A Framework for Business Analysis and Valuation Using Financial Statements

A variety of questions can be addressed by business analysis using financial state- ments, as shown in the following examples:

o 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?"

o 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?"

o 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?"

o A corporate manager may ask: "Is my firm properly valued by investors? Is our in- vestor communication program adequate to facilitate this process?"

o 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?"

o 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?"

Intermediaries using financial statement data to do business analysis have to be aware that financial reports are influenced both by the firm’s business activities and by its accounting system. A key aspect of financial statement analysis, therefore, involves un- derstanding the influence of the accounting system on the quality of the financial state- ment data being used in the analysis. The institutional features of accounting systems discussed below determine the extent of that influence.

Accounting System Feature 1: Accrual Accounting

Accounting System Feature 2: Accounting Standards and Auditing

Accounting System Feature 3: Managers’ Reporting Strategy

FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS

Because managers’ insider knowledge is a source both of value and distortion in account- ing data, it is difficult for outside users of financial statements to separate true information from distortion and noise. Not being able to undo accounting distortions completely, in- vestors “discount” a firm’s reported accounting performance. In doing so, they make a probabilistic assessment of the extent to which a firm’s reported numbers reflect economic reality. As a result, investors can have only an imprecise assessment of an individual firm’s performance. Financial and information intermediaries can add value by improving inves- tors’ understanding of a firm’s current performance and its future prospects.

Effective financial statement analysis is valuable because it attempts to get at managers’ inside information from public financial statement data. Because intermediaries do not have direct or complete access to this information, they rely on their knowledge of the firm’s industry and its competitive strategies to interpret financial statements. Successful intermediaries have at least as good an understanding of the industry economics as do the firm’s managers, and a reasonably good understanding of the firm’s competitive strategy. Although outside analysts have an information disadvantage relative to the firm’s manag- ers, they are more objective in evaluating the economic consequences of the firm’s invest- ment and operating decisions. Figure 1-3 provides a schematic overview of how business intermediaries use financial statements to accomplish four key steps: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis, and (4) prospective analysis.

Analysis Step 1: Business Strategy Analysis

The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the company’s profit potential at a qualitative level. Business strategy analysis involves analyzing a firm’s industry and its strategy to create a sustainable com- petitive advantage. This qualitative analysis is an essential first step because it enables the analyst to frame the subsequent accounting and financial analysis better. For exam- ple, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates eval- uating whether current profitability is sustainable. Finally, business analysis enables the analyst to make sound assumptions in forecasting a firm’s future performance.

Analysis Step 2: Accounting Analysis

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

Analysis Step 3: Financial Analysis

The goal of financial analysis is to use financial data to evaluate the current and past per- formance of a firm and to assess its sustainability. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use financial data to explore business issues. Ratio analysis and cash flow analysis are the two most commonly used financial tools. Ratio analysis focuses on evaluating a firm’s product market performance and financial poli- cies; cash flow analysis focuses on a firm’s liquidity and financial flexibility.

Analysis Step 4: Prospective Analysis

Prospective analysis, which focuses on forecasting a firm’s future, is the final step in business analysis. Two commonly used techniques in prospective analysis are financial statement forecasting and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis, and financial analysis in order to make pre- dictions about a firm’s future.

While the value of a firm is a function of its future cash flow performance, it is also possible to assess a firm’s value based on the firm’s current book value of equity, and its future return on equity (ROE) and growth. Strategy analysis, accounting analysis, and financial analysis, the first three steps in the framework discussed here, provide an ex- cellent foundation for estimating a firm’s intrinsic value. Strategy analysis, in addition to enabling sound accounting and financial analysis, also helps in assessing potential changes in a firm’s competitive advantage and their implications for the firm’s future ROE and growth. Accounting analysis provides an unbiased estimate of a firm’s current book value and ROE. Financial analysis allows you to gain an in-depth understanding of what drives the firm’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.