A FRAMEWORK FOR BUSINESS ANALYSIS AND VALUATION USING FINANCIAL STATEMENTS

CAPITAL MARKET- are where savings and investments are channeled between suppliers—people or
institutions with capital to lend or invest—and those in need.

INFLUENCES OF THE ACCOUNTING SYSTEM ON INFORMATION QUALITY

 Accrual Accounting- accounting method where revenue or expenses are recorded when a
transaction occurs versus when payment is received or made. The method follows the matching
principle, which says that revenues and expenses should be recognized in the same period.
 Accounting Conventions and Standards- customs or guidelines associated with the practical
application of accounting principles and are aimed at bringing about consistency in the
maintenance of accounts. Accounting conventions are generally accepted principles and are not
considered legally binding.
 Manager’s Reporting Strategy- involves the formulation and implementation of the major goals
and initiatives taken by an organization's managers on behalf of stakeholders.
 Auditing- make sure that a company’s financial statements are accurate and are following
regulatory guidelines. Auditing also gives investors, creditors, and other stakeholders reasonable
assurance that they can rely on a company and its integrity.

STRATEGY ANALYSIS- refers to the process of conducting research on a company and its operating
environment to formulate a strategy Strategic Analysis - Overview, Examples, Levels of Strategy
(corporatefinanceinstitute.com)

 an important starting point for the analysis of financial statements

 allows the identification of the firm’s profit drivers and key risks

STRATEGIC CHOICES- the choice of an industry or a set of industries in which the firm operates
(industry choice)

 the manner in which the firm intends to compete with other firms in its chosen industry or
industries (competitive positioning)
 the way in which the firm expects to create and exploit synergies across the range of businesses
in which it operates (corporate strategy).

INDUSTRY ANALYSIS

Degree of Actual and Potential Competition

At the most basic level, the profits in an industry are a function of the maximum price that customers
are willing to pay for the industry’s product or service. One of the key determinants of the price is the
degree to which there is competition among suppliers of the same or similar products.

- Industry analysis is a market assessment tool used by businesses and analysts to understand the
competitive dynamics of an industry. It helps them get a sense of what is happening in an
industry, e.g., demand-supply statistics, degree of competition within the industry, state of
competition of the industry with other emerging industries, future prospects of the industry
 taking into account technological changes, credit system within the industry, and the influence
of external factors on the industry.
- Industry analysis, for an entrepreneur or a company, is a method that helps to understand a
company’s position relative to other participants in the industry. It helps them to identify both
the opportunities and threats coming their way and gives them a strong idea of the present and
future scenario of the industry. The key to surviving in this ever-changing business environment
is to understand the differences between yourself and your competitors in the industry and use
it to your full advantage.

The Competitive Forces Model is an important tool used in strategic analysis to analyze the
competitiveness in an industry. The model is more commonly referred to as the Porter’s Five Forces
Model, which includes the following five forces: intensity of rivalry, threat of potential new entrants,
bargaining power of buyers, bargaining power of suppliers, and threat of substitute goods and/or
services. In our competitive forces model, we include a sixth force, the power of complementary goods
and/or services providers. The model helps a company understand the risks in the industry it is operating
in and decide how it wants to execute its strategies in response to competition.

RIVALRY AMONG EXISTING FIRMS- The number of participants in the industry and their respective
market shares are a direct representation of the competitiveness of the industry. These are directly
affected by all the factors mentioned above. Lack of differentiation in products tends to add to the
intensity of competition. High exit costs such as high fixed assets, government restrictions, labor unions,
etc. also make the competitors fight the battle a little harder.

 Industry Growth Rate

 Concentration and Balance of Competitors
 Degree of Differentiation and Switching Costs
 Scale/Learning Economies and the Ratio of Fixed to Variable Costs
 Excess Capacity and Exit Barriers
 Concentration of rivals – the more competitors, the more intense the rivalry
 Product homogeneity – industries selling very similar products are likely to be more competitive
 Consumer switching costs – if it costs consumers a lot to switch from one company’s product to
a competitor’s, the company is likely to face less competition
 Excess production capacity – when there is excess production capacity available in an industry,
there is a higher chance of increased rivalry as companies find the industry more attractive to
enter
 Brand loyalty – rivalry is high when customers have low brand loyalty
 Network effects – refers to the positive effect on the value of a product when there is an
additional user of the product. When a network effect exists, the value of a product or service
increases as more people are using it.

Threat of New Entrants- This indicates the ease with which new firms can enter the market of a
particular industry. If it is easy to enter an industry, companies face the constant risk of new
competitors. If the entry is difficult, whichever company enjoys little competitive advantage reaps the
benefits for a longer period. Also, under difficult entry circumstances, companies face a constant set of
competitors.
  Economies of Scale
 First Mover Advantage
 Access to Channels of Distribution and Relationship
 Legal Barriers
 Switching costs
 Network effects
 Excess production capacity
 Cost advantage or economies of scale – The threat of potential entrants tends to be higher
when companies can realize economies of scale by mass production
 Government regulation – industries with strict government regulation pose a higher barrier to
potential new entrants
 Barriers to exit – when exiting an industry requires high costs, companies are less likely to enter
the industry in the first place
 Investment in specialist equipment – companies also consider the amount of capital that needs
to be invested in specialist equipment when entering an industry
 High fixed costs – things such as specialist equipment, properties, and land are examples of high
fixed costs
 Specialized skills – when entering an industry requiring specialized skills or techniques, there is a
higher barrier to entry for potential entrants

Threat of Substitute Products- The industry is always competing with another industry producing a
similar substitute product. Hence, all firms in an industry have potential competitors from other
industries. This takes a toll on their profitability because they are unable to charge exorbitant prices.
Substitutes can take two forms – products with the same function/quality but lesser price, or products
of the same price but of better quality or providing more utility.

- Relevant substitutes are not necessarily those that have the same form as the existing products
but those that perform the same function.
 Switching costs are low for customers
 Substitutes have superior pricing relative to the current products
 Substitutes have better attributes or performance characteristics

Bargaining Power of Buyers- The complete opposite happens when the bargaining power lies with the
customers. If consumers/buyers enjoy market power, they are in a position to negotiate lower prices,
better quality, or additional services and discounts. This is the case in an industry with more competitors
but with a single buyer constituting a large share of the industry’s sales.

 Price Sensitivity
 Relative Bargaining Power
The bargaining power of suppliers is high when:
 Suppliers are large or concentrated
 Suppliers can credibly threaten forward integration in the industry
 Rivals purchase a small percentage of the suppliers’ products
Purchasers’ price elasticity is high when:
 There are few alternative suppliers available
  There are few substitute inputs available
 Switching costs are high for purchasers

Bargaining Power of Suppliers- This refers to the bargaining power of suppliers. If the industry relies on
a small number of suppliers, they enjoy a considerable amount of bargaining power. This can particularly
affect small businesses because it directly influences the quality and the price of the final product.

 The analysis of the relative power of suppliers is a mirror image of the analysis of the buyer’s
power in an industry.
 Suppliers are powerful when there are only a few companies and few substitutes available to
their customers.

Complementary goods or services can add value to the existing products in an industry.

COMMON TYPES OF CORPORATE STRATEGY

 GROWTH STRATEGY
 CONSOLIDATION STRATEGY
 GLOBAL STRATEGY
 COOPERATIVE STRATEGY
 E-BUSINESS STRATEGY

1. GROWTH STRATEGY- selected by a business organization to fuel revenue and earnings growth.

Horizontal integration – The merger or acquisition of new business operations. An example of

horizontal integration would be Apple entering the search-engine market or a new industry related to
laptops and smartphones.

Vertical integration – Integrating successive stages in the production and marketing process under the
ownership or control of a single management organization. An example might include a gas-station
company acquiring a oil refinery.

Diversification – A corporate strategy in which a company acquires or establishes a business other than
that of its current product. Diversification can occur either at the business-unit level or at the corporate
level. At the business-unit level, diversification is most likely to involve expansion into a new segment of
an industry in which the business already competes. At the corporate level, it generally means entrance
into a promising business outside the scope of the existing business unit.

2. CONSOLIDATION STRATEGY- refers to the mergers and acquisitions of many smaller companies into
much larger ones for economic benefit.

3. GLOBAL STRATEGY- is an organization’s strategic guide to pursuing various geographic markets.

4. COOPERATIVE STRATEGY- where each member expects the benefit from cooperation will outweigh
the cost of individual efforts.
5. E-BUSINESS STRATEGY- long-term plan for putting in place the right digital technology for a company
to manage its electronic communications with all partners - that's internal through the intranet and
externally through to customers, suppliers and other partners.

EXAMPLES OF CORPORATE STRATEGY

BRAND ACQUISITION AND BRAND EXPANSION

Financial statement analysis is a valuable activity when managers have completed in-formation on a
firm’s strategies and a variety of institutional factors make it unlikely that they fully disclose this
information. In this setting, outside analysts attempt to create “in-side information” from analyzing
financial statement data, thereby gaining valuable in-sights about the firm’s current performance and
future prospects.

Financial reporting plays a critical role in the functioning of both the information intermediaries and
financial intermediaries. Information intermediaries add value by either enhancing the credibility of
financial reports (as auditors do), or by analyzing the information in the financial statements (as analysts
and the rating agencies do).

Corporate managers are responsible for acquiring physical and financial resources from the firm’s
environment and using them to create value for the firm’s investors.

Accounting standards (Generally Accepted Accounting Principles), promulgated by the Financial

Accounting Standards Board (FASB and similar standard-setting bodies in other countries, also limit
potential distortions that managers can introduce into reported numbers. Uniform accounting standards
attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways, either
over time or across firms.

Internal factors that already exist and have contributed to the current position and may continue to
exist.

External factors are usually contingent events. Assess their importance based on the likelihood of them
happening and their potential impact on the company. Also, consider whether management has the
intention and ability to take advantage of the opportunity/avoid the threats.