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provides another motivation for management manipulation of accounting numbers. In-
come management distorts ¬nancial accounting data, making them less valuable to ex-
ternal users of ¬nancial statements. Therefore, the delegation of ¬nancial reporting
decisions to corporate managers has both costs and bene¬ts.
6 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Analysis and Valuation Using Financial Statements

A number of accounting conventions have evolved to ensure that managers use their
accounting ¬‚exibility to summarize their knowledge of the ¬rm™s business activities, and
not to disguise reality for self-serving purposes. For example, the measurability and con-
servatism conventions are accounting responses to concerns about distortions from man-
agers™ potentially optimistic bias. Both these conventions attempt to limit managers™
optimistic bias by imposing their own pessimistic bias.
Accounting standards (Generally Accepted Accounting Principles), promulgated by
the Financial Accounting Standards Board (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 managers™ ability to record
similar economic transactions in dissimilar ways, either over time or across ¬rms.
Increased uniformity from accounting standards, however, comes at the expense of
reduced ¬‚exibility for managers to re¬‚ect genuine business differences in their ¬rm™s ¬-
nancial statements. Rigid accounting standards work best for economic transactions
whose accounting treatment is not predicated on managers™ proprietary information.
However, when there is signi¬cant business judgment involved in assessing a transac-
tion™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 a desired accounting result.
Auditing, broadly de¬ned as a veri¬cation of the integrity of the reported ¬nancial
statements by someone other than the preparer, ensures that managers use accounting
rules and conventions consistently over time, and that their accounting estimates are rea-
sonable. Therefore, auditing improves the quality of accounting data.
Third-party auditing may also reduce the quality of ¬nancial reporting because it
constrains the kind of accounting rules and conventions that evolve over time. For ex-
ample, the FASB considers the views of auditors in the standard-setting process. Auditors
are likely to argue against accounting standards producing numbers that are dif¬cult to
audit, even if the proposed rules produce relevant information for investors.
The legal environment in which accounting disputes between managers, auditors, and
investors are adjudicated can also have a signi¬cant effect on the quality of reported
numbers. The threat of lawsuits and resulting penalties have the bene¬cial effect of im-
proving the accuracy of disclosure. However, the potential for a signi¬cant legal liability
might also discourage managers and auditors from supporting accounting proposals re-
quiring risky forecasts, such as forward-looking disclosures.

Accounting System Feature 3: Managers™ Reporting Strategy
Because the mechanisms that limit managers™ ability to distort accounting data add
noise, it is not optimal to use accounting regulation to eliminate managerial ¬‚exibility
completely. Therefore, real-world accounting systems leave considerable room for
managers to in¬‚uence ¬nancial statement data. A ¬rm™s reporting strategy, that is, the
A Framework for Business Analysis and Valuation Using Financial Statements

1-7 Part 1 Framework

manner in which managers use their accounting discretion, has an important in¬‚uence
on the ¬rm™s ¬nancial statements.
Corporate managers can choose accounting and disclosure policies that make it more
or less dif¬cult for external users of ¬nancial reports to understand the true economic
picture of their businesses. 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
prescribe minimum disclosure requirements, but they do not restrict managers from vol-
untarily providing additional disclosures.
A superior disclosure strategy will enable managers to communicate the underlying
business reality to outside investors. One important constraint on a ¬rm™s disclosure
strategy is the competitive dynamics in product markets. Disclosure of proprietary infor-
mation about business strategies and their expected economic consequences may hurt
the ¬rm™s competitive position. Subject to this constraint, managers can use ¬nancial
statements to provide information useful to investors in assessing their ¬rm™s true eco-
nomic performance.
Managers can also use ¬nancial reporting strategies to manipulate investors™ percep-
tions. Using the discretion granted to them, managers can make it dif¬cult for investors
to identify poor performance on a timely basis. For example, managers can choose ac-
counting policies and estimates to provide an optimistic assessment of the ¬rm™s true
performance. They can also make it costly for investors to understand the true perfor-
mance by controlling the extent of information that is disclosed voluntarily.
The extent to which ¬nancial statements are informative about the underlying busi-
ness reality varies across ¬rms”and across time for a given ¬rm. This variation in ac-
counting quality provides both an important opportunity and a challenge in doing
business analysis. The process through which analysts can separate noise from informa-
tion in ¬nancial statements, and gain valuable business insights from ¬nancial statement
analysis, is discussed next.

Because managers™ insider knowledge is a source both of value and distortion in account-
ing data, it is dif¬cult for outside users of ¬nancial statements to separate true information
from distortion and noise. Not being able to undo accounting distortions completely, in-
vestors “discount” a ¬rm™s reported accounting performance. In doing so, they make a
probabilistic assessment of the extent to which a ¬rm™s reported numbers re¬‚ect economic
reality. As a result, investors can have only an imprecise assessment of an individual ¬rm™s
performance. Financial and information intermediaries can add value by improving inves-
tors™ understanding of a ¬rm™s current performance and its future prospects.
Effective ¬nancial statement analysis is valuable because it attempts to get at managers™
inside information from public ¬nancial statement data. Because intermediaries do not
have direct or complete access to this information, they rely on their knowledge of the
8 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Analysis and Valuation Using Financial Statements

¬rm™s industry and its competitive strategies to interpret ¬nancial statements. Successful
intermediaries have at least as good an understanding of the industry economics as do the
¬rm™s managers, and a reasonably good understanding of the ¬rm™s competitive strategy.
Although outside analysts have an information disadvantage relative to the ¬rm™s manag-
ers, they are more objective in evaluating the economic consequences of the ¬rm™s invest-
ment and operating decisions. Figure 1-3 provides a schematic overview of how business
intermediaries use ¬nancial statements to accomplish four key steps: (1) business strategy
analysis, (2) accounting analysis, (3) ¬nancial analysis, and (4) prospective analysis.

Figure 1-3 Analysis Using Financial Statements

Financial Statements Business Application Context
Managers™ superior informa- Credit analysis
tion on business activities Securities analysis
Noise from estimation errors Mergers and acquisitions
Distortions from managers™ analysis
accounting choices Debt/Dividend analysis
Corporate communication
Other Public Data strategy analysis
General business analysis
Industry and ¬rm data
Outside ¬nancial statements


Business Strategy
Generate performance
expectations through
industry analysis and com-
petitive strategy analysis.

Accounting Analysis Financial Analysis Prospective Analysis
Evaluate accounting Evaluate performance Make forecasts and
quality by assessing using ratios and cash value business.
accounting policies ¬‚ow analysis.
and estimates.
A Framework for Business Analysis and Valuation Using Financial Statements

1-9 Part 1 Framework

Analysis Step 1: Business Strategy Analysis
The purpose of business strategy analysis is to identify key pro¬t drivers and business
risks, and to assess the company™s pro¬t potential at a qualitative level. Business strategy
analysis involves analyzing a ¬rm™s industry and its strategy to create a sustainable com-
petitive advantage. This qualitative analysis is an essential ¬rst step because it enables
the analyst to frame the subsequent accounting and ¬nancial analysis better. For exam-
ple, identifying the key success factors and key business risks allows the identi¬cation
of key accounting policies. Assessment of a ¬rm™s competitive strategy facilitates eval-
uating whether current pro¬tability is sustainable. Finally, business analysis enables the
analyst to make sound assumptions in forecasting a ¬rm™s future performance.

Analysis Step 2: Accounting Analysis
The purpose of accounting analysis is to evaluate the degree to which a ¬rm™s accounting
captures the underlying business reality. By identifying places where there is account-
ing ¬‚exibility, and by evaluating the appropriateness of the ¬rm™s accounting policies
and estimates, analysts can assess the degree of distortion in a ¬rm™s accounting
numbers. Another important step in accounting analysis is to “undo” any accounting dis-
tortions by recasting a ¬rm™s accounting numbers to create unbiased accounting data.
Sound accounting analysis improves the reliability of conclusions from ¬nancial analy-
sis, the next step in ¬nancial statement analysis.

Analysis Step 3: Financial Analysis
The goal of ¬nancial analysis is to use ¬nancial data to evaluate the current and past per-
formance of a ¬rm and to assess its sustainability. There are two important skills related
to ¬nancial analysis. First, the analysis should be systematic and ef¬cient. Second, the
analysis should allow the analyst to use ¬nancial data to explore business issues. Ratio
analysis and cash ¬‚ow analysis are the two most commonly used ¬nancial tools. Ratio
analysis focuses on evaluating a ¬rm™s product market performance and ¬nancial poli-
cies; cash ¬‚ow analysis focuses on a ¬rm™s liquidity and ¬nancial ¬‚exibility.

Analysis Step 4: Prospective Analysis
Prospective analysis, which focuses on forecasting a ¬rm™s future, is the ¬nal step in
business analysis. Two commonly used techniques in prospective analysis are ¬nancial
statement forecasting and valuation. Both these tools allow the synthesis of the insights
from business analysis, accounting analysis, and ¬nancial analysis in order to make pre-
dictions about a ¬rm™s future.
10 A Framework for Business Analysis and Valuation Using Financial Statements

A Framework for Business Analysis and Valuation Using Financial Statements

While the value of a ¬rm is a function of its future cash ¬‚ow performance, it is also
possible to assess a ¬rm™s value based on the ¬rm™s current book value of equity, and its
future return on equity (ROE) and growth. Strategy analysis, accounting analysis, and
¬nancial analysis, the ¬rst three steps in the framework discussed here, provide an ex-
cellent foundation for estimating a ¬rm™s intrinsic value. Strategy analysis, in addition
to enabling sound accounting and ¬nancial analysis, also helps in assessing potential
changes in a ¬rm™s competitive advantage and their implications for the ¬rm™s future
ROE and growth. Accounting analysis provides an unbiased estimate of a ¬rm™s current
book value and ROE. Financial analysis allows you to gain an in-depth understanding of
what drives the ¬rm™s current ROE.
The predictions from a sound business analysis are useful to a variety of parties and
can be applied in various contexts. The exact nature of the analysis will depend on the
context. The contexts that we will examine include securities analysis, credit evaluation,
mergers and acquisitions, evaluation of debt and dividend policies, and assessing corpo-
rate communication strategies. The four analytical steps described above are useful in
each of these contexts. Appropriate use of these tools, however, requires a familiarity
with the economic theories and institutional factors relevant to the context.

Financial statements provide the most widely available data on public corporations™ eco-
nomic activities; investors and other stakeholders rely on them to assess the plans and
performance of ¬rms and corporate managers. Accrual accounting data in ¬nancial
statements are noisy, and unsophisticated investors can assess ¬rms™ performance only
imprecisely. Financial analysts who understand managers™ disclosure strategies have an
opportunity to create inside information from public data, and they play a valuable role
in enabling outside parties to evaluate a ¬rm™s current and prospective performance.
This chapter has outlined the framework for business analysis with ¬nancial state-
ments, using the four key steps: business strategy analysis, accounting analysis, ¬nancial
analysis, and prospective analysis. The remaining chapters in this book describe these
steps in greater detail and discuss how they can be used in a variety of business contexts.

1. John, who has just completed his first finance course, is unsure whether he should
take a course in business analysis and valuation using financial statements, since he
believes that financial analysis adds little value, given the efficiency of capital mar-
kets. Explain to John when financial analysis can add value, even if capital markets
are efficient.
2. Accounting statements rarely report financial performance without error. List three
types of errors that can arise in financial reporting.
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