02/02/2015

Financial Statement Analysis

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Semester and Staff
 Staff
 Subject Co‐ordinator and Lecturer:
 Dr Trenton Milner
 trenton@uow.edu.au 
 Consulting:
 Monday:  12:30 pm (Sydney)
 Wednesday:  3:30 pm (Sydney)
 Thursday: 2:30 pm (Wollongong)
 Or by appointment
 Contact Expectations (yours & mine)
 Semester
 11 weeks of lectures and tutorials

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My Teaching Style
 Interaction
 The art of common courtesy
 Engagement
 Approachable
 Helpful hints
 Beyond the textbook
 LET’S HAVE FUN while you learn!

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What I need from YOU!!
 A willingness to interact
 Your commitment to your own learning
 A positive attitude
 Sufficient time allowance

YOU are responsible for YOUR learning……I am here to 

help guide the way….

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Key Expectations and Requirements
 Learning is an active (not passive) process
 Learning is something you do, not something we impart!
 People do not learn through a process of osmosis
 Students are expected to attend all lectures and tutorials
 Students are also expected to prepare for each class and to verbally 
contribute to every class , as required
 Academic staff are learning facilitators:
 We have a responsibility to the business community to maintain a high 
standard of graduates
 We all have a broader social responsibility to perform to the best of 
our abilities and to add value to the community

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This Unit: FIN 924
 Textbook: 
 Palepu et al. (2010), Business Analysis & Valuation using 
Financial Statements, 1st Asia Pacific Edition, Cengage 
Australia.
 Also highly recommended:
 Emerson, Writing Guidelines for Business Students, 4th
Edition, Cengage.
 Moodle / SOLS / eLearn
 Who has access?

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Assessment
 In Session Test ‐ Week 6:
 20% (individual)
 Major Assignment ‐ Week 10:
 20% (group)
 Tutorial tasks ‐ Mystery Week:
 10% (individual)
 Exam ‐ Week 13 (TBC):
 50% (individual)

 Time requirement: minimum of 12.5 hours per week

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Each Week
 We are going to go through a case study that should 
help with your assignment
 If you go home each week & do your assignment, it will 
be easy
 Each week we will go through part of your exam too
 The exercises are designed for you to undertake in your 
exam
 So if you skip class…

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Why Financial Statement Analysis?
 Financial statements are an important source of information to the 
capital markets and business analysts.
 Financial Statement provides most publicly available data, Help in 
addressing questions about
 Performance of the firm – current and future value of stock
 Credit risk involved in lending
 Structure of the industry in which the firm operates
 Proper valuation of the firm. If undervalued firm may be 
target for takeover
 Accounting policies and accrual estimates of the firm 
 Analyzing financial statements addresses a number of issues of interest 
to external stakeholders and company insiders.

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The Role of Financial Reporting in 
Capital Markets
 Financial reporting provide much‐needed information to capital 
market participants
 Entrepreneurs have better information than investors in capital 
markets
 Information problems can lead to “lemons”, a problem which can 
breakdown the capital markets
 The intermediaries – Financial  and Information ‐ can prevent market 
breakdown
 Financial Intermediaries – banks, venture capitalists, mutual funds, and 
insurance companies
 focus on funds from individuals.
 Information Intermediaries – financial analysts, auditors, financial press 
 provide information
 Financial intermediaries depend upon the information in financial 
statements to evaluate investment opportunities.
 Information intermediaries assure the quality of financial statement 
representations.
 Relevant and reliable financial information is essential for the functioning 
of capital markets.

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How Capital Markets Function

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From Business Activities to 
Financial Statements
 Financial statements measure and summarize the 
economic consequences of business activities.

 Accounting systems facilitate information quality.
 The role of accrual accounting.
 The need for generally accepted accounting principles 
(GAAP).
 Auditing and the quality of financial information.

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Accounting System
Selects, measures and aggregate financial information 
data
Financial Reports are prepared on accrual rather than 
cash basis
Economic transactions are recorded on the basis of 
expected not actual cash receipts and payments 
(Accrual)
Periodic performance measurements through accrual 
accounting

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Accounting Standards and Auditing
 Accounting standards limits distortions that can be 
introduced in reporting
 AASB and IASB standardise the reporting ability of 
managers
 Uniformity, however, reduces flexibility
 Auditing helps in the verification of the integrity of 
the financial statements, improves quality of data
 Legal environment – threat of lawsuits can help in 
improving disclosures

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Manager’s Reporting Strategy
 Managers have accounting discretions in the real world.
 Managers have choice of accounting and disclosures 
policies
 Manager’s use financial statements to provide information 
to investors and can also manipulate information to 
influence investors
 Variation in accounting quality across businesses provides 
challenges and opportunities to analysts in separating 
noise and gain valuable insights

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Financial Statements and Business 
Analysis
 Business intermediaries use financial statements to 
accomplish four key objectives:
 Four Step Process
 Business Strategy Analysis – Industry Analysis and 
competitive strategy analysis
 Accounting Analysis ‐ Assess accounting policies and 
estimates
 Financial Analysis – Evaluate performance using ratios and 
cash flow analysis
 Prospective Analysis – Make forecast and value business

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Business Application
 Credit Analysis – Ratings, cost of capital, financial 
distress
 Securities Analysis‐ Earning and price forecasts. More 
accurate than models used.
 Mergers & Acquisition Analysis‐ Combining resources, 
economies of scale, capturing tax benefits, increasing 
product‐market returns.

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Summary
 Financial statements are source of widely available data on 
publicly traded corporations.

 Accrual accounting attempts to accurately reflect 
expectations of economic performance, but requires 
careful analysis.

 This chapter has outlined a useful framework for business 
analysis using financial statements.

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Emergency Procedures
• Sydney Business School staff will be informed by the Building Managers what type of
emergency has occurred and what the procedure is.

• Sydney Business School staff members (wearing a yellow or red helmet) will instruct
all staff and students in the SBS premises on what to do in an emergency.

• If leaving the building take all your belongings with you and leave in an orderly but
prompt manner.

• In a fire emergency the assembly point is at First fleet Park which is the open park
between the Museum of Contemporary Art and Circular Quay.

• In the case of another type of emergency, the assembly point will be advised by the
Building Managers, and this will be communicated to students and staff via staff
members.

• Staff and students may not re-enter the building until advised by the building
managers or security staff.

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Assembly Area

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Emergency Procedures
• Sydney Business School staff will be informed by the Building Managers what
type of emergency has occurred and what the procedure is.
• Sydney Business School staff members (wearing a yellow or red helmet) will
instruct all staff and students in the SBS premises on what to do in an
emergency.
• If leaving the building take all your belongings with you and leave in an orderly
but prompt manner.
• In a fire emergency the assembly point is shown on the next slide.
• In the case of another type of emergency, the assembly point will be advised
by the Building Managers, and this will be communicated to students and staff
via staff members.
• Staff and students may not re-enter the building until advised by the building
managers or security staff.

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Case Study. Dot.Com Crash of 2000
 This case helps in understanding the role of key 
intermediaries‐ venture capitalists, investment banks, 
sell‐side and buy‐side analysts, professional managers 
and public accountants in the functioning of capital 
markets
 The case focuses on the potential value these 
intermediaries create and some of the governance and 
incentive challenges they face 

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Scient Corporation
 The firm was founded in Nov.1997. It provided services in Information 
technology and System design, strategy consulting
 The company grew to 2000 employees in 3 yrs

 Year ended March 31     Revenues         Net Loss

 (in $  thousands)                (in $ thousands)
 1998                                            
179                 (1,159)
 1999                                       
20,675                   (13,198)
 2000                                      
155,729                   (16,015)
The firm’s stock reached $133.75 in March 2000 but fell to $44 by June 
2000 and $2.94 in February 2001.

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Venture Capitalists
 Screen early stage investment opportunities
 Develop risky but promising ventures through investment, 
support and oversight
 Reward tied to returns at liquidation of stake in public or 
M&A market
 Driven by IPO market
 Focus on short‐term behaviour of stock market
 Venture capitalists funded too many flawed ideas.
 Entrepreneurs pursued flawed strategy by putting growth 
and market share over profits

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Investment Banks
 Help companies in raising capital in public markets by 
underwriting and distributing new issues
 Incentives by way of proportion of capital raised in public 
issues
 Represent the interest of seller rather than the buyer of 
securities
 Reputation suffers if security overpriced or public 
companies turn out to be lemons
 Willing to exploit hot market on the potential of internet to 
underwrite and market at inflated prices.

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Sell‐side analysts
 Provide research reports and investment recommendations 
to individual and professional investors on new and 
existing securities.
 Rewards tied to accuracy of earning forecasts and 
investment banking fess generated
 Bias in favour of seller of securities to maintain access to 
information and to obtain investment banking deals
 Focus on short term earning forecasts
 Mostly affiliated with brokerage houses and investment 
banks. Commission used to fund research. 

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Buy‐side Analysts
 Provide proprietary research reports and recommendations 
to fund managers.
 Rewards tied to earning forecasts and short‐term stock 
return performance from investment recommendations
 Focus on forecasting short‐term earnings and short‐term 
stock prices.
 Bought stock of flawed and unproven businesses because 
of preferential allocation of IPO shares. These shares were 
dumped to investors at attractive prices

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Fund Managers
 Buy and sell securities to earn superior risk‐adjusted 
returns
 Paid as function of the size of asset under management and 
relative performance of the fund vs. a bench mark.
 Focus on attractive new securities which are often driven by 
short‐term performance of the fund.
 Relative performance evaluation often result in herd 
behaviour.

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Auditors
 Enhance credibility of financial information reported 
by the company
 Attest to its conference with Standards and GAAP
 Rewarded for new client acquisition, client retention 
and generating non‐audit fees
 Unwillingness to confront the client to increase the 
probability of retention and to attract non‐audit 
income.

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Valuation challenges for dot.coms
 Traditional methods of valuations are difficult to apply – EBITDA, P/E 
ratio. No positive cash flow initially
 New methods are not yet tested very well – Theoretical earnings per 
share, comparable companies method of EPS, Inudtsry specific 
methods
 Dot. Com rely on future and future is uncertain
 Evaluation of future earnings and valuation difficult
 Business valuation of technology – Stages of marketing
 Link between valuation and marketing

Ref: Savoie, Valuing dot.coms, The university of Texas, Dallas, school of Management

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Conclusions
 Intermediaries are not perfect so markets are likely to be 
imperfect either.
 The dot com bubble is an extreme example but it happens 
less dramatically but more frequently in individual stock.
 Intermediaries can perform their functions if they are 
insulated from market forces up to a point.
 Reforms to make professional investors more responsive to 
the markets.

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