FINC 3015 Financial

Valuations

Dr Craig Mellare
S1, 2021

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Topic 2A Purpose of
Financial Statements

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 Topic Overview
Using financial statements
– The purpose of financial statements in financial valuation analysis.
– The role of the income, balance sheet, and cash flow financial statements.
– The elements that make up these financial statements.

– The links between financial statements.

I want you to know these things so to be able to construct your own

statements which will form the basis of your valuation.
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 Ten Commandments of Financial Statement Analysis
– Individuals must pass a proficiency test before obtaining a driver's license
(Beaver, W., Horngreen J.E., (1991,FAJ)
– By contrast, investors need not pass any proficiency test before trying to use financial
statements as part of their investment analysis.
– Investors are not required to have taken a course in accounting or financial statement
analysis. They are not required even to have read or understood books written on the
subject.
– Yet analysing financial statements requires at least as much knowledge and skill as
driving an automobile. Perhaps each financial statement should contain a warning to
potential users, similar to those found on many products.

– We’ll go through their ‘commandments’ later but the point is that someone
can only go so far with valuations without understanding financial
statements.
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 Financial Statements
– Accounting plays an important role in valuation analysis:
– It is the language for describing financial position and performance
– Provides the framework that valuation takes place in.

– We use the language of accounting to…

– Understand historical financial performance.
– Forecast financial performance.

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 Financial Statements
– Specifically we can use financial statements for:
– Establishing company profiles

– Cash flow analysis

– Budget planning and financial statement forecasting

– Comparable companies analysis

– M&A and due diligence analysis

– Pitch book presentations

– DCF valuation

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 Financial Statements
– This can be done because these statements allow us to
assess:
– Operating performance
– Liquidity and solvency
– Asset efficiency
– Capital structure
– Future funding requirements
– Current and future capital expenditure needs
– Debt servicing capacity
– Cash flow generation capacity
– Dividend paying capacity
– Credit Risk
– …and so much more!!!
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 Complete and Internally Consistent

The accounting framework helps in the creation of a complete

and internally consistent set of projected events for the firm.

The focus here is on financial analysis and not accounting in

its own right.

Accounting techniques are useful in describing the operating

aspects of the firm. For example, sales, costs, assets employed.

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 Complete Set of Financial Statements
– Under Australian Accounting
Standards and the Corporations Act
(2001), companies must provide a
complete set of financial statements.
This comprises of:

a) A statement of financial position

b) A statement of comprehensive income
c) A statement of cash flows
d) A statement of changes in equity
e) Notes to the accounts (changes to
accounting policy plus other
explanatory information)

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 Underpinnings of accounting
– The building blocks of accounting are Assets and Liabilities. Assets
represent future benefits and liabilities represent future obligations. The
difference between asset and liability value is the equity in the firm that
belongs to the owners:

Equity = Assets – Liabilities

– Equity is also known as net assets or book value. If all assets are and
liabilities were recorded at market values then

Book Value of Equity = Market Value of Equity?

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 Underpinnings of accounting
– Due to difficulties in determining market values accountants
do not attempt this task!!!
– Accountants seek to supply reliable (read historical cost) information,
leaving users to make the subjective adjustments required for a
valuation.
– Other: Current Cost, Realisable Value (Settlement), Present Value

– Financial analysis involves finding benefits and obligations

that have been ignored in the preparation of financial
statements and determining those that have been incorrectly
valued.
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 Clarity in Financial Reporting
– Role of incentives
– Management want to present the best possible version of their accounts (at least most of
the time!).
– So we have GAAP and non-GAAP performance measures.
• For some discussion of this, try looking at this (Deloitte) .
• A study by Audit Analytics recently revealed that 97% of companies in the S&P500
used non-GAAP financials in 2017.
– It’s not always done to conceal ‘poor’ performance or help management reach
KPIs. In fact, it may serve to provide supplemental/relevant information.
– WeWork’s “Community Adjusted EBITDA” recently raised eyebrows because
it measured net income before not only interest, taxes, depreciation, and
amortization, but also “building- and community-level operating expenses,” a
category that includes rent and tenancy expenses, utilities, internet, the salaries
of building staff, and the cost of building amenities (which WeWork has
described as “our largest category of expenses”).
– Interesting Links: Link one; Link two; Link three; Link four
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 Let’s take a look at why this is important
– Qantas
– Underlying PBT is
a non-GAAP
measure.
– It’s the key
performance
measure in the
company’s FY16
Investor Pack.
• Would any of
the things
missing from
that definition
concern you?
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 The End

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