PowerpointPresentation Chapter 8

Corporate FINANCE.
Theory and practice
Chapter 8
HOW TO PERFORM A FINANCIAL

ANALYSIS
P. Quiry,
M. Dallocchio, Y. LeFur, A. Salvi
Corporate Finance. Theory and Practice
John Wiley & Sons, London, 2009
Corporate FINANCE. Theory and practice
Chapter 8– HOW TO PERFORM A FINACIAL ANALYSIS
TOPICS
•Financial analysis
•Economic analysis of the company
•Accounting analysis of the company
•Financial analysis plan
•Ratings
•Z-score functions
•Experts systems
© 2009 - John Wiley & Sons 2

Quiry, Dallocchio, LeFur, Salvi - Corporate Finance. Theory and Practice
Chapter 8 – HOW TO PERFORM A FINACIAL ANALYSIS
WHAT IS FINANCIAL ANALYSIS
Financial analysis assesses:
• whether the company is able to create value

 shareholders’ standpoint
• the solvency and liquidity of a company

 lenders’ standpoint
the applied techniques are the same

WHAT IS FINANCIAL ANALYSI
Financial analysis = rigorous approach to the issues

facing a business that helps
rationalise the study of economic
and accounting data
The purpose is to provide a global assessment of the

company’s current and future position
Economic analysis Accounting analysis
Financial analysis

Chapter 8– HOW TO PERFORM A FINACIAL ANALYSIS
ECONOMIC ANALYSIS
Understanding of a company’s economics requires the

analysis of the company’s:
• market(s)
• position within its market(s)
• production model(s)
• distribution networks
• human resources management system

THE COMPANY’S MARKET

market ≠ economic sector
Example: what is the market for pay TV operators (BskyB,
Premiere, Telepiù or Canal+)? The entertainment market.
A market is defined by consistent behaviour
Market = competitive arena in which a business has some
industrial, commercial or service-oriented
expertise
After defining the market, financial analysts have to:

• understand in which segment the company operates
• assess growth opportunities
• identify risk factors


Segmentation
Segmentation involves geographical and sociological
(luxury, mid-range or entry-level) variables
Market growth organic volume growth
Types of growth
value growth
Product life cycle
Introduction Expansion Maturity Decline
Duration of growth:
SALES
PROFITS
Time

Growth duration is influenced by growth drivers:
• technological advances (e.g. High speed Internet connections)
• new products changes in the economic situation (eg. expansion of
air travel with the rise in living standards)
• changes in consumer lifestyles (e.g.. eating out)
• changing fashions
• demographic trends (e.g.. the popularity of cruises owing to the
ageing of the population)
• Environmental consideration (e.g. electric cars)
• delayed uptake of a product (e.g. Internet access in France owing
to the success of the previous generation Minitel videotext
information system)
Not always an expanding markets is also attractive: it depends on
the balance between supply and demand.
Example: video games sector (where growth is high but ROCE is poor)
vs. tobacco (mature but rich).

Market risk
• Depends on whether the product is:
− original equipment
 special attraction for consumers
− replacement item
 sensitivity to general economic conditions
• barriers to entry to the company’s market, currently

weakening due to:
− deregulation
− technological advances
− internationalisation
The 5 record industry majors Sony, Bertelsmann, Universal, Warner

and EMI had achieved a mkt share of 85%. They have rapidly seen
their grip loosened by the development of Internet and piracy!

Market share
Market share = portion of business in the market
achieved by the company
Advantages of high market shares:
• loyalty among its customers (lower volatility)
• position of strength toward its customer and supplier (e.g. mass
retailers)
• attractive position (vs. suppliers, inventors and other market
participants)
Limits of the concept of market share:

• it is not always relevant (e.g. construction and public works market)
• if it does not create value it is purposeless (price reduction to increase
market share may destroy value)
• market share ≠ size (e.g. better to have a large share of a small market
than middling sales in a vast market)


Competition
Number and size of the “perfect” competitors depend on market
conditions
•If the market is expanding is better to have small rivals.
•If the market has reached maturity and companies have
specialised in particular niches, it is better to have large rivals.
prices  •minimisation of costs

•importance of market share
Competition is •demand for engineers and controllers
driven by
products  •maximisation of service and
quality
•importance of customer loyalty
•demand for marketing specialists
PRODUCTION
Value chain
Value chain = all the companies involved in the
manufacturing process, from the raw
materials to the end product
Study of the value chain encompasses:

• analysis of the role played by the market participants
• comprehension of their strengths and weaknesses
The purpose is to identify where NOT to invest

or NOT to lend within the value chain

Value chain - THE FILM INDUSTRY

• Production company. Plays both an artistic and a financial role.
The producer writes or adapts the screenplay and brings together a
director and actors. The production company finances the film using its
own funds and by arranging contributions from third parties, such as
co-producers and television companies, which secure the right to
broadcast the film, as well as by earning advances from film
distribution companies (guaranteed minimum payment).
• Distributor. Has a dual role assuming responsibility for logistics and
financial aspects. It distributes the film reels to hundreds of cinemas
and promotes the film. It helps finance the film by guaranteeing the
producer minimum income from cinema operators, regardless of the
actual level of box office receipts generated by the film.
• Cinema operator. Owns or leases its cinemas, organises the
screenings and collects the box-office tickets.

• During the 1980s, the number of box-office tickets fell

right across Europe owing to the advent of new TV
channels and video cassettes.
• Which category of player was worst affected and has now
generally lost its independence?


• Cinema operators? Granted, the fall in box-office admissions led
to a contraction in their sales. Some had to shut down cinemas, but
since their properties were located in town and city centres, cinema
operators that owned the premises had no trouble in finding
buyers, such as banks and shops, that were prepared to pay a
decent price for these properties. The others modernised their
theatres, built up their sales of confectionery that carry very high
margins and have capitalised on the renewed growth in audiences
across Europe over the past ten years.
• Production companies? Obviously, lower audiences meant lower
box-office tickets, but at the same time other media outlets
developed for films (television channels, video cassettes),
generating new sources of revenue for film producers.


• Film distribution companies were the worst hit. Some went
bankrupt, while others were snapped up by film producers or cinema
operators.
• They had:
– only one source of revenue: box-office tickets.
– no bricks-and-mortar assets which could be redeveloped.
– no access to the alternative sources of income (royalties from pay TV
or video cassettes) which caused the slump in the number of tickets
sold. They had agreed to pay a guaranteed minimum to film production
companies based on estimated box-office receipts, but given the steady
decline in admissions, these estimates systematically proved over-
optimistic.

PRODUCTION
Production models
• In a service-dominated economy, the production models are rarely
analysed, even though we believe this is a very useful exercise.
• The first step is to establish whether:
– the company assumes responsibility for or subcontracts the
production function,
– production takes place in Europe or it has been transferred to low
labour-cost countries
– the labour force is made up of permanent or temporary staff
• This step allows the analyst to measure the flexibility of the income
statement in the event of a recession or strong growth in the market.

PRODUCTION
Production models
Processes Products
Specific and temporary organisation Unique, custom-made
Project
comprising experts designed for the user
Flexibility through overcapacity, not Multiple, differentiated,
Workshop very specialised equipment, multi- not standardised
skilled workforce produced on demand
Flexibility through semi-finished
Diversified but made up of
Mass inventories, not very qualified or
standardised components,
production multi-skilled workforce, low barriers
high volumes, low unit cost
to entry
Total lack of flexibility but no semi-
Unique,
Process- finished inventories, advanced
complex,
specific automatisation, small and highly
very high volumes
technical workforce
product and production model have to be consistent

PRODUCTION
Examples
Diversified but made up
Unique Multiple, differentiated Unique
Products: of standardised
custom-made not standardised complex
components
designed for the user produced on demand very high volumes
Processes: high volumes
Project: Pyramids in Egypt

Specific and temporary organisation Cathedrals
comprising experts Hubble telescope
Aerospace
Workshop:
Catering
Flexibility through overcapacity, not
Machine tools
very specialised equipment, multi-
skilled workforce
Consumer appliances
Mass production:
Shoes
Flexibility through semi-finished Textiles
inventories not very qualified or multi-
skilled workforce
Process-specific: Automotive
Total lack of flexibility but no semi- Energy
finished inventories, advanced Sugar production
automatisation, small and highly Chemicals
technical workforce
Source: adapted from JC Tarondeau

PRODUCTION
Capital expenditure
Innovation in products and production systems

A company has
to invest: major innovations Product innovation
Frequency of
Process innovation
 at first in the
product
 then in the
production
Time
process Maximisation of the Minimisation of the
product's performance product's cost
Source: Utterback and Abernathy (1975)

PRODUCTION
Capital expenditure
• Investing too early in the production process is wrong for two reasons:
– Money should not be invested in production facilities that are not yet stable
and might even have to be abandoned.
– It is preferable to use the same funds to anchor the product more firmly in
its market through technical innovation and marketing campaigns.
• More and more, companies are looking to outsource their manufacturing
or service operations, thereby reducing their core expertise to project
design and management.
• Outsourcing trend has given rise to companies such as Solectron,
Flextronics and Celestica, whose sole expertise is industrial
manufacturing and which are able to secure low costs by leveraging
economies of scale because they produce items on behalf of several
competing groups.

DISTRIBUTION SYSTEM
Roles of the distribution system:
• logistics
• advice and services
• financing
Risk of a distribution network  non-fulfilment of its role
Producers and distributors have the same goal:

let consumers buy the product
Producers can also decide to take control of the distribution
the choice depends on: required investments and

importance of end-customers proximity
DISTRIBUTION SYSTEM
• The closer companies can get to their end

customers, possibly even handling the distribution role
themselves, the faster and more accurately they
will find out what their customers want (i.e.
pricing, product ranges, innovation, etc.).
• This approach makes more sense where the key factor
motivating customer purchases is not pricing but
the product’s image, after-sales service and
quality, which must be tightly controlled by the
company itself rather than an external player.

HUMAN RESOURCES
Shareholders
Inside shareholders  who also works within the company
• strong attachment to the company
• scale-, power- and prestige-related objectives
• substantial personal risk
Outside shareholders  who have purely financial objectives

Managers
Managers’ objectives and financial interest can be aligned with
shareholders’ by means of share-options based incentive
systems
Corporate culture
Very difficult to assess
Key factor in case of acquisitions or diversification ventures
HUMAN RESOURCES
Corporate culture
• Is a key factor, particularly when a company embarks

on acquisitions or diversification ventures.
• Matsushita of Japan acquired US film producer Universal,
but the deal never really worked because Matsushita's
engineering culture was far removed from the artistic culture
prevailing in Hollywood studios.
• Conversely, Danone has turned itself from a glass producer
into a food giant because its chairman fully grasped that he
needed marketing specialists rather than engineers to
manage this diversification, which has now become the
group's sole business.

ACCOUNTING ANALYSIS
If the company’s accounting principles are in line with practices
 the accounts provide a good reflection

of the company’s economic reality
Otherwise
the accounts provide a distorted picture of

the company’s economic reality,
probably with the aim of make it look better

STANDARD FINANCIAL ANALYSIS PLAN
Financial analysis comprises interlinked steps

that must be carried out in a logical sequence
Key principle:
wealth creation requires investments

that must be financed
and provide sufficient return


Two preliminary tasks:
GET TO KNOW THE BUSINESS WELL...
 The market(s)
 The product(s)
 Production model(s)
 Distribution network
 Human resources
… AS WELL AS THE COMPANY'S

ACCOUNTING POLICIES
Auditors' reports
 Accounting principles
 Consolidation techniques and scope
 Goodwill, brands, and other intangibles
 Provisions
 Inventories
 Unconsolidated subsidiaries
 etc.


Four-stage WEALTH CREATION
 Margin analysis
plan: ─ structure
─ scissors effect
─ operating leverage (breakeven point)
CAPITAL-EMPLOYED POLICY
 Working capital
 Capital expenditures
FINANCING POLICY
 Cash flows
 Equity/Debt
 Liquidity, interest rate and currency risk
PROFITABILITY
 Analysis of return on capital employed and return
on equity: leverage effect
 Comparison between ROCE/rate of return
required by shareholders and lenders
─ value
─ solvency
TREND ANALYSIS
The role of trends analysis is to look at the past to assess
the present situation and to forecast the future
Analysts have to look at performance over several years
Drawbacks:
• company’s data have to be roughly comparable

– changes in the company’s business activities, business model, scope
of consolidation, or accounting rules deprive of sense the analysis
• accounting information is always published with a delay

– company’s situation at publication of the accounts can be different in
respect to what is stated

COMPARATIVE ANALYSIS
Comparative analysis consists of comparing a company’s key
profit indicators and ratios with those typical of companies
operating in the same sector of activity
Viability is a relative concept  a judgement can derive only

from benchmarking
Drawbacks:
• which rival firms are analysed depends on the level of detail

applied on the concept of sector
• cases of mass delusions could temporarily overvalue all the
stocks in a particular sector

NORMATIVE ANALYSIS
Normative analysis consists of a comparison

of the company’s indicators and ratios
with standard value of them (“rules of thumbs”)
Norms are determined from statistical studies
Profitability is what really matters(15% net income)

RATINGS
Credit ratings reflect opinions about
the risk of a borrowing resulting from
a continuous assessment of the borrower’s solvency
They are performed by:

• specialised agencies
• banks
• credit insurers
• borrower’s ability to honour the payments

Financial risk • guarantees and legal characteristics of the
borrowings

SCORING TECHNIQUES
Credit scoring is an analytical technique intended
to carry out a pre-emptive check-up of a company
It consists of:
1. choice of indicators of potential difficulties
2. calculation of the given company’s ratios
3. construction of the Z-score function for the company:
n
 a   i
 Ri
i 1
4. comparison of the company’s Z-score with normative values

derived from failed companies, in order to give an opinion
about the probability of corporate failure
SCORING TECHNIQUES
Advantages:
• by means of scoring techniques comparisons are not based on
the single ratios, they are combined
• each ratio is weighted
Drawbacks:
• need for
− a large sample
− a consistent database
− data from a period long enough to analyse trends
− up-to-date data
• not suited for large groups or for predicting in advance which

companies will be more profitable

EXPERT SYSTEMS
Expert systems comprise software
developed to carry out financial analysis
Purpose:
Purpose to develop lines of reasoning akin to those used
by human analysts
1. The analyst enters the company’s latest financial statements

and other market and social indicators
2. The analyst is asked questions about the company, its
environment and its business activities; answers activate the
rules contained in the expert system’s database
3. The expert system produces a financial report comprising an
assessment of the company and other recommendations

CONCLUSIONS
•Financial analysis aims at explain how a company can create
value (shareholders’ viewpoint) or to determine whether it is
solvent (lenders standpoint).
•First of all, financial analysis involves an examination of the
company’s economics. Next, it entails a detailed analysis of its
accounting principles to ensure that they not distort its
economic reality.
•The most important principle to follow when conducting a
financial analysis is that wealth creation requires capital
employed that must be financed and be sufficiently profitable.
•Analysts may use trend analysis, comparative analysis and
normative analysis.
•Ratings represent an evaluation of a borrower’s ability to meet
its financial commitments. Scoring techniques are used to
calculate a probability of corporate failure.


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Corporate FINANCE.

Theory and practice

HOW TO PERFORM A FINANCIAL

•Economic analysis of the company

•Accounting analysis of the company

•Financial analysis plan

© 2009 - John Wiley & Sons 2

WHAT IS FINANCIAL ANALYSIS

Financial analysis assesses:

• whether the company is able to create value

• the solvency and liquidity of a company

the applied techniques are the same

© 2009 - John Wiley & Sons 3

WHAT IS FINANCIAL ANALYSI

Financial analysis = rigorous approach to the issues

The purpose is to provide a global assessment of the

Economic analysis Accounting analysis

© 2009 - John Wiley & Sons 4

Understanding of a company’s economics requires the

© 2009 - John Wiley & Sons 5

THE COMPANY’S MARKET

After defining the market, financial analysts have to:

© 2009 - John Wiley & Sons 6

THE COMPANY’S MARKET

Product life cycle

Introduction Expansion Maturity Decline

THE COMPANY’S MARKET

THE COMPANY’S MARKET

• barriers to entry to the company’s market, currently

The 5 record industry majors Sony, Bertelsmann, Universal, Warner

THE COMPANY’S MARKET

Limits of the concept of market share:

© 2009 - John Wiley & Sons 10

THE COMPANY’S MARKET

prices  •minimisation of costs

Study of the value chain encompasses:

The purpose is to identify where NOT to invest

© 2009 - John Wiley & Sons 12

Value chain - THE FILM INDUSTRY

© 2009 - John Wiley & Sons 13

Value chain - THE FILM INDUSTRY

• During the 1980s, the number of box-office tickets fell

© 2009 - John Wiley & Sons 14

Value chain - THE FILM INDUSTRY

© 2009 - John Wiley & Sons 15

Value chain - THE FILM INDUSTRY

© 2009 - John Wiley & Sons 16

© 2009 - John Wiley & Sons 17

product and production model have to be consistent

Project: Pyramids in Egypt

© 2009 - John Wiley & Sons 19

Innovation in products and production systems

Source: Utterback and Abernathy (1975)

© 2009 - John Wiley & Sons 20

© 2009 - John Wiley & Sons 21

Producers and distributors have the same goal:

Producers can also decide to take control of the distribution

the choice depends on: required investments and

• The closer companies can get to their end

© 2009 - John Wiley & Sons 23

Outside shareholders  who have purely financial objectives

• Is a key factor, particularly when a company embarks