A framework for business

analysis and valuation using

financial statements
Why financial statement analysis?
To assess the plan and performance of firms and
corporate managers
Financial statements are an important source of
information to the capital markets and business
analysts.
Analyzing financial statements addresses a number of
issues of interest to external stakeholders and company
insiders.
Why financial statement analysis?
Security analyst:
How well is the firm I am following performing?

Did the firm meet my performance expectations?

What is the value of the firms stock given my

assessment of the firms current and future
performance?
Why financial statement analysis?
Loan officer:
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
solvency?
What is the firms business risk?
What is the additional risk created by the firms
financing and dividend policies?
Why financial statement analysis?
Management consultant:
What is the structure of the industry in which the firm is
operating?
What are the strategies pursued by various players in
the industry?
How have these factors affected the relative
performance of different firms in the industry?
Why financial statement analysis?
Corporate manager:
Is my firm properly valued by investors ?
Is our investor communication program adequate to
facilitate this process?
Is this firm a potential takeover target?
How much value can beaded if we acquire this firm?
How can we finance the acquisition?
Why financial statement analysis?
An independent auditor:
Are the accounting policies and accrual estimates in this
companys financial statements consistent with my
understanding of this business and its recent
performance?
Do these financial reports communicate the current
status and significant risks of the business?
Role of financial reporting in capital
markets
A vibrant economy requires a financial system that
moves funds from savers to borrowers.

But how does it ensure that your hard-earned money is

used by those with the best productive investment
opportunities?
Issues in funds flow
1. Entrepreneurs typically have better information than
savers on the value of business opportunities.

2. Communication from entrepreneurs to investors may

not be credible as they have incentive from inflating the
value.

3. Savers may lack financial sophistication needed to

analyze and differentiate business opportunities.
Asymmetric Information: Adverse Selection and
Moral Hazard
In your introductory finance course, you probably
assumed a world of symmetric informationthe case
where all parties to a transaction or contract have the
same information, be that little or a lot

In many situations, this is not the case. We refer to this

as asymmetric information.
Asymmetric Information: Adverse Selection and
Moral Hazard
Asymmetric information can take on many forms, and is
quite complicated.

However, to begin to understand the implications of

asymmetric information, we will focus on two specific
forms:
Adverse selection
Moral hazard
Asymmetric Information: Adverse Selection and
Moral Hazard
Adverse Selection
1. Occurs when one party in a transaction has better
information than the other party

2. Before transaction occurs

3. Potential borrowers most likely to produce adverse outcome

are ones most likely to seek loan and be selected
Asymmetric Information: Adverse Selection and
Moral Hazard
Moral Hazard
1. Occurs when one party has an incentive to behave
differently once an agreement is made between parties

2. After transaction occurs

Asymmetric Information: Adverse Selection and
Moral Hazard
The analysis of how asymmetric information problems
affect behavior is known as agency theory.

We will now use these ideas of adverse selection and

moral hazard to explain how they influence financial
structure.
 The Lemons Problem: How Adverse
Selection Influences Financial Structure

Lemons Problem in Used Cars

1. If we can't distinguish between good and bad (lemons)
used cars, we are willing pay only an average of good and
bad car values
2. Result: Good cars wont be sold, and the used car market
will function inefficiently.

What helps us avoid this problem with used cars?

 The Lemons Problem: How Adverse
Selection Influences Financial Structure

Lemons Problem in Securities Markets

If we can't distinguish between good and bad securities,

willing pay only average of good and bad securities value

Result: Good securities undervalued and firms won't issue

them; bad securities overvalued so too many issued

Investors won't want buy bad securities, so market won't

function well
Tools to help solve adverse selection
(Lemons) problems
1. Financial intermediation such as venture capital and private
equity firms, banks, mutual funds, and insurance companies
focus on aggregating funds from individual investors and
distributing these funds to businesses seeking sources of
capital.

2. Information intermediaries such as auditors and company

audit committees serve as credibility enhancers to provide an
independent assessment of business claims.
Tools to help solve adverse selection
(Lemons) problems
3. Private production and sale of information like financial
analysts, credit rating agencies and the financial press collect
and analyze business information used to make business
decisions.

4. Transaction facilitators such as stock exchanges and

brokerage houses facilitate buying and selling in markets.
Tools to help solve adverse selection
(Lemons) problems
5. Government regulation to increase information.
The Role of Financial Reporting in
Capital Markets
Financial reporting provide much needed information to
capital market participants
Financial intermediaries depend upon the information
in financial statements to evaluate investment
opportunities.
Information intermediaries assure the quality of
financial statement representations.
Relevant and reliable financial information is
essential for the functioning of capital markets.
How Capital Markets Function
From Business Activities to
Financial Statements
Financial statements measure and summarize the economic
consequences of business activities.

Accounting systems facilitate information quality.

The role of accrual basis accounting.
The need for generally accepted accounting principles (GAAP).
Auditing and the quality of financial information.
From
Business
Activities
to
Financial
Stateme
nts
Influences of the accounting system on
information quality
Analysts of financial reports should understand the influence of
both
1. firms business activities and
2. accounting system
Influences of the accounting system on
information quality
Accrual accounting

Accounting conventions and standards

Managers reporting strategy

Auditing
Financial Statements and Business
Analysis
Business intermediaries use financial statements to accomplish
four key objectives:

Business strategy analysis

Accounting analysis
Financial analysis
Prospective analysis
Business strategy analysis
To identify key profit drivers and business risks

To assess the companys profit potential at a qualitative level

Involves analyzing a firms industry and its strategy to create a

sustainable competitive advantage

Enables to make sound assumptions in forecasting the firms

future performance.
Accounting analysis
To evaluate the degree to which a firms accounting captures its
underlying business economics

Identifies places where there is accounting flexibility and

evaluates the appropriateness of accounting policies

Undo any distortions by recasting the accounting numbers to

create unbiased accounting data.
Financial analysis
to use financial data to evaluate the current and past
performance of the firm
To assess its sustainability

Two skills:
1. Analysis should be systematic and efficient.
2. Should allow the analyst to use financial data to explore
business issues.
Ratio analysis and cash flow analysis are common tools.
Prospective analysis
Focuses on forecasting the firms future

Common techniques are financial statement forecasting and

valuation.

Synthesis of the insights from business analysis, accounting

analysis and financial analysis to predict the future.
Prospective analysis
Value of the firm is the function of its future cash flow
performance.

Firms current book value of equity and its future return on

equity and growth.
Prospective analysis
Strategy analysis helps in assessing potential changes in a
firms competitive advantage and their implications for the firms
future ROE and growth.

Accounting analysis provides an unbiased estimate of a firms

current book value and ROE

Financial analysis allows an in-depth understanding of what

drives the firms current ROE
Business
Strategy
Analysis