FSA summary
Chapter 1 A framework for business analysis and valuation
using financial statements
In chapter 1 a comprehensive framework for financial statement analysis is outlined. Financial
statements provide the most widely available data on public corporations economic activities.
Capital markets: Channelling financial resources from savers to business enterprises that need
capital. Financial statements play an important role in the functioning of capital markets.
1.1 The role of financial reporting in capital markets
The aim of an good economy is to allocate savings to investment opportunities, if an economy does
this well, new business ideas are created. This leads to jobs, innovation and wealth. The opposite
goes for economies were savings aren’t allocated for investment opportunities.
However, this could be complicated because there are some problems:
Information asymmetry between savers and entrepreneurs: Entrepreneurs have more information on
the inside of the business than investors (lemons problem)
Potentially conflicting interest – credibility problems: Communication by entrepreneurs to savers is
not completely credible because savers know that entrepreneurs have an incentive to inflate the
value of their ideas.
Expertise asymmetry: Savers generally lack the financial sophistication needed to analyse and
differentiate between the various business opportunities.
Lemons problem: The entrepreneurs who seek capital on the capital market are divided by good and
bad ideas. Because the investors can’t distinguish the good ideas from the bad ones, problems arise.
The good and bad ideas are both valued average. This leads to the entrepreneurs with good ideas
leaving the capital market, with only bad ideas remaining.
Financial intermediaries: The emergence of intermediaries can prevent a market breakdown.
Financial intermediaries are venture capital firms, bans, collective investment funds, pension funds
and insurance companies. These aggregate funds form individual investors and analyse different
investment alternatives. They act as the middleman in a financial transaction.
Information intermediaries: Information intermediaries are auditors, financial analysts, credit rating
agencies and the financial press. They focus on assuring the information investors need to invest in a
company or not.
The intermediaries help investors distinguish good ideas from bad ones.
1.2 From business activities to financial statements
Corporate managers are responsible for acquiring physical and financial resources from the firms
environment and use them to create value for the firms investors.
Financial statements summarize the economic consequences of its business activities. The firms
business activities in any period are too numerous to be reported individually to outsiders.
,Periodically, firms typically produce five financial reports:
1. An income statement, which describes the operating performance during a period
2. A balance sheet that stated the firm’s assets and how they are financed
3. A cash flow statement that summarizes the cash flow of the firm
4. A statement of other comprehensive income that outlines the sources of change in equity
that are not the result of transactions with the owners of the firm and not included in the
income statement.
5. A statement of change in equity that summarizes all sources of change in equity during the
period between two consecutive balance sheet.
1.3 Influences of the accounting system on information quality
The quality of the financial statements is influenced by the accounting system used by the firm.
Therefore some features are acknowledged that influences the extend of the accounting influence:
Feature 1 Accrual accounting: Unlike cash accounting, accrual accounting distinguishes between the
recording of costs or benefits with economic activities and the actual payment. In accrual accounting
costs and benefits are recorded when the performance is done, not when the actual payment is
made. This leads to assets (economic resources controlled by a firm), liabilities (economic obligations
of a firm that arise form benefits received in the past) and equity (the difference between assets and
liabilities). The need for accrual accounting arises from investors demand for periodic financial
reports.
Feature 2 Accounting conventions and standard: Accounting standards and rules limit
management’s ability to misuse accounting judgements by regulating how firms record particular
types of transactions. Because investors see profits as a measure of managers performance,
managers have incentives to use their accounting discretion to distort reported profits by making
biased assumptions. The International Accounting Standards Board (IASB) is delegated by more than
120 countries to set these standard.
Feature 3 Managers reporting strategy: It is not optimal to limit managerial flexibility in reporting,
because it adds noise. Therefore real world accounting systems leave considerable room for
managers to influence financial statements data. The reporting strategy is how managers use their
accounting discretion and has an important influence on the firm’s financial statements. Managers
can voluntarily chose to disclose more information than needed. This can lead to a better image for
investors but can also lead to a disadvantage because competitors know more.
Feature 4 Auditing: Auditing is a verification of the integrity of the reported financial statements by
someone other than the preparer. Auditing also ensures that managers use accounting rules and
conventions consistently over time and that their accounting system are reasonable.
Legal liability: The legal environment in which accounting disputes between managers, auditors and
investors are adjudicated can also significantly affect the quality of reported numbers. The threat of
lawsuits and resulting penalties have the beneficial effect of improving the accuracy of disclosure.
Public enforcement: Some countries adhere the idea that strong accounting standard, external
auditing and the threat of legal liability does not suffice to ensure that financial statements provide a
truthful picture of economic reality. Therefore some countries have set up public enforcement
bodies that review companies’ compliance with accounting standard and take action to correct
noncompliance.
,1.4 Alternative mechanisms to communicate with investors
When companies want to communicate their performances with investors more effectively they can
choose to do it alternatively:
Analyst meeting: One way for managers to help mitigate information problems is to meet regularly
with financial analysts that follow the firm. At these meetings management will field questions about
the firms current financial performances and discuss its future business plans.
Voluntary disclosure: Another way for managers to improve the credibility of their financial
reporting is through voluntary disclosure. Accounting rules usually prescribe minimum disclosure
requirements, but they do not restrict managers from voluntarily providing additional information.
Voluntary disclosure could include articulating the companies long term strategy, specification of
non-financial leading indicators that are useful in judging the effectiveness of the strategy
implementation, explanation of the relationship between the leading indicators and future profits.
Non-financial reporting: The definitions of assets and liabilities discussed earlier in this chapter
illustrate that financial statements report on firms economic resources and obligations. The way
companies perform can also been disclosed as ESG. This way the company shows their impact on the
world.
1.5 From financial statements to business analysis
For outsiders it is difficult to distinguish the business reality and financial statements. Therefore
financial and information intermediaries accomplish four steps to fill this gap and make the
knowledge about the company even.
Step 1: Business strategy analysis: The purpose 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
analysing a firms industry and its strategy to create a sustainable competitive advantage. This is the
topic of chapter 2.
Step 2: Accounting analysis: The purpose of accounting analysis is to evaluate to which a firms
accounting captures the underlying business reality. By identifying places where there is accounting
flexibility and evaluating the appropriateness of the firms accounting policies and estimates. This is
also the topic of chapter 3 and 4.
Step 3: Financial analysis: The goal of financial analysis is to use financial data to evaluate a firms
current and past performance and assess its sustainability. There are two important skills related to
financial analysis. First the analysis should by systematic and efficient. Second the analysis should
allow the analyst to use financial data to explore business issues. This topic is discussed in chapter 5.
Step 4: Prospective analysis: Focuses on forecasting a firms future. This is the final step in business
analysis. There are two techniques used to do the prospective analysis: forecasting and valuation.
(Chapter 6,7 and 8)
, Chapter 2 Business strategy analysis
Strategy analysis involves the following topics: Industry analysis, competitive strategy analysis and
corporate strategy analysis.
2.1 Industry analysis
Degree of actual and potential competition: The profits in an industry are a function of the
maximum price that customers are willing to pay for the industry’s product of service. One of the key
determinants of the price is the degree to which there is competition among suppliers of the same or
similar products (industry competition). There are three potential sources of competition in an
industry:
1. Rivalry between existing firms:
In most industries, the average level of profitability is primarily influenced by the nature of rivalry
among existing firms in the industry. Several factors determine the intensity of competition between
existing players in an industry:
Industry growth rate: If an industry grows rapidly, firms won’t buy shares of each other to get market
share. If the industry isn’t growing, competition is very high and companies will buy market shares of
each other.
Concentration and balance of competitors: When there are high numbers of firms in the same
industry the degree of concentration in an industry is high. The degree of concentration influences
whether firms in an industry can coordinate their pricing and other competitive moves.
Excess capacity and exit barriers: If capacity in an industry is larger than customer demand, firms
have a strong incentive to cut prices to fill capacity.
Degree of differentiation and switching costs: The extend to which firms in an industry can avoid
head- on competition depends on whether they can differentiate their products and services. If
products within an industry are very similar, customers are ready to switch from one competitor to
another purely based on prices.
Scale/ learning economies and the ratio of fixed to variable costs: If the learning curve is steep, size
becomes an important factor for companies. In such situations there are incentives to engage in
aggressive competition for market share.
2. Threat of entry of new firms
The potential of earning abnormal profits will attract new entrants to an industry. The very threat of
new firms entering an industry potentially forces incumbent firms to make additional investment in
advertising of to keep prices low.
Scale: When there are large economies of scale, new entrants will initially suffer from a cost
disadvantage in competing with existing firms.
First mover advantage: Early entrants in an industry may deter future entrants if there are first
mover advantages. For example, the first entrant set the industry standards and benefits of the
knowledge it has over new entrants.
Access to channels of distribution and relationships: Limited capacity in the existing distribution
channels and high costs of developing new channels can act as powerful barriers to entry.
