1) Chapter 1 – A framework for business analysis and valuation using

financial statements

Financial statement analysis aims to bridge the gap between managers’ information on firm
strategies and the information that is disclosed, in order to serve suppliers of capital. On a
conceptual level, savings of the economy is to be allocated to investment opportunities. As
there are many entrepreneurs that would like to attract this capital, how to know where to
allocate, this is a difficult problem for at least three reasons:

- Information asymmetry between savers and entrepreneurs

- Potentially conflicting interests – credibility problems; entrepreneurs have incentive to
inflate
- Expertise asymmetry – savers lack expertise to analyze.

The information and incentive issues are also described as the lemons problem. Half of the
ideas are good and the other half are bad, and this is not distinguishable by investors,
implying that every idea will be valued as ‘average’. This penalizes the good idea, as its value
will be averaged by the bad ones. This makes the ‘good entrepreneurs’ to leave the capital
market, and in the end the bad ideas crowd out the good ideas, and investors eventually lose
confidence. Intermediaries can help bridge this information gap. Financial intermediaries
focus on aggregating funds from individual investors and analyzing different investment
alternatives to make investment decisions. Information intermediaries focus on providing
or assuring information to investors on the quality of various business investment
opportunities. Both these intermediaries help distinguish good ideas from bad ones. The
relative importance of these two varies per country. Continental Europe emphasizes financing
via financial intermediaries to entrepreneurs, whereas Anglo-Saxon countries legal rights of
individual investors (where information intermediaries supply them with information).

An emergence of a model of strong legal protection of investors’ rights disciplines

entrepreneurs and well-developed stock exchanges, and enables information intermediaries
for enhancing the credibility of financial reports or analyzing the information in the financial
statements. Financial intermediaries rely on this information to analyze investment
opportunities. However, incentive or governance issues can arise in either type of
intermediary organization, but still, overall the market prices tend to reflect all available
information. Despite this, individual securities may still be temporarily mispriced, thereby
justifying the need for financial statement analysis. These financial statements summarize
the economic consequences of a firm’s business activities. This is basically made up of (1) an
income statement, (2) a balance sheet, (3) a cash flow statement, (4) a statement of other
comprehensive income and (5) a statement of changes in equity.

Financial reports are influenced both by the firm’s business activities and by its accounting
system. An understanding of the influence of the accounting system on the quality of
financial statement data is key. The important features are as follows:

 Accrual Accounting – distinguishes between the recording of costs or benefits associated

with economic activities and the actual payment or receipt of cash. Therefore, the effects
of economic transactions are based on expected instead of actual cash receipts and
payments. Timing differences between the event of recording and experiencing cash in-
or outflows results in the recognition of assets and liabilities on the balance sheet. Assets
have (1) the potential to produce future economic benefits and (2) are measurable with a
reasonable degree of certainty. Liabilities are economic obligations that (1) arise from
benefits received in the past, (2) have the potential of being required to be met and (3)
cannot be feasibly avoided by the firm. Equity is the difference between assets and
liabilities. Income or revenue consist of economic resources earned and performance
obligations settled during a time period, where the realization principle requires that the
performance is delivered and the customer pays or is expected to pay cash with a
reasonable degree of certainty. Expenses are economic resources used up and economic
obligations created during a time period. Profit or loss is the difference between income
and expenses. Some income or expense items might not be related to economic activities,
but be a result from remeasurement of assets or liabilities. Accrual accounting is designed
to provide more complete information as it reports the full economic consequence of the
transactions undertaken in a given period.
 Accounting Conventions and Standards – firm’s managers are granted with accounting
discretion to allow them to reflect inside information in reported financial statements.
This can, however, enable them to manage their earnings, as they might be incentivized,
and this makes the information less valuable to external users of financial statements.
Accounting conventions have been implemented to secure that managers use their
accounting flexibility to summarize their knowledge of the firm’s business activities and
not disguise reality for self-serving purposes. Accounting standards limit management’s
ability to misuse accounting judgment by regulating how particular types of transactions
are recorded, and are complemented with a set of disclosure principles which guide the
 amount and kinds of information that are disclosed and require qualitative information to
be disclosed as well. uniform accounting standards create a uniform accounting language
to improve the comparability and credibility of financial statements, by limiting a firm’s
ability to distort them. This reduces flexibility in reporting and reduces reflection of
genuine business differences.
 Managers’ Reporting Strategy – as accounting regulation usually prescribes minimum
disclosure requirements, managers can choose for a superior disclosure strategy which
enables them to communicate the underlying business reality to outside investors. They
can provide information useful to investors in assessing the firm’s true economic
performance, or use financial reporting strategies to manipulate investors’ perceptions,
and made it difficult for investors to identify poor performance on a timely basis, or make
it costly for investors to understand the true performance. The variation in accounting
quality provides opportunities and challenges in doing business analysis.
 Auditing, Legal Liability, and Public Enforcement – Auditing is the verification of the
integrity of the reported financial statements by someone other than the preparer, and
therefore improves the quality and credibility of accounting data. Independence of the
auditor is maintained via a set of rules and regulations. The primary responsibility for the
financial statements remain with corporate managers. However, auditing is imperfect, as
they can also fail because of lapses in quality or judgment. Legal liability relates to the
legal environment in which accounting disputes are adjudicated. The threat of lawsuits
serves as an incentive for improving the accuracy of disclosure, and the audit as well.
legal liability regimes vary in strictness, with the US being very strict and investors can
hold managers liable for their investment losses if they prove that the firm’s disclosures
on which they relied were misleading. A drawback of strict legal environment is the
discouragement for managers and auditors from supporting accounting proposals
requiring risky forecasts. Public enforcement bodies proactively or on a complaint basis
initiate reviews of companies’ compliance with accounting standards and take actions to
correct noncompliance. This is usually done on a sampling basis. Struct public
enforcement can also reduce the quality of financial reporting because they may pressure
companies to exercise excessive prudence in their accounting choices.

Firms that wish to communicate effectively with external investors are often forced to use
alternative media, given the limitations of accounting standards, auditing and enforcement.
Two alternative ways of communication with external investors and analysts are discussed:
 - Analyst Meetings: management will field questions about the firm’s current financial
performance and discuss its future business plans. However, regulations preventing
unfair disclosure in analyst meeting have already emerged. Countries must ensure that
exchange-listed companies disclosure nonpublic private information promptly and
simultaneously to all investors, which can reduce the information that managers are
willing to disclose.
- Voluntary disclosure: articulation of the company’s long-term strategy, specification
of nonfinancial leading indicators, explanation of the relationship between these
indicators and future profits, and forecasts of future performance, among others.
These disclosures may, however, hurt the firm’s competitive position, and managers
face a trade-off between providing information and withholding information to
maximize the firm’s product market advantage. Furthermore, management’s legal
liability might restrict management’s voluntary disclosure as it might provide room
for dissatisfied shareholders to bring civil actions against management. Furthermore,
management credibility might be harmed in case of voluntary disclosers, as these are
usually not audited.

Given the aforementioned values and distortions in accounting data, outside users of financial
statements need to make a probabilistic assessment of the extent to which a firm’s reported
numbers reflect economic reality. The intermediaries mentioned before can add value by
improving investors’ understanding of a firm’s current performance and its future prospects.
Intermediaries rely on their knowledge of the firm’s industry and its competitive strategies to
interpret financial statements. Although having an information disadvantage, outside analysts
are more objective. Business intermediaries use financial statements to accomplish four key
steps:

1. Business Strategy Analysis: identify key profit drivers and business risk, and assess the
company’s profit potential at a qualitative level.
2. Accounting Analysis: evaluate the degree to which a firm’s accounting captures the
underlying business reality. Where is accounting flexibility? Are the accounting policies
and estimates appropriate? This improves the reliability of conclusions form financial
analysis
3. Financial Analysis: use financial data to evaluate the current and past performance of a
firm and assess its sustainability. This should be systematic and efficient, and should
 allow the analyst to use financial data to explore business issues. An example is ratio
analysis and cash flow analysis (liquidity and financial flexibility).
4. Prospective analysis: focuses on forecasting a firm’s future. This could consist of
financial statement forecasting and valuation, which allow the synthesis of the insights
from the preceding 3 analyses, as these allow for estimating a firm’s intrinsic value, and
this fourth step subsequently implies making predictions about a firm’s future.

Financial statement analysis can add value outside the capital market context, and several
other market participants might rely on analytical tools.

This book focuses on publicly traded corporations. However, private corporations’ financial
statements are required to be audited by an external auditor as well. for example, venture
capitalists can use financial statements of nonpublic firms to evaluate potential investments.
The usefulness of nonpublic firms’ financial statements relative to public ones are less,
however, because:

- Information and incentive problems are smaller, and therefore capital supplies and
managers maintain close relationships.
- Private corporations often produce one set of financial statements that meets the
requirements of both tax rules and accounting rules, which is not very much in line
with accrual accounting, making them less useful in assessing the corporations’ true
economic performance.