Financial statement analysis
Chapter 1 - A framework for business analysis and valuation using financial statements
Financial statement analysis is a valuable activity in a situation where managers have complete
information on their firm’s strategies, but a variety of institutional factors make full disclosure
unlikely. Outside analysts attempt to create inside information by analysing financial statement
data, gaining valuable insights about current and future performance. This starts with the role that
financial reporting plays in the functioning of capital markets.
Critical for any economy is the allocation of savings to investment opportunities, spurring
innovation and wealth, a process which is dominated worldwide today by capital markets. The
‘lemons’ problem occurs since entrepreneurs have an incentive to inflate their profit prospects,
and investors often have fewer information in a situation of information asymmetry. Investors are
only willing to accept the average rate for bad and good investors, being unable to distinguish,
offering rates unattractive for entrepreneurs offering good investments, crowding them out and
leaving only the bad ones in the market. Therefore
savings reach entrepreneurs with business ideas
through financial intermediaries, such as venture
capital firms, mutual funds, banks, and insurance
funds, all of whom aggregate funds and analyse
investment alternatives.
On the other side are information intermediaries such
as auditors, financial analysts, bond-rating agencies,
and the press, providing information to investors on
investment opportunities.
A firm’s financial statements summarise the economic
consequences of its business activities, which are
themselves too numerous or secret for competitive
reasons to disclose. The firm’s accounting system
provides a mechanism through which business
activities are selected, measured, and aggregated
into financial statement data. The institutional features
of accounting systems discussed below determine
the quality of the financial statement data.
Accounting system feature 1: accrual accounting
Fundamental for corporate financial reports is that
they’re prepared using accrual (expectations based)
rather than cash accounting: unlike cash accounting,
accrual accounting distinguishes recordings of costs
and benefits of activities from the actual payment and receipt of the cash. Net income is the
primary periodic performance index in accrual accounting, and computed on the basis of
expected cash receipts and payments due to activities, not necessarily the actual cash receipts
and payments. Due to the periodic nature of financial reporting accrual accounting, so using
expected cash receipts and outflows, provides a more complete picture of periodic performance
than an arbitrary closing of accounting books at a certain date.
Accounting system feature 2: accounting standards and auditing
Since accrual accounting deals with expectations of future cash consequences of current events
it’s subjective and relies on assumptions, which we trust managers to make appropriately. This
accounting discretion granted managers allows them to reflect inside information in reported
financial statements, but also allows them to distort reported profits by making biased
assumptions to boost perceived performance. This delegation of FR (financial reporting) to
corporate managers thus has both cost and benefits.
GAAP accounting standards limit distortions managers can introduce into reports, but this
increasing of uniformity of accounting standards reduces flexibility for managers to reflect genuine
differences across firm’s FS (financial statements). Rigid standards may prevent managers from
using their superior inside business knowledge to assess a transaction’s economic
,consequences. In addition, too rigid standards may induce managers to spend resources on
restructuring of business transactions to achieve accounting profits rather than actual value.
Auditing is the verification of the integrity of the reported financial statements by someone other
than the preparer, and ensures consistency and adherence to accounting standards in FS. They
do however discourage FS that are difficult to audit even if these produce relevant investor
information.
Accounting system feature 3: managers’ reporting strategy
So the mechanisms limiting managers’ ability to distort earnings data in FS also adds noise,
meaning it’s not optimal to use accounting regulation to eliminate managerial flexibility completely.
Real-world accounting systems therefore leave considerable room for managers to influence FS
data, allowing it to set its reporting strategy which considerably influences FS.
Corporate managers can choose accounting and disclosure policies from a broad set of
alternatives, affecting the difficulty for external FS users of assessing true economic outlook of the
firm. Regulations usually prescribe minimum disclosure requirements, allowing managers to
disclose additions to their liking. Superior disclosure strategy enables managers to communicate
the underlying business reality to outside investors, but must also not share proprietary
information about strategies that may harm its competitive position.
Investors are unable to undo accounting
distortions completely and must discount a
firm’s reported accounting performance,
making a probabilistic assessment of how
reflective these reports are of economic
reality. Investors only have an imprecise
assessment of firm performance, financial
and information intermediaries can add value
by improving understanding of the firm and
its performance. Intermediaries’ goal is
understanding industry economics and the
competitive strategy of a firm. Despite their
information disadvantage, they are more
objective. The figure provides a schematic
overview of how business intermediaries use
FS to accomplish 4 key steps: (1) business
strategy analysis, (2) accounting analysis, (3)
financial analysis, and (4) prospective
analysis.
Analysis step 1: business strategy analysis
Purpose of business strategy analysis is
identifying key profit drivers and business
risks, and assessing profit potential. It
involves analysing firm industry and its
strategy for creating a sustainable
competitive advantage, which is qualitative
analysis.
Analysis step 2: accounting analysis
Accounting analysis is to evaluate the degree to which firm accounting captures business reality,
as analysts evaluate appropriateness of accounting policies and estimates, and the degree of
distortion in the FS numbers. Any distortions are undone by recasting numbers and creating
unbiased data, allowing for reliable financial analysis in the next step.
Analysis step 3: financial analysis
Goal of financial analysis is using financial data to evaluate performance of a firm and to assess
its sustainability. The analysis should be systematic and efficient, and allow the analyst to use
data to explore business issues. Ratio analysis and cash flow analysis are the two most
commonly used financial tools. Ratio analysis focusses on financial policies and product market
performance, cash flow analysis on liquidity and financial flexibility.
,Analysis step 4: prospective analysis
Prospective analysis forecasts a firm’s future, through FS forecasting and valuation, taking into
account the business analysis (competitive advantage and profit drivers), accounting analysis
(reliable representation of FS data), and financial analysis (ratios and performance in financing and
product market) and using the 3 to predict a firm’s future.
A firm’s value is a function of future cash flow performance, but can also be assessed based on
current book value of equity and its future return on equity (ROE) and growth. Strategy,
accounting, and financial analysis provide excellent foundations for estimating firm intrinsic value,
and the future ROE and growth. Financial analysis provides an in-depth understanding of what
drives current ROE.
Chapter 2 - Strategy analysis
Strategy analysis is an important starting point for FS analysis, examining firm economics at a
qualitative level so that the subsequent two steps of analysis (accounting and financial) are
grounded in business reality. It also allows identification of key risks and profit drivers, helping for
the fourth step of prospective analysis in assessing current performance and forecasts.
Firm value depends on its ability to earn a return on its capital in excess of its cost of capital,
which in turn depends on capital markets. Its profit potential depends on strategic choices:
-Industry choice: the choice of an industry (or industries) in which the firm operates;
-Competitive positioning: the manner in which the firm intends to compete with industry peers;
-Corporate strategy: the way in which the firm expects to create and exploit synergies in the way
its business operates.
Thus strategy analysis focuses on industry analysis, competitive strategy analysis, and corporate
strategy analysis, the three steps we briefly discuss in this chapter.
Industry analysis
Analysing firm profit potential starts with assessing that
of the industry. Ratio of EBIT to asset book value of US
companies between 1981 and 1997 was 8.8%, but 43%
more for bakery products while it was 23% less for silver
ore mining: industry differences are vast. The ‘five forces’
shown in the figure are often the framework used to
explain the influence of industry structure on industry
profitability. Intensity of competition determines potential
for abnormal profits, which depends no rivalry among
existing firms, new entrants threats, and substitute
products threats. Whether or not such potential profits
are then actually kept by the industry depends on
bargaining power in the input and output markets, so
relative to the customers and suppliers.
Degree of actual and potential competition
Industry profits are a function of the maximum price
customers are willing to pay, which depends on
competition from suppliers of identical or similar
products. At perfect competition, micro-economic theory
suggests prices equalling marginal costs. Three sources
of potential competition exist: existing firms rivalry, threat
of new entrants, and substitute products.
Competitive force 1: rivalry among existing firms
Firms may compete aggressively on price, or find some way to coordinate pricing or compete in
non-price dimensions instead, like innovation and brand image. This depends on:
-Industry growth rate: rapid growth means incumbent firms need not compete for market share to
grow, while stagnant industries force firms to take market share from competitors to grow,
causing price wars.
-Concentration and balance of competitors: firm number in industries and their relative size
determines concentration, since one or a few very large and equal-sized players can implicitly
, cooperate and avoid destructive price competition, while fragmentation makes competition likely
severe.
-Degree of differentiation and switching costs: if firms can differentiate products they can avoid
head-on price competition, while very similar products mean customers can switch easily based
on price. This however also depends on switching costs, since low switching costs also increase
price competition.
-Scale economies or learning economies, and the ratio of fixed to variable costs: a steep learning
curve or some other form of scale economies makes size an important factor. This incentivises
firms to aggressively engage in competition for market share. Similarly, if fixed costs are high
relative to variable costs, reducing prices to utilise installed capacity and sunk costs means
further price competition. The airline industry is one prime example of high fixed costs, and has
price wars often.
-Excess capacity and exit barriers: if capacity is larger than demand, firms are incentivised
strongly to cut prices to fill capacity, a problem that is exacerbated if barriers to exit are high, e.g.
due to specialised assets difficult to resell, or regulations. Think of the current oil crisis: large
investments in rigs and fracking installations are highly specialised, making the barriers to exit
high, and combined with excess capacity causing oil prices to reach unprecedented lows.
Competitive force 2: threat of new entrants
The potential for earning abnormal profits attracts new entrants, the threat of which already
constrains prices that incumbent firms can set. The ease of entry is thus a key determinant of
profitability, and the height of barriers to entry depends on a number of factors:
-Economies of scale: when large, new entrants either have to invest in a large capacity or enter
with a capacity that is less than optimum, causing a cost disadvantage. These economies of scale
may arise due to large R&D costs, brand advertising, or very expensive P&E.
-First mover advantage: early entrants may deter future entrants if there are benefits to being the
first, e.g. being able to set industry standards, entering exclusive arrangements with suppliers, or
acquiring scarce government licenses. Learning economies also cause first mover advantages, as
do large switching costs; think of a user having grown accustomed to Microsoft since it was
simply one of the only choices when she started using computers.
-Access to distribution channels and relationships: limited capacity in existing distribution
channels and high costs of developing new channels can act as powerful barriers to entry, e.g.
new consumer goods having to find supermarket shelf space; they’ll have to compete with
existing relationships between supplier and retailer, as well as their distribution channels.
-Legal barriers: simply patents and copyrights in R&D-intensive industries, or licensing regulations
as we see for telecom and taxi services.
Competitive force 3: threat of substitute productes
Relevant substitutes need not necessarily have the same form as existing products: airlines and
long-haul busses or trains, or the threat of substitution stemming from new technologies such as
energy-conserving technologies threatening fossil fuel industries. The threat of substitutes
depends on the relative price and performance of competing products or services, and consumer
willingness to substitute. Their perception of whether or not two products are substitutes depends
on performing a similar function for a similar price, but even then willingness to switch is required.
Relative bargaining power in input and output markets
We discussed as first of the two main factors in industry profitability the degree of actual and
potential competition, owing to (1) existing firms’ rivalry, (2) threat of entrants, and (3) substitutes.
This degree of industry competition determines the potential for abnormal profits, not the actual
profits which in turn are influenced by the industry’s bargaining power with suppliers and
customers.
Competitive force 4: buyer bargaining power
Buyers’ price sensitivity and relative bargaining power determine the power of buyers: the extent
to which they care to bargain, and the extent to which they succeed in forcing the price down.
Buyers are more price sensitive when the product is undifferentiated and switching costs are low.
When a product is a large fraction of buyers’ cost, the buyer is likely to expend resources in
pursuit of a lower cost alternative. A small fraction of input prices is likely under lower pressure
from alternatives. Also, when an input is not important for end-product quality price becomes the
most important determinant in buying decisions, and vice versa.
