Introduction to Business Analysis and Valuation Using Financial Statements

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Introduction to Business Analysis and

Valuation using Financial Statements

The contents of this presentation are based on Palepu & Healy (2015) and Dey (2015)

Dr. Vinodh Madhavan

Assistant Professor – Finance

IMT Ghaziabad

Contact Details: [email protected] | [email protected]


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Why study Business Analysis and Valuationusing Financial Statements?

Business Analysis using Financial Statements helps in answering the

following questions.

How well is the firm performing ? What is the value of the firm’s stock givenits current and future performance?

What is the credit risk involved in lending to a firm? How well is the firm

managing its liquidity and solvency. What is the structure of the industry in which a firm is operating? How do the

strategies adopted by different players in the market place affect therelative performance of players in the industry?

Are the accounting policies and accrual estimates in a company’s financialstatements consistent with one’s understanding of the firm’s business andits recent performance?

Do the financial statements communicate the current status and significant

risks of the business?


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Capitalism vs. Central Planning

Structure of economies in general can be classified into two broadcategories.

Capitalism

The capitalistic model relies on the market mechanism to governeconomic activity and decisions regarding investments are madeprivately.

Central Planning

The centrally planned economies use central planning andgovernment agencies to pool national savings and to directinvestments in business enterprises.

Most (if not all) of the economies in the world have partly or entirely abandoned

central planning in favor of market model . Consequently capital markets playan instrumental role in channeling the financial resources from the saversof capital to business enterprises that need capital.


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Information Asymmetry

Managers of a corporation have in-depth information of the firm’s

strategies and its performance.

However managers of the firm are not in a position to fully disclose allavailable information owing to a variety of institutional factors.

In light of this ever-lasting information asymmetry, professional analystsundertake financial statement analysis in an effort to create (uncover)insider-information that would offer valuable insights on the firm’s current performance and its future prospects.

In a nutshell, as much as financial statements help in mitigating informationasymmetry, financial statement analysis helps uncover further not-so-obviousinformation that is hidden within the financial statements.


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A world in which there are no Financial Statements

In the absence of financial statements, we have a world wherein saversand entrepreneurs who would like to do business with one another facethe following complications.

Entrepreneurs have better information than savers on the value of the business investment opportunities

Communication by entrepreneurs is not credible since entrepreneurshave an incentive to inflate the value of their ideas.

Savers lack the financial sophistication needed to analyze anddifferentiate among various entrepreneurs.

The above complications lead to what is termed as “lemons problem” whichin turn leads to break down of capital markets.


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Institutions such as venture capital firms, private equity firms, banks,mutual funds, and insurance companies that focus on aggregating fundsfrom individual investors and distributing those to businesses seekingcapital, play an instrumental role in preventing the break down of capitalmarkets.

Other notable intermediaries that make a difference in this regard are

Auditors and in-company (in-house) audit committee

Financial Analysts, Credit Rating Agencies, and Financial press Stock Exchanges and Brokerage houses

Regulators such as FASB, SEC, IASB, MCA, SEBI

Courts

Key Institutional Players in a capital market system


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Business Activities to Financial Statements

Corporate managers are responsible for acquiring physical and financialresources from the firm’s environment and using them appropriately tocreate value of firm’s investors.

Value is created when firms earn a return on its investment in excess of the cost ofcapital .

Managers formulate business strategies to achieve this goal and constantlystrive to implement firm strategy through mutually reinforcing businessactivities.

The economic environment of the firm – firm’s inputs, firm’s outputmarkets, the industry to which the firm belongs to, and the regulationsunder which the firm operates – influences the business activities of thefirm.


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The firm’s business strategy determines how the firm positions itself in theenvironment to achieve competitive advantage.

Financial Statements summarize the economic consequences of the firm’s business activities.

The accounting system provides a mechanism by which the firm’s businessactivities are selected, measured, and aggregated into financial statementdata.

A key aspect of Financial Statement Analysis involves understanding theinfluence of accounting system on the quality of financial statements thatare generated.



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Financial Statements to Business Analysis

Corporate managers’ insider knowledge manifests in the financial

statements of the firm and it constitutes both value as well as distortion.

External users of financial statements experience difficulty in discerningvaluable information from noise and distortion in the financial

statements.

Consequently, the financial statements of a firm are impreciseassessments of the firm’s performance.

In an effort to accommodate for their inability to discern and undoaccounting distortions, investors discount the firm’s reported accountingperformance.


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Effective financial statement analysis is valuable because it attempts to

uncover managers’ insider-information from financial statements.

Since financial intermediaries such as analysts and credit ratingagencies do not have access to the corporation to the extent the

managers of the firm have, they are more objective in evaluating theeconomic consequences of the firm’s investment and operatingdecisions.

Financial Statements Analysis involves four steps: (1) business strategyanalysis, (2) accounting analysis, (3) financial analysis, and (4)prospective analysis.

Financial Statements to Business Analysis


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Business Strategy Analysis

Business Strategy analysis is aimed at identifying a key profit drivers business risks and profit potential of a firm at a qualitative level.

Identification of key profit drivers and business risks helps in identification

of key accounting policies.

Assessment of a firm’s competitive strategy facilitates evaluating if thecurrent profitability of the firm is sustainable.

The above actions help an analyst in making sound assumptions whileforecasting future firm performance.


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Accounting Analysis

This phase of financial statements analysis is aimed at evaluating the extentto which the financial statements of a firm capture its underlying businesseconomics.

An experienced analyst would be able to readily identify instances ofaccounting flexibility and in-turn evaluate the appropriateness of firm’s accounting policies and estimates .

Consequently the analyst would be able to undo accounting distortions by

recasting a firm’s accounting numbers to create unbiased accounting data.

Without unbiased accounting data, conclusions based on subsequentfinancial analysis would be unreliable.


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Financial Analysis

The goal of financial analysis is to use the financial data to evaluate thecurrent and past performance of a firm and to assess its sustainability.

Ratio analysis and cash flow analysis are two most commonly usedfinancial tools.

Ratio analysis focuses on evaluating a firm’s product market performance

and financial policies while cash flow analysis focuses on a firm’s liquidityand financial flexibility.


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Prospective Analysis Prospective Analysis, which focuses on forecasting a firm’s future is the final

step in business analysis.

Two commonly used techniques in prospective analysis are financial statementforecasting and valuation. These techniques facilitate synthesis of insightsderived from business strategy analysis, accounting analysis and financial

analysis.

The intrinsic value of a firm is a function of the firm’s future cash flows. Theintrinsic value could also be derived based on current book value of equity

and firm’s future return on equity (ROE) and growth.

Strategy analysis, accounting analysis and financial analysis help in assessingpotential changes in the firm’s competitive advantage and the implications ofsuch a change when it comes to future ROE and growth.


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Need for Business Analysis in broad areas Predictions derived from effective financial statement analysis are useful to a

variety of parties and can be applied in various contexts such as, but not

limited to, Security Analysis, Credit Evaluation, Mergers and Acquisitions(M&As) and Assessment of Corporate Communication Strategies.

Notwithstanding prevalence of reasonable market efficiency, financial

statement analysis (FSA) does add value in areas outside capital markets -credit analysis, competitive benchmarking, and M&As.

Over time market become efficient precisely because market participants

rely on analytical tools such as FSA to analyze information and makeinvestment decisions.

Such actions by market participants impose greater discipline on corporate

managers to develop appropriate disclosure and communication strategy.


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Accounting Standards

The set of conventions, rules, procedures which define accepted accounting

practice in USA constitute Generally Accepted Accounting Principles(GAAP)

GAAP represents the fundamental positions that have been agreed uponoften tacitly by accountants and encompasses contemporary permissible

accounting practice in USA.

Competing set of accounting standards issued by International AccountingStandards Board (IASB) are referred to as International Financial Reporting

Standards (IFRS) or International Accounting Standards (IAS).

The IASB works with national accounting standard-setters to achieveconvergence in accounting standards around the world.


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Although Indian companies currently prepare financial statements

accordance with Indian GAAP (IGAAP), India has committed that itsnational accounting standards will converge with IFRS in the nearfuture.

Unlike European countries that follow IFRS standards in its entirety(adoption), India would maintain certain carve out exceptions in itstransition to IFRS (convergence). Converged Indian IFRS Standards arereferred to as “Ind-AS”.

Ministry of Corporate Affairs (MCA) came out with 35 Ind-ASstandards in Feb 2011. However the initial plans laid out by MCA forIndian companies to make the transition from IGAAP to Ind-AS forfinancial reporting were deferred.

Accounting Standards


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Ind-AS With the formation of new government in 2014, there was a flurry of

activities in-connection with transition from IGAAP to Ind-AS thatculminated in notification of 39 Ind-AS standards coupled with theimplementation roadmap.

The National Advisory Committee on Accounting Standards (NACAS) wasset up under the Companies Act 1956 to advise the Indian government onformulating and laying down accounting standards.

From 2016-2017, it will be mandatory for all companies, both listed andunlisted, with net worth of at least Rs. 500 crore to transition to adoptInd-AS.

From FY 18, Ind-AS will be mandatory for all listed entities with networth of 250-500 crore.


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Banks , Non-banking financial companies (NBFCs) and insurance companies

are likely to become Ind-AS compliant in FY 19, subject to approval by RBIand IRDA.

As far as 2015-2016 is concerned. Adoption of Ind-AS is voluntary.

The following are certain unresolved concerns in Industry circles when itcomes to adoption of Ind-AS.

Request for deferment of Ind-AS 115 (revenue recognition) to 2018-2019.

Implications of Ind-AS in relation to direct taxes, indirect taxes, anddisclosures by companies going for Initial public offerings (IPOs).

The manner of implementation of Ind-AS for an NBFC should (a) an NBFC be a holding company or (b) should an NBFC be a subsidiary of a holding

company that has to be Ind-AS compliant from 2016-2017 onwards.

Ind AS


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Financial Statements

Financial statements of a firm can be classified as Stock or statusreports and flow reports

Stock reports are reports as of a specified instant in time. For instance,the balance sheet is a stock report that offers a snapshot of the assets,liabilities and Stockholder Equity of a reporting entity.

Flow reports are reports that pertain to a period of time. NotableExamples: Income Statement, Statement of Cash Flows.

Documents

Introduction to Business Analysis and Valuation Using Financial Statements