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Summary Financial Statement Analysis
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Summary Financial Statement Analysis
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Week 1: Framework and Strategy Analysis (Chapter 1&2)Analyze the financial statements of the company and understand the environment of the company.
If you want to make an investment, you need to take the following thing into consideration: Amount
of loans a company has, Cash, Profit or loss + risks, and the Internal controls. After analyzed all of
this, you are able to look at the return the income (the yield) this particular share had provided in the
previous years, and be able to forecast it in the future.
When you make the analysis of a company, don’t be fooled by simple indicators, like the ROE, but
look for the context in which the company operates. If you look at the context you can see the rends
of the company for the future. A number just have no meaning, if it doesn’t have context.
Chapter 1: A framework for business analysis and valuation using financial statements
Financial statement analysis has two big components:
Business analysis using financial statements; the assessment of the company while putting it
into context
Valuation; determining the actual value of the company based on the first step. How much
money is the company actual worth? If it’s worth more than the market price, you should
invest in the company, if it’s not you should sell the shares.
This is the purpose for the equity analysis. But there are also other purposes:
Security analysis; determine the actual price to see if we have to invest or sell
Credit analysis; determine if the particular entity is able to get more loan (banks do this)
Merger and acquisitions analysis; assessment of companies in order to perform mergers and
acquisitions. If a company is undervalued, a bigger company is acquiring it, solve the issues of
the company, and then sell the company with a big profit.
General business analysis
Audit risk analysis; very important one! An auditing team is going to audit the financial
statements to establish the audit risk. To what extend is the company likely to require a lot of
effort to determine if they follow the rules of not. Based on this audit risk analysis, auditors
charge fees or decide to refuse the company from the audit.
The functioning of capital markets ; from saving to business ideas
There are people with business ideas who need funding, and there
are people with saving that would like to invest the money to
produce even more money. Between the people with savings and the
people with business ideas there are the financial intermediaries
and the information intermediaries.
There are a couple of ‘problems’ in this setting:
- There is information asymmetry; insiders of the company know more than the outsiders. By
using the financial statement and different types of contracting, we try to minimize the
information asymmetry between the internals and externals ((un)informed investors).
- Incentive problems; managers or the insiders of the company might have a lot of incentives
to manipulate the way the company looks like for externals.
- Expertise asymmetry; outsiders don’t have any idea about what the insider is telling them,
because they have now knowledge about the products etc.
,From business activities to financial
statements
The (variables of) business environment
impacts the business activities by determining
the business strategy. Different market
situations have different business strategies.
- Financing activities; everything that is
connected to loans and equity
The business environment impacts the accounting environment. All the things of the accounting
environment goes into and impacts the accounting system. The accounting system has one main
function; measure and report economic consequences of business activities, by having an accounting
strategy. The accounting system should map exactly what’s happening with the company in a
formalized format; financial statements. This would give an indication of overall activities.
The different choices that a manger can make in the accounting strategy, is the reason why the
managers are able to do accounting fraud. Almost everything in accounting is led by individual
choices, there are no hard rules but principals that managers need to take into account. These
principles guide managers to give their own view over the financial statements.
- When doing an accounting analysis of a firm you need to look carefully at this. The company
has extensive disclosures of their accounting choices estimates. You need to look if these
accounting choices are justified or not.
Financial statements represent the managers superior information but also includes estimation
errors. So an error/fault isn’t always necessary a type of fraud of the manager.
Product of financial reporting
Managers have superior information on business activities and are the preparers of financial
statements (the accounting department of the company makes the financial statements, but under
the supervision of the managers). This provides a unique source of public data; every year they need
to disclosure it. But in the financial statements you have:
Noise from estimation errors
Managers may have personal interest which differ from the ones of the stakeholder
All of this is coming to provide an overall image of how we can perform financial statement analysis;
financial statements, with the manager superior information, noise from estimation errors,
distortions, other public data, the industry and firm data, and outside financial statements.
The tools of analysis; there are different steps in the
financial statement analysis;
1. Business strategy analysis; looking at the
company, before looking at its financial
statements and performances. You analyze the
industry overall; country, areas, competitive
forces; the context. The context is impacting all
other steps.
2. Accounting analysis; judge if the accounting
policies are good/ bad for the company
3. Financial analysis; what you know through the
financial indicators; see the trends in everything
to get an idea of the performance
, 4. Prospective analysis; by using the business environment, accounting and financial analysis
You shouldn’t judge a company by its last profit numbers or ratios. The context mattes a lot! You
need to understand the product and the industry that the company is dealing with, the numbers
and ratio’s can have huge different meanings in different contexts.
Chapter 2: strategy analysis; The industry structure and profitability
In order to determine how profitable the industry is, you can
use the framework provided by the Porters’ 5 forces. You
have to look at:
The degree on actual and potential competition
o Rivalry among existing firms
o Tread of new entrants; is it easy or hard for
someone to come in the market?
o Threat of substitute products; substitute is for
example common
transportation, railways, airplanes
The bargaining power in input and output markets
o Bargaining power of buyers; whenever a
company doesn’t care if it loses 1 or 2
buyers, the bargaining power buyers is low,
the company has a lot of power
o Bargaining power of suppliers; if the
company can leave the supplier, the
bargaining power of suppliers is low.
Strategies
There are two big strategies for creating competitive
advantage:
- Cost leadership; cars. Companies provide a
product for a low price, they produce for the
cheapest amount of money. Small margins to
sell a lot, because it’s cheap
- Differentiation; there is only one product like
this, completely different than the rest.
The competitive strategy leads to a competitive
advantage. You need to look at how sustainable the
advantage is. If a company doesn’t involve different
competitive advantages in a couple years, the company will become in the average of the industry.
The knowhow should stay focused on one type of business that can be replicate in different counties,
in order to keep the company profitable. You shouldn’t enter different industries, because its very
hard to apply something that works in one industry into another industry, there is no expertise.
IKEA & Easy Jet
, Q&A
Key accounting policies
You identify the key accounting policies after you perform the analysis of the company on the
strategy of the company, and after you looked at the actual product and actual line of business of the
company. Each business have different issues.
When you identify the key accounting policies you don’t make up the ratios, but you look at the way
of measurement of the assets. You identify which features of the company could have a lot of
discretion in the accounting policies. The key accounting policies are based on the environment of
the company. If you see something weir, you flag it.
Abnormal vs. normal
What is expected and what is unexpected. The extra is the abnormal return; You can have a negative
abnormal returns or a positive abnormal return.
Why financial statement analysis?
On the market there are a lot of efficiencies. There is a lot of information available about listed
companies. A lot of market participants do get it, understand it correctly, and act immediately upon
this information. But the markets are not efficient, there is always some information which is not
available to everyone and which is not reflected in the share price. there is always an unexpected
event; errors.
Academic research has shown that there are also a lot of inefficiencies in the market. If markets
would be efficient in the exact moment when a company disclosers the financial information, this
should be immediately imbedded in the prices; you should see an immediately change by the price
going up or down significantly, and then continue on its normal trend. But what happens is that there
is a drift; only a part of the market incorporate the information about the earnings announcement,
the rest of the market incorporate the information in later phases. This is market abnormal.
If everyone will start doing the financial statement analysis, the market will be efficient. And then
people will say the market is efficient, why are we doing financial statement analysis, they are going
to stop with financial statement analysis. And then the one still continuing will benefit , the other will
be jealous and going to start again with the financial statement analysis. It’s a circle.
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