Chapter 1: A framework for business analysis and valuation using financial
statements
Capital markets
Capital markets channel financial resources from savers to business enterprises that need
capital. Savings need to flow to the business ideas.
Matching savers and businesses is complicated for three reasons:
- information asymmetry between savers and entrepreneurs
- entrepreneurs typically have better information on the value of business
investment opportunities than savers -> lemon problem
- potentially conflicting interests - credibility problems
- communication by entrepreneurs is not perse credible as they have the
incentive to inflate the value of their ideas
- expertise asymmetry
- savers generally lack the financial knowledge to analyze and differentiate
between various business opportunities -> to solve this, we need
intermediaries
The information and incentive issues lead to lemon problems: half of the businesses have
good ideas, half have bad. If investors cannot distinguish between these, the bad ideas will
try to claim that their idea is as valuable as a good idea. Investors then value good and bad
ideas at an average level, which penalizes the good ideas. This causes the good ideas to
leave the capital market, and over time bad ideas crowd out good ideas, and investors lose
confidence in the market.
Intermediaries can prevent such a market breakdown as they provide an independent
certification of quality. -> they distinguish good from bad:
- financial intermediaries e.g. banks, pension funds
- focus on aggregating funds from individual investors and analyzing different
investment alternatives to make investment decisions
- information intermediaries e.g. auditors, financial analysts
- focus on providing information to investors on the quality of various business
investment opportunities. Provide business ideas to the savers.
,Financial reporting plays a critical role for both intermediaries. Information intermediaries add
value by either enhancing the credibility of financial reports (auditors) or analyze the
information in the financial statements (rating agencies). Financial intermediaries rely on the
information in the financial statements to analyze investment opportunities.
Why is financial statement analysis important?
Financial statement analysis is a valuable activity when:
- manager have complete information on a firm’s strategies
- and a variety of institutional factors make it unlikely that these managers will fully
reveal this information
Why do we need it?
- outside analysts try to create inside information from analyzing financial statement
data, thereby gaining insight about performance and prospects.
A firm’s business activities are influenced by its economic environment and its business
strategy. The economic environment includes the firm’s industry, its input and output
markets, and the regulation under which the firm operates. The firm’s business strategy
determines how the firm positions itself in its environment to achieve competitive advantage.
Types of financial statements
Financial statements summarize the economic consequence of its business activities. The
firm’s accounting system provides a mechanism through which business activities are
aggregated into financial statements data. Typically, businesses have these financial
reports:
- income statement -> describes the operating performance during a time period. it
shows where the profit in a year comes from:
Net sales (or total revenue)
- cost of sales
= gross profit
- all other costs
= operating profit
- financial expenses
= Income before taxes
- income taxes
= Net income from continuing operations
-+ gains/losses from discontinued operations
= Net income
-> Net income attributable to shareholders
-> Portion left: net income attributable to non-controlling interests
-> discontinued operations is a business or product line which is shut down or sold off
- balance sheet (or the statement of financial position)-> states on the left side the
firm’s assets and on the right side the liabilities and equity. Left side shows how the
firm’s money is used, the right side displays where the money comes from. All are
ordered on their liquidity.
Asset = a firm’s economic resources to produce future economic benefits and is measurable
with a certain degree of certainty e.g. inventory
Current assets -> held for short term e.g. accounts receivable, cash
, Non-current assets -> held for long term e.g. property, plant, equipment
Liability = a firm’s economic obligations that arise from benefits received in the past e.g. loan
Current liabilities -> short-term -> e.g. account payable, income taxes
Non-current liabilities -> long-term e.g. pensions
Some liabilities are called debt, they create interest we have to pay.
Equity = the difference between a firm’s assets and its liabilities
Can be obtained by retained earnings or the shareholders’ equity. Retained earnings
= the amount of net income left over for the business after it has paid out its dividends.
Income (or revenues) =It consists of economic resources earned and performance
obligations settled during a time period. Revenue should be recognized when it has
delivered the goods and the customer has paid or is expected to pay with certainty.
Expenses = economic resources used up and economic obligations created during a time
period. They are (a) costs directly associated with revenues recognized in the same period
(cost of inventory sold), or (b) costs associated with benefits that are consumed in this time
period (depreciation), or (c) resources whose future benefits are not certain (research
expenditures).
Profit or loss = the difference between a firm’s income and expenses in a time period
Recognition of income/expenses depends on assets/liability. E.g. increase in trade
receivables and decrease in inventory, lead to recognition of the associated income and
expense.
- cash flow statements -> It provides us with an idea of the actual flow of money
through the firm. (there is a difference in what we need to pay and we actually paid.
E.g. depreciation is not cash effective. Therefore, they will be added again to income
before taxes)
Operating activities
Income before taxes
+ depreciation
+ interest expenses (so we subtract the actual interest paid).
The statement of cash flows changes because of the operating acitivties, investing activities
and financing activities.
Investing activities -> e.g. purchasing a new plant
Financing activities -> e.g. dividend paid, repayment of debt
- statements of other comprehensive income -> outlines the change in equity which
are not the result of transaction with the owners of the firm and are not include in the
income statements
- statements of changes in equity -> this summarizes all sources of change in equity
during the period between two consecutive balance sheets, consisting of total
comprehensive income (the sum of profit or loss and other comprehensive income)
and the financial effects of transactions with the owners of the firms.
Balance at dec 2015 + net income - all other changes relevant to the equity holders (such
as dividend payment, repurchase of treasury shares, re-issuance of treasury shares due to
the conversion of convertible bonds) = balance at dec 2016
, -> statement of comprehensive income: in this income statement, we see net income, and
we only find items or lines which are not part of the business activity such as hedging
activities or differences due to foreign exchanges. This statement is used to calculate the
change in equity.
Accounting features
Financial reports are influenced by the firm’s business activities and its accounting system.
The features of the accounting systems determine the extent of that influence:
- Accrual accounting:
Corporate financial reports are prepared using accrual accounting rather than cash
accounting. Accrual accounting distinguishes between the recording of costs or benefits
associated with economic activities and the actual payment of cash. To compute profit or
loss, the effects of transactions are recorded on the basis of expected cash receipts, not
actual.
- Accounting conventions and standards
A firm’s manager makes the appropriate estimates and assumptions of their expected future
cash as they have intimate knowledge of their firm’s business. They are however
incentivised to distort reported profits as investors view profits as a measure of managers’
performance. Therefore, there exist accounting standards.
-> accounting standards set rules and principles about discretion. The discretion allows the
managers to have as much flexibility to properly present their business activities in their
financial statement. However, this flexibility might distort the actual numbers and hide certain
activities of the companies. Therefore, certain standards are needed
The standards (International Financial Regulation Standards -> principle-based accounting
standards) make sure that liabilities cannot be undervalued and assets overvalued. Also, it
stipulates how firms record contractual arrangements to lease resources. These standards
are accompanied by disclosure principles, which guide the amount and kinds of information
that are disclosed.
-> these standards create a uniform accounting language, improving the comparability of
financial statements and increasing the credibility of financial statements as firm’s cannot
distort them.
More than 100 countries have delegated the task of setting accounting standards to the
International Accounting Standards Board. In the US, the Security and Exchange
Commission has the legal authority to set accounting standards.
However, when there is significant business judgement involved in assessing a transaction’s
economic consequences (e.g. determining the economic benefits of product developments),
rigid standards (e.g. requiring the immediate expensing of product development outlays) are
likely to be dysfunctional for some companies as it prevents managers from using the
superior knowledge to determine how best to report the economic of key business events.
Also, if the standards are too rigid, they may induce managers to restructure business
transactions to achieve a desired accounting result or forego transactions which are difficult
to report on.
