown in the following examples:
• A security analyst may be interested in asking: “How well is the firm I am follow-
ing performing? Did the firm meet my performance expectations? If not, why not?
What is the value of the firm™s stock given my assessment of the firm™s current and
future performance?”
• A loan officer may need to ask: “What is the credit risk involved in lending a certain
amount of money to this firm? How well is the firm managing its liquidity and sol-
vency? What is the firm™s business risk? What is the additional risk created by the
firm™s financing and dividend policies?”
• A management consultant might ask: “What is the structure of the industry in which
the firm is operating? What are the strategies pursued by various players in the in-
dustry? What is the relative performance of different firms in the industry?”
• A corporate manager may ask: “Is my firm properly valued by investors? Is our in-
vestor communication program adequate to facilitate this process?”
• A corporate manager could ask: “Is this firm a potential takeover target? How much
value can be added if we acquire this firm? How can we finance the acquisition?”
• An independent auditor would want to ask: “Are the accounting policies and accru-
al estimates in this company™s financial statements consistent with my understand-
ing of this business and its recent performance? Do these financial reports
communicate the current status and significant risks of the business?”
Financial statement analysis is a valuable activity when managers have complete in-
formation on a ¬rm™s strategies and a variety of institutional factors make it unlikely that
they fully disclose this information. In this setting, outside analysts attempt to create “in-
side information” from analyzing ¬nancial statement data, thereby gaining valuable in-
sights about the ¬rm™s current performance and future prospects.
To understand the contribution that ¬nancial statement analysis can make, it is im-
portant to understand the role of ¬nancial reporting in the functioning of capital markets


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2 A Framework for Business Analysis and Valuation Using Financial Statements




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A Framework for Business Analysis and Valuation Using Financial Statements




and the institutional forces that shape ¬nancial statements. Therefore, we present ¬rst a
brief description of these forces; then we discuss the steps that an analyst must perform
to extract information from ¬nancial statements and provide valuable forecasts.


THE ROLE OF FINANCIAL REPORTING IN CAPITAL MARKETS
A critical challenge for any economy is the allocation of savings to investment opportu-
nities. Economies that do this well can exploit new business ideas to spur innovation and
create jobs and wealth at a rapid pace. In contrast, economies that manage this process
poorly dissipate their wealth and fail to support business opportunities.
In the twentieth century, we have seen two distinct models for channeling savings
into business investments. Communist and socialist market economies have used central
planning and government agencies to pool national savings and to direct investments in
business enterprises. The failure of this model is evident from the fact that most of these
economies have abandoned it in favor of the second model”the market model. In al-
most all countries in the world today, capital markets play an important role in channel-
ing ¬nancial resources from savers to business enterprises that need capital.
Figure 1-1 provides a schematic representation of how capital markets typically
work. Savings in any economy are widely distributed among households. There are usu-
ally many new entrepreneurs and existing companies that would like to attract these sav-
ings to fund their business ideas. While both savers and entrepreneurs would like to do
business with each other, matching savings to business investment opportunities is com-
plicated for at least two reasons. First, entrepreneurs typically have better information
than savers on the value of business investment opportunities. Second, communication
by entrepreneurs to investors is not completely credible because investors know entre-
preneurs have an incentive to in¬‚ate the value of their ideas.

Figure 1-1 Capital Markets



Savings

Financial Information
Intermediaries Intermediaries



Business
Ideas
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A Framework for Business Analysis and Valuation Using Financial Statements




1-3 Part 1 Framework




These information and incentive problems lead to what economists call the “lemons”
problem, which can potentially break down the functioning of the capital market.1 It works
like this. Consider a situation where half the business ideas are “good” and the other half
are “bad.” If investors cannot distinguish between the two types of business ideas, entre-
preneurs with “bad” ideas will try to claim that their ideas are as valuable as the “good”
ideas. Realizing this possibility, investors value both good and bad ideas at an average
level. Unfortunately, this penalizes good ideas, and entrepreneurs with good ideas ¬nd the
terms on which they can get ¬nancing to be unattractive. As these entrepreneurs leave the
capital market, the proportion of bad ideas in the market increases. Over time, bad ideas
“crowd out” good ideas, and investors lose con¬dence in this market.
The emergence of intermediaries can prevent such a market breakdown. Intermediar-
ies are like a car mechanic who provides an independent certi¬cation of a used car™s
quality to help a buyer and seller agree on a price. There are two types of intermediaries
in the capital markets. Financial intermediaries, such as venture capital ¬rms, banks,
mutual funds, and insurance companies, focus on aggregating funds from individual in-
vestors and analyzing different investment alternatives to make investment decisions. In-
formation intermediaries, such as auditors, ¬nancial analysts, bond-rating agencies, and
the ¬nancial press, focus on providing information to investors (and to ¬nancial inter-
mediaries who represent them) on the quality of various business investment opportuni-
ties. Both these types of intermediaries add value by helping investors distinguish
“good” investment opportunities from the “bad” ones.
Financial reporting plays a critical role in the functioning of both the information in-
termediaries and ¬nancial intermediaries. Information intermediaries add value by ei-
ther enhancing the credibility of ¬nancial reports (as auditors do), or by analyzing the
information in the ¬nancial statements (as analysts and the rating agencies do). Financial
intermediaries rely on the information in the ¬nancial statements, and supplement this
information with other sources of information, to analyze investment opportunities. In
the following section, we discuss key aspects of the ¬nancial reporting system design
that enable it to play effectively this vital role in the functioning of the capital markets.


FROM BUSINESS ACTIVITIES TO FINANCIAL STATEMENTS
Corporate managers are responsible for acquiring physical and ¬nancial resources from
the ¬rm™s environment and using them to create value for the ¬rm™s investors. Value is
created when the ¬rm earns a return on its investment in excess of the cost of capital.
Managers formulate business strategies to achieve this goal, and they implement them
through business activities. A ¬rm™s business activities are in¬‚uenced by its economic
environment and its own business strategy. The economic environment includes the
¬rm™s industry, its input and output markets, and the regulations under which the ¬rm
operates. The ¬rm™s business strategy determines how the ¬rm positions itself in its en-
vironment to achieve a competitive advantage.
4 A Framework for Business Analysis and Valuation Using Financial Statements




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A Framework for Business Analysis and Valuation Using Financial Statements




As shown in Figure 1-2, a ¬rm™s ¬nancial statements summarize the economic con-
sequences of its business activities. The ¬rm™s business activities in any time period are
too numerous to be reported individually to outsiders. Further, some of the activities un-
dertaken by the ¬rm are proprietary in nature, and disclosing these activities in detail
could be a detriment to the ¬rm™s competitive position. The ¬rm™s accounting system
provides a mechanism through which business activities are selected, measured, and ag-
gregated into ¬nancial statement data.
Intermediaries using ¬nancial statement data to do business analysis have to be aware
that ¬nancial reports are in¬‚uenced both by the ¬rm™s business activities and by its

Figure 1-2 From Business Activities to Financial Statements


Business Environment Business Strategy
Labor markets Scope of business:
Capital markets Degree of diversi¬-
Product markets: cation
Business Activities
Suppliers Type of diversi¬cation
Operating activities
Customers Competitive positioning:
Investment activities
Competitors Cost leadership
Financing activities
Business regulations Differentiation
Key success factors and
risks



Accounting Environment Accounting Strategy
Accounting System
Capital market structure Choice of accounting
Measure and
Contracting and policies
report economic
governance Choice of accounting
consequences of
Accounting conventions estimates
business activities.
and regulations Choice of reporting
Tax and ¬nancial format
accounting linkages Choice of supplementary
Third-party auditing disclosures
Legal system for
accounting disputes

Financial Statements
Managers™ superior
information on
business activities
Estimation errors
Distortions from man-
agers™ accounting
choices
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A Framework for Business Analysis and Valuation Using Financial Statements




1-5 Part 1 Framework




accounting system. A key aspect of ¬nancial statement analysis, therefore, involves un-
derstanding the in¬‚uence of the accounting system on the quality of the ¬nancial state-
ment data being used in the analysis. The institutional features of accounting systems
discussed below determine the extent of that in¬‚uence.


Accounting System Feature 1: Accrual Accounting
One of the fundamental features of corporate ¬nancial reports is that they are prepared
using accrual rather than cash accounting. Unlike cash accounting, accrual accounting
distinguishes between the recording of costs and bene¬ts associated with economic ac-
tivities and the actual payment and receipt of cash. Net income is the primary periodic
performance index under accrual accounting. To compute net income, the effects of eco-
nomic transactions are recorded on the basis of expected, not necessarily actual, cash re-
ceipts and payments. Expected cash receipts from the delivery of products or services
are recognized as revenues, and expected cash out¬‚ows associated with these revenues
are recognized as expenses.
The need for accrual accounting arises from investors™ demand for ¬nancial reports
on a periodic basis. Because ¬rms undertake economic transactions on a continual basis,
the arbitrary closing of accounting books at the end of a reporting period leads to a fun-
damental measurement problem. Since cash accounting does not report the full eco-
nomic consequence of the transactions undertaken in a given period, accrual accounting
is designed to provide more complete information on a ¬rm™s periodic performance.


Accounting System Feature 2: Accounting Standards and Auditing
The use of accrual accounting lies at the center of many important complexities in cor-
porate ¬nancial reporting. Because accrual accounting deals with expectations of future
cash consequences of current events, it is subjective and relies on a variety of assump-
tions. Who should be charged with the primary responsibility of making these assump-
tions? A ¬rm™s managers are entrusted with the task of making the appropriate estimates
and assumptions to prepare the ¬nancial statements because they have intimate knowl-
edge of their ¬rm™s business.
The accounting discretion granted to managers is potentially valuable because it al-
lows them to re¬‚ect inside information in reported ¬nancial statements. However, since
investors view pro¬ts as a measure of managers™ performance, managers have incentives
to use their accounting discretion to distort reported pro¬ts by making biased assump-
tions. Further, the use of accounting numbers in contracts between the ¬rm and outsiders

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