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Summary for exam of 'Financial Statement Analysis'

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Rijksuniversiteit Groningen (RuG)

It is a summary of the book 'Business Analysis and Valuation' that is used for the course Financial Statement Analysis, given in period 1 of the third year of the bachelor Bedrijfskunde A&C. Summary covers all chapters that are discussed in the lectures. Summary is divided in weeks with the corresp...

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FSA notes for exam
Lecture 1: Framework and Strategy analysis
Chapter 1 and 2

Aim of FSA
- The aim is to teach you (1) how can we use of analytical procedures to
evaluate the strategy, accounting, financial health, risks, performance, and
future potential of a business, and (2) how can we reflect the outcome of all
analytical procedures in decision making (such as buying shares, capital
budgeting, lending, etc.)

FSA has 2 major components
- Business analysis using financial statements
- Valuation

Purpose of FSA:
- Security analysis = what is the proper value of securities (bonds, shares)
- Credit analysis = investor needs to know if the firm will meet its debt
obligations
- Merger and acquisition analysis = investment bankers need to analyze what
the merger will be worth
- General business analysis
- Audit risk analysis = to estimate the audit risk

Problems in the capital markets
- Information asymmetry = one party has more information than the other
person, hidden information (CG) e.g., manager of company vs banker.
o To mitigate this problem > information intermediaries = a party that
generates new information about a company
o Also, financial newspapers = a source of new information
o Also credit rating agencies = they will analyze the company and give it a
credit rating
- Incentive problems
- Expertise asymmetry = investors are often less informed than experts in the
field
o To mitigate this problem > financial intermediaries

“The market for lemons” and asymmetric information
- The market of used cars
- = the buyer doesn’t know all the issues with the used car, but the seller (=
owner) does = information asymmetry
- Information and financial intermediaries help to reduce this problem
- Situation: half the ideas are “good” half are “bad”. The entrepreneurs with the
bad ideas, will try to claim that their ideas are as valuable as the “good” ideas.

4 Institutional features of accounting systems that affect the quality of financial
statements
- Difference between accrual vs. cash accounting:
o Cash accounting = record the transaction when you receive the cash

1

, o Accrual accounting = record the transaction when you sell the product
- What are the financial standards?
o IFRS vs. US Standards
- Managers’ reporting strategy
- Auditing, legal liability, and public enforcement

FSA has 4 major steps:
1. Business strategy analysis
2. Accounting analysis
3. Financial analysis
4. Prospective analysis

Chapter 2: Strategy analysis
- Industry and profitability
- Competitive strategy analysis
- Corporate strategy analysis
- Management analysis

Industry and profitability – Porter’s 5 forces
1. Rivalry among existing firms (concentration, differentiation, switching costs, legal
barriers)
2. Threat of new entrants (scale economies, first mover advantage)
3. Threat of substitute products (relative price and performance, buyers’ willingness to
switch)
4. Bargaining power of buyers (switching costs, differentiation, number of buyers,
volume per buyer)
5. Bargaining power of suppliers (switching costs, differentiation, number of buyers,
volume per buyer)

Competitive strategy analysis – creating a competitive advantage
Two strategies:
1. Cost leadership 2. Differentiation
a. Supply same product or a. Supply a unique product
service at a lower cost or service at a cost lower
b. Economies of scale and than the price
scope b. Superior product quality
c. Efficient production c. Superior product variety
d. Simpler product designs d. Superior customer
e. Lower input costs service
f. Low-cost distribution e. More flexible delivery
g. Little research and f. Investment in brand
development or brand image
advertising g. Investment in R&D
h. Tight cost control system h. Control system focus on
IKEA creativity and innovation

Competitive advantage = match between firm’s core competencies and key success
factors to execute strategy
- Match between firm’s value chain and activities required to execute strategy
- Sustainability of competitive advantage

2

, Lecture 2: Accounting Analysis
Chapter 3 and 4

Chapter 3 – accounting quality: the basics

Accounting quality
- = the degree to which accrual accounting reflects the economic reality of the
firm
o Accrual accounting = recording the revenues when the transaction
happened, not when the cash is collected
- Comparability between firms?
- Ideally, all assets and liabilities would be measured at fair value
- But, for different type of assets there are no markets available, which makes it
very subjective to determine fair value

Accounting quality
Three sources of “noise” in the quality of accounting:
1. Rigidity in accounting rules > principle based (IFRS) vs. rule-based (US)
2. Random forecast errors (accrual accounting) > you need to make a prediction
whether you can collect all your account receivables
3. Managers’ accounting choices to achieve specific objectives

Accounting choices provide flexibility in how the financial statement prepares depict
the economic reality of different firms.
Flexibility in:
- Depreciation, amortization, depletion
- Inventories (FIFO, average cost, LIFO)
- Revenue recognition (the moment when we recognize the revenue)
- Expenditures on assets (do they extend the life of the asset)

Accounting choices
Manage accounting information to achieve certain objectives
- Capital market considerations: beating earnings forecasts
- Debt covenants: contracts with banks
- Management compensation: depend on profits
- Mergers and take-overs: corporate control contests
- Tax effects: relations with tax reporting
- Regulatory considerations: protecting domestic industries
- Competitive considerations: proprietary information
- Stakeholder considerations: demands of labor unions

Steps in accounting analysis

Step 1: identify key accounting policies (accounting policy disclosures)
- Competitive strategy is important

Step 2: assess accounting flexibility (less flexibility makes accounting less
informative)
- How flexible are the accounting rules (IFRS vs. US)
- Inventories: FIFO, average cost, or LIFO. It is also similar to other companies
in the same industries?

3

, Step 3: evaluate accounting strategy
1. Reporting incentives (covenants, M&As, bonus targets, etc.)
2. Deviations from the norm (industry)
3. Accounting changes
4. Past accounting errors
5. Structuring of transactions (lease term, Enron joint-ventures)

Step 4: evaluate the quality of disclosure
1. Strategic choices (adequate disclosure)
2. Accounting choices (notes)
3. Discussion of financial performance
4. Non-financial performance indication
5. Segment information (for example geographic info or industries info)
6. Bad news
7. Investor relations

Step 5: identify potential red flags
- After performing an overall analysis of the company, we need to identify what
are main issues = red flags on which we need to focus our future efforts
- Future efforts = important use of resources!
o Red flag analysis is only a starting point for further investigation!

Examples of potential red flags
- Unusual transactions or unexplained accounting changes especially when
operating profit is poor
- Unusual inventory/receivables increase in relation to sales increase
- Increasing gap between reported profits and OCF
- Increasing gap between reported profits and tax profits
- Sale of receivables (to get cash now > they don’t want to wait 60 days to
possibly collect the cash) with recourse or special purpose entities
- Qualified audit opinions, key audit matters or changes in auditors (qualified
opinion = there is something wrong with the numbers, clean opinion = auditors
say numbers are okay)
- New year-end date
- Large year-end adjustments (interim reporting)
- Poor internal governance mechanisms (independent directors, internal
auditors, audit committee)
- Related party transactions: potentially self-serving

Step 6: recast financial statements and undo accounting distortions
- In case of detechting financial reporting distortions, analysts should make
adjustments for these misstatements
- Best manner to do it: standardized accounting nomenclatures and formatting –
standard templates

Standardized financial statements
- Operating, investment and financing activities;
- Current and non-current assets/liabilities
- Continued and discontinued operations (predicting future-earnings)
- Recurring and non-recurring activities (predicting future-earnings)

4

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