Summary book - Business Analysis and Valuation
Chapter 1
Capital markets = play an important role in channelling financial resources from savers to business
enterprises that need capital.
The role of financial reporting in capital markets
Savings = savers
Business ideas = entrepreneurs
Matching savings to business investment opportunities through the use of capital markets is
complicated for at least three reasons:
1. Information asymmetry between savers and entrepreneurs
2. Potentially conflicting interests – credibility problems
3. Expertise asymmetry
This leads to the lemons problem: this can break down the functioning of the capital market.
In the market there are good business ideas and bad business ideas. The investor can’t distinguish
between the two types of business ideas, as that entrepreneurs with bad business ideas will claim that
their business idea is good. For this reason, investors value both good and bad ideas at an average
level. This can result in the fact that entrepreneurs with good ideas can find the financing unattractive.
As these entrepreneurs leave the capital market, the proportion of bad ideas in the market increases.
Over time, bad ideas crowd out good ideas and investors lose confident in this market.
Intermediaries can prevent this! (Provides an independent certification of a products/idea’s quality)
Financial intermediaries: venture firms, capital firms, banks, collective investment funds,
pension funds, insurance companies. They focus on aggregating funds from individual
investors and analysing different investment alternatives to make investment decisions.
Information intermediaries: auditors, financial analysts, credit-rating agencies, and the
financial press. They focus on providing or assuring information to investors on the quality of
various business investment opportunities.
Over the past decade, many countries have been moving towards a model of strong legal protection
of investors rights.
Economic environment
The firm’s industry
It’s input and output markets
The regulations under which the firm operates
The firm’s business strategy determines how the firm positions itself in its environment to achieve a
competitive advantage.
,Financial statements = summarize the economic consequences of its business activities.
Firms typically provide five financial reports
1. An income statement = describes the operating performance during a time period
2. A balance sheet = states the firm’s assets and how they are financed
3. A cash flow statement = summarizes the cash flows of the firm
4. A statement of other comprehensive income = outlines the sources of changes in equity that
are (a) not the result of transactions with the owners of the firm and (b) not included in the
income statement
5. A statement of changes in equity = summaries all sources of changes in equity during the
period between two consecutive balance sheets, consisting of (a) total comprehensive income
and (b) the financial effects of transactions with the owners of the firm.
Figure 1.2 page 5 business activities and financial statements
Financial reports are influenced by
- The firm’s business activities
- Its accounting system (intermediaries must understand the influence of the accounting system)
Features of accounting systems
Feature 1: Accrual accounting
Corporate financial reports are prepared using accrual rather than cash accounting. Unlike cash
accounting, accrual accounting distinguishes between the recording of costs or benefits associated
with economic activities and the actual payment or receipt of cash. The effects of economic
transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments.
- Expected cash receipts are recognized as revenues, and expected cash outflows associated
with these revenues are recognized as expenses.
Balance sheet
Assets = economic resources controlled by a firm that (a) have the potential to produce future
economic benefits and (b) are measurable with a reasonable degree of certainty.
Liabilities = economic obligations of a firm that (a) arise from benefits received in the past, (b) have
the potential of being required to be met, and (c) cannot be feasibly avoided by the firm.
Equity = the difference between a firm’s assets and it’s liabilities.
Assets = liabilities + equity
Income statement
Income/revenue = economic resources earned (or increases in assets that affect equity) and
performance obligations settles (or decreases in liabilities that affect equity) during a time period.
Expenses = economic resources used up (or decreases in assets that affect equity) and economic
obligations created (or increases in liabilities that affect equity) during a time period.
Profit/loss = the difference between a firm’s income and expenses in a time period
Profit/loss = Income – Expenses
Summary: Expenses are (a) costs directly associated with revenues recognized in the same period (the
cost of inventory sold), or (b) costs associated with benefits that are consumed in this time
period(depreciation on non-current assets used in the period), or (c) resources whose future benefits
are not reasonably certain (expenditures or inventory write downs)
Need for accrual accounting arises from investors’ demand for financial reports on a periodic basis.
Feature 2: Accounting conventions and standards
Accrual accounting deals with expectations of future cash consequences of current events, it is
subjective and relies on a variety of assumptions. Managers are responsible for these assumptions and
,estimates. Because investors view profits as a measure of managers’ performance, managers
have incentives to use their accounting discretion to distort reported profits by making biased
assumptions Accounting standards and rules minimize this behaviour = uniform accounting
language (improve comparability and increase credibility, reduced flexibility)
Feature 3: Managers’ reporting strategy = the manner in which managers use their accounting
discretion
Constraint: the competitive dynamics in product markets. Disclosure of proprietary
information may hurt the business competitive position.
Feature 4: Auditing, legal liability, and public enforcement
Auditing: a verification of the integrity of the reported financial statements by someone other than the
preparer.
- Ensures that managers use accounting rules and conventions consistently over time and that
their accounting estimates are reasonable. Therefore auditing improves the quality of
accounting data.
- An auditor must not audit the same company for more than ten consecutive years
- An external auditor does not provide any non-audit services to the audited company
- Third party auditing may reduce the quality of financial reporting because it constraints the
kind of accounting rules and conventions that evolve over time.
Legal liability
- The legal environment in which accounting disputes between managers, auditors, and
investors are adjudicated can also have a significant effect on the quality of reported numbers.
Public enforcement
- Proactively or on a complaint basis initiate reviews of companies’ compliance with accounting
standards and take actions to correct noncompliance.
- Can reduce the quality of financial reporting because, in their attempt to avoid an accounting
credibility crisis on public capital markets, enforcement bodies may pressure companies to
exercise excessive prudence in their accounting choices.
- It deters violations of accounting rules just through its presence
Alternative forms of communication with investors for managers
1. Analyst meetings: meet regularly with financial analysts that follow the firm. At these
meetings management will field questions about the firm’s current financial performance and
discuss its future business plans. (through conference calls)
2. Voluntary disclosure: voluntary providing additional information.
o Constraint 1: may hurt the firms’ competitive position
o Constraint 2: management’s legal liability. External stakeholders can question the
additional information.
o Constraint 3: management credibility can limit a firms’ incentives to provide
voluntary disclosures.
How business intermediaries use financial statements to accomplish four key steps
1.Business strategy analysis
Purpose is to identify key profit drivers and business risks and to assess the company’s profit potential
at a qualitive level.
- Analysing a firm’s industry and its strategy to create a sustainable competitive advantage
- Enables the analyst to make sound assumptions in forecasting a firm’s future performance
2.Accouting analysis
Purpose is to evaluate the degree to which a firm’s accounting captures the underlying business reality.
, - Identifying places where there is accounting flexibility, and by evaluating the appropriateness
of the firm’s accounting policies and estimates, analysts can assess the degree of distortion in
a firm’s accounting numbers.
- Undo any accounting distortions by recasting a firm’s accounting numbers to create unbiased
accounting data.
3.Financial analysis
Goal is to use financial data to evaluate the current and the past performance of a firm and to assess its
sustainability.
- Important skill 1: analysis should be systematic and efficient
- Important skill 2: analysis should allow the analyst to use financial data to explore business
issues (ratio and cash flow most commonly used)
4.Prospective analysis
Focuses on forecasting a firm’s future. Two commonly used techniques are financial statement
forecasting and valuation.
Public versus private corporations
Many states of the EU require that privately held corporations prepare their financial
statements under a common, largely country-specific set of rules and make their financial
statements publicly available.
UK and EU laws also require that private corporations’ financial statements be audited by an
external auditor.
Private corporations’ financial statements are less useful than that of public corporations’
financial statements:
o (1) Information and incentive problems are smaller in private than in public
corporations
o (2) Private corporations often produce one set of financial statements that meets the
requirements of both tax rules and accounting rules
o (3) When private corporations’ financial statements also comply tax rules, they are
less useful in assessing the corporations’ true economic performance
Chapter 2
Strategy Analysis = important starting point for the analysis of financial statements. It allows the
analyst to probe the economics of a firm at a qualitive level so that the subsequent accounting and the
financial analysis is grounded in the business reality. It also allows the identification of the firm’s
profit drivers and key risks to make forecasts and assess the sustainability of the firm’s current
performance. Includes Industry Analysis, Strategy Analysis and Corporate Strategy Analysis.
Firm’s value = return on its capital – cost of its capital
A firms profit potential is determined by its own strategic choices:
1. Industry choice
2. Competitive Strategy
3. Corporate Strategy – the way in which the firm expects to create and exploit synergies across
the range of business in which it operates
Industry Analysis
The average profitability of an industry is influenced by five forces. The intensity of competition
determines the potential for creating abnormal profits in an industry. Whether or not the potential
profits are kept by the industry is determined by the relative bargaining power of the firms in the
industry and their customers and suppliers.
