Advanced Financial Statement Analysis
Lecture 1
Financial statement analysis
Capital markets play a key role in in channelling financial resources from savers to
businesses. Often, there is a separation between the ownership (= shareholders) and the
control of the company (= CEO, CFO etc. → the ones making the business decisions on
behalf of shareholders).
Financial statement analysis (FSA) is useful when managers have complete information on a
firm’s strategies, and a variety of factors make it unlikely that they fully disclose this
information → outsiders (e.g. financial analysts) attempt to generate inside information by
analysing financial statements to understand current performance and future prospects.
There are two problems:
1. Adverse selection
Before engaging in a transaction, corporate managers (= insiders) know more about
the quality of their company and its future prospects than do outside shareholders.
2. Moral hazard
After engaging in a transaction, corporate managers have incentives to perform
actions for their own benefit instead of for the benefit of the company.
The “lemons” problem: 1) because of these information and incentive problems, investors
are not able to distinguish between good and bad investments; 2) investors will value good
and bad investments at an average level; 3) penalizes good investments, good entrepreneurs
leave the market; 4) bad investments crowd out good investments; 5) break down of the
market.
Intermediaries can help the market from breaking down, by giving information about firms:
- Financial intermediaries (e.g. banks, investment funds) → flow of capital (focus on
aggregating funds from individual investors and analysing different investment alternatives)
- Information intermediaries (e.g. auditors, financial analysts) → flow of information (focus
on providing or assuring information to investors)
In this course, we take the position of the information intermediary.
The accounting system
Ideally, financial statements summarise the economic consequences of a firm’s business
activities. The accounting system measures and report economic consequences of business
activities. Therefore, a key aspect of FSA involves understanding the influence of the
accounting system on the quality of the financial statement data being used in the analysis.
Institutional features that determine the extent of the influence of the accounting system:
1. Accrual accounting
One of the fundamental features of corporate financial reports is that they are
prepared using accrual rather than cash accounting. Unlike cash accounting, accrual
accounting distinguishes between the recording of costs or benefits and the actual
payment or receipt of cash.
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,2. Accounting conventions and standards
- Managers are entrusted with making estimates and assumptions to prepare
financial statements – this discretion can be valuable because it allows managers to
reflect inside information in reported financial statements → benefits of discretion.
- However, managers also have incentives to distort reported numbers because
compensation/contract is often based on earnings numbers (earnings management)
→ costs of discretion.
- (Uniform) accounting standards limit managers’ ability to misuse accounting
judgement, but at the same time can come at the cost of reduced flexibility for
managers to reflect their inside information in reported financial statements.
3. Managers’ reporting strategy
- How do managers use their accounting discretion?
- Voluntary disclosure or additional information?
4. Auditing, legal liability and enforcement
- Auditing verifies the integrity of reported financial statements.
- Threat of lawsuits and resulting penalties have the beneficial effect of improving the
quality of disclosure.
- Public enforcement bodies further enhance the pressure for high quality F/S.
Steps of financial statement analysis
Because managers’ insider knowledge is a source of both value and distortion in accounting
data, it is difficult for outside users of financial statements to separate true information
from distortion and noise → leads to investors discounting a firm’s reported accounting
performance.
Effective FSA is valuable because it attempts to get at managers’ inside information from
publicly available financial statement data. Four key steps of FSA:
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.
2. Accounting analysis
The purpose of accounting analysis is to evaluate the degree to which a firm’s
financial statements capture the underlying business reality.
3. Financial analysis
The goal is to use financial data to evaluate the current and past performance of a
firm and to assess its sustainability (e.g. use of ratios and cash flow analysis).
4. Prospective analysis
Focuses on forecasting the future and valuing the business.
Business strategy analysis
Strategy analysis is the starting point for FSA:
- It allows an analyst to probe the economics of a company at a qualitative level in order to
ground the subsequent accounting and financial analysis in business reality
- Allows the identification of key profit drivers and risks
- Enables the analyst to assess the sustainability of current performance
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,Five forces of industry structure and profitability:
1) Rivalry among existing firms (e.g. concentration of competitors, degree of differentiation
and switching costs, industry growth rate)
In most industries the average level of profitability is primarily influenced by the
nature of rivalry among existing firms in the industry.
2) Threat of new entrants (e.g. economies of scale, access to channels of distributions, legal
barriers (licensing regulations))
The very threat of new firms entering an industry potentially forces incumbent firms
to make additional investments in, for example, advertising or to keep prices low.
3) Threat of substitute products
4) Bargaining power of buyers
* Price sensitivity →more price-sensitive when the product is undifferentiated and
switching costs are low.
* Relative bargaining power of buyers → determined by the number of buyers
relative to the number of suppliers
5) Bargaining power of suppliers (e.g. number of companies and substitutes)
Lecture 2
Accounting analysis
The purpose of accounting analysis is to evaluate the degree to which a firm’s financial
statements capture the underlying business reality. To assess the degree of distortion, we
identify places with accounting flexibility and evaluate the appropriateness of a firm’s
accounting policies and estimates. Another important skill is adjusting a firm's accounting
numbers using cash flow information and information from the notes to the financial
statements to undo accounting distortions.
Why accounting analysis?
- When performing ratio analysis, we want to base our analysis on the most informative
numbers
- When forecasting, we want to know how sustainable current revenues and earnings are
(when numbers are wrong, forecasting will be wrong)
- When valuing a company, we want the forecasts used in the valuation model to be sound
and to capture business reality (when ratio analysis and forecasting is wrong, valuation will
be wrong)
Three potential sources of noise and bias in accounting data:
1. Noise from accounting rules
Accounting rules introduce noise and bias because is often difficult to restrict
management discretion without losing valuable information (e.g. US GAAP prescribes
that all R&D activities should be expensed → low discretion, while it actually is an
investment that could be recorded on the balance sheet).
2. Forecast errors
Managers can’t perfectly predict future consequences of current transactions, and
can use this in their favour (e.g. managers have to make judgements about the
probability of collecting payments).
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, 3. Managers’ accounting choices
Managers have incentives to exercise their accounting discretion to achieve certain
objectives (e.g. capital market or tax considerations, management compensation).
Steps in accounting analysis:
1. Identify key accounting policies
In accounting analysis, the analyst should identify and evaluate the policies and
estimates a company uses to measure its key success factors and risks.
* Banking industry = interest and credit risk management (key success factors and
risks) →affects accounting through loan loss reserves.
* Manufacturing = R&D and product defects (key success factors and risks) →affects
accounting through warranty expenses and reserves.
2. Assess accounting flexibility
Not all firms have equal flexibility in choosing their accounting policies and estimates
(constrained by accounting standards). If managers have considerable flexibility in
choosing the policies and estimates, accounting numbers have the potential to be
informative, depending upon how managers exercise this flexibility. Some areas
always have flexibility →depreciation, inventory valuation (FIFO/average cost),
amortizing intangibles (useful life assumptions).
* High accounting flexibility = bank managers →some freedom to estimate expected
defaults on their losses.
* Low accounting flexibility = marketing is a key to success for consumer products.
However, they are required to expense their marketing outlays (can’t capitalize).
3. Evaluate accounting strategy
When managers have accounting flexibility, they can use it either to communicate
their firm’s economic situation or hide true performance.
Look at reporting incentives, deviation from industry norms, justification for
accounting changes, history of past errors and complex structuring of transactions.
4. Evaluate quality of disclosure
Does the overall quality of disclosure make it easier or more difficult for an analyst
to assess the firm’s accounting quality and to use its financial statements to
understand business reality?
Look at accounting choices (explain accounting policies and assumptions), discussion
of financial performance (explain performance changes), non-financial performance
information (if accounting rules restrict the firms from measuring its key success
factors appropriately, does the firm provide adequate additional disclosures?).
5. Identify potential “red flags”
A common approach to accounting quality analysis is to look for red flags pointing to
potentially questionable accounting quality →suggests the analyst should examine
certain items more closely.
Examples = unexplained changes in accounting, increasing gap between profits and
cash flow from operations (= accruals), unusual increases in inventories relative to
sales, qualified audit opinions, related party-transactions.
6. Recast financial statements and undo accounting distortions
If the accounting analysis suggests that the firm’s reported numbers are misleading,
analysts should attempt to restate the numbers, using:
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