Chap 1

Chapter 1
Overview of
Financial
Reporting,
Financial
Statement
Analysis, and
Valuation
© 2018 Cengage. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Six-Step Process
Chapter: 01 2
STEP 1: Identify the Industry Economic
Characteristics (Slide 1 of 2)
• Economic characteristics and competitive

dynamics influences the strategies firms will
employ.
• Analyst should consider the economic
characteristics and competitive dynamics
while analyzing and forecasting financial
statements.
Chapter: 01 3
STEP 1: Identify the Industry Economic
Characteristics (Slide 2 of 2)
Profit
Margin Asset T/O ROA LTD/TA
Grocery 3.5% 2.900 10.15% 29.8%
Pharmaceutical 12.1% 0.678 8.20% 25.3%
Utility 10.5% 0.495 5.20% 65.6%
Bank 13.0% 0.090 1.20% 8.7%
Chapter: 01 4
Tools for Studying Industry
Economics
• Porter’s Five Forces classification framework
• Value chain analysis
• Economic Attributes Framework
Chapter: 01 5
Porter’s Five Forces Classification Framework
• Horizontal competition
– Rivalry among Existing Firms
– Threat of New Entrants
– Threat of Substitutes
• Vertical competition
– Buyer Power
– Supplier Power
Chapter: 01 6
Rivalry among Existing Firms
• Often the first order of competition.

• Industries are characterized by:
– Concentrated rivalry.
– Diffuse rivalry.
• Greater the industry concentration, the lower
the competition between existing rivals and
thus the more profitable the firms will be.
Chapter: 01 7
Threat of New Entrants
• How easily can new firms enter a market?

• Are there entry barriers?
• Do the existing rivals have distinct competitive
advantages making it difficult for other firms
to enter and compete?
– If so, firms in the industry will likely generate
higher profits than if new entrants can enter the
market easily.
Chapter: 01 8
Threat of Substitutes
• How easily can customers switch to substitute

products or services?
• How likely are they to switch?
• With close substitutes, competition increases
and profitability decreases.
• Unique products with few substitutes enhance
profitability.
Chapter: 01 9
Buyer Power
• Relates to the relative number of buyers and

sellers in the industry and the leverage buyers
have with respect to price.
• Relates to buyers’ price sensitivity and the
elasticity of demand.
• Are the buyers price takers or price setters?
Chapter: 01 10
Supplier Power
• Relates to leverage in negotiating input prices

from suppliers.
• If an industry has a large number of potential
buyers of inputs that are produced by
relatively few suppliers, the suppliers will have
greater power in setting prices and generating
profits.
Value Chain Analysis
Economic Attributes Framework
• Demand
• Supply
• Manufacturing
• Marketing
• Investing & Financing
Demand
• Are customers highly price-sensitive or

relatively insensitive?
• Is demand growing rapidly or is the industry
relatively mature?
• Does demand move with the economic cycle
or is it insensitive to it?
• Does demand vary with the seasons or is it
relatively stable throughout the year?
Supply
• Are suppliers offering similar or unique

products?
• Are there high barriers to entry?
• Are there high barriers to exit, such as
environment cleanup costs?
Manufacturing
• Is the manufacturing process capital-intensive

or labor-intensive … or a combination of the
two?
• Is the manufacturing process complex with
low tolerance for error, or relatively simple
with ranges of products that are of acceptable
quality?
Marketing
• Is the product promoted to other businesses

or marketed directly to consumers?
• Does steady demand pull products through
distribution channels, or must firms
continually create demand?
Investing and Financing
• Are the assets of firms in the industry

relatively short-term or long-term?
• Is there relatively little risk or high risk in the
assets of firms in the industry?
• Is the industry relatively profitable and
mature, generating enough cash flows or
growing rapidly and in need of external
financing?
STEP 2: Identify The Company Strategies
(Screen 1 of 4)
Framework for Strategy Analysis

• Nature of product or service
• Integration within value chain
• Geographical diversification
• Industry diversification
(Screen 2 of 4)
• Nature of Product or Service

– Product differentiation strategy
• Unique products
• Achieving relatively high profit margins
– Low-cost leadership strategy
• Non-differentiated products
• Accepting a lower profit margin in return for a higher
sales volume and market share
(Screen 3 of 4)
• Integration in Value Chain

– Manufacturing: Is the firm conducting all
manufacturing operations itself, outsourcing all
manufacturing, or outsourcing the manufacturing
of components but conducting the assembly
operation in-house?
– Distribution: Is the firm maintaining control over
the distribution function or outsourcing it?
(Screen 4 of 4)
• Geographical Diversification
– Is the firm targeting its products to its domestic
market or integrating horizontally across many
countries?
• Industry Diversification
– Is the firm operating in a single industry or
diversifying across multiple industries?
STEP 3: Assess The Quality Of The Financial
Statements (Screen 1 of 7)
• Income Statement
• Balance Sheet
• Statement of Cash Flows
• Statement of Shareholders’ Equity
• Statement of Comprehensive Income
First four statements are required; most companies
include all five.
Accounting Quality
Accounting information should

•be a fair and complete representation of the
firm’s economic performance, financial position,
and risk.
•provide relevant information to forecast the
firm’s expected future earnings and cash flows.
Accounting Principles
• GAAP determines the valuation and

measurement methods used in preparing
financial statements.
• SEC has the legal authority to specify
acceptable accounting principles in the United
States, but it has delegated that authority to
the FASB.
• Balance Sheet or Statement of Financial

Position.
Assets = Liabilities + Shareholders’ Equity
– Assets portion of the balance sheet reports the
effects of a firm’s operating decisions and
investing decisions.
– Liabilities and shareholders’ equity portion of the
balance sheet reports obligations that arise from a
firm’s operating decisions and financing decisions.
• Assets
– A firm can recognize as assets only those
resources:
1. for which it has the rights to future economic benefits as
a result of a past transaction or event.
2. for which the firm can predict and measure, the future
benefits with a reasonable degree of precision and
reliability.
– Categorized into Current Assets, Investments,
Property, Plant, and Equipment and Intangibles.
• Liabilities
– Reflect managers’ expectations of future sacrifices
of resources to satisfy existing obligations.
– Categorized into:
• Current liabilities: includes obligations a firm expects to
settle within one year.
• Noncurrent liabilities: includes long-term debt
obligations, other liabilities, and deferred income taxes.
• Shareholders’ Equity
– Firms residual interest or claim.
• It includes:
– Amounts initially contributed by shareholders for
an interest in a firm.
– Cumulative net income in excess of dividends
declared.
– Shareholders' equity effects the recognition or
valuation of certain assets or liabilities.
– Treasury stock.
Assessing the Quality of the Balance Sheet as a
Complete Representation of Economic Position
(Screen 1 of 2)
• Analyst recognizes:
– Resources of a firm that generate future cash
flows appear as assets only if they were acquired
from another firm and have a measurable
acquisition cost.
– Nonmonetary assets are reported at acquisition
cost, net of accumulated depreciation, or
amortization.
Assessing the Quality of the Balance Sheet as a
Complete Representation of Economic Position
(Screen 2 of 2)
• Analyst recognizes (cont’d):

– Rights to use resources and commitments to make
future payments may not appear as assets and
liabilities.
– Noncurrent liabilities appear at the present value
of expected cash flows discounted at an interest
rate prevailing when the liability initially arose.
• Income Statement - Measuring Operating

Performance
– Provides information about the profitability of a
firm for a period of time.
– Under accrual basis of accounting, revenue is
recognized when:
It has completed all (or substantially all) of the
revenue-generating process by delivering products or
services to customers.
It is reasonably certain it has satisfied a liability or
generated an asset that it can measure reliably.
Statement Of Cash Flows

– Assesses a firm’s past ability to generate free cash
flows and for predicting future free cash flows.
– Categories:
• Operating
• Investing
• Financing
Transactions not directly involving cash are disclosed either in a
supplementary schedule or in a note to the statement of cash flows.
STEP 4: Analyze Profitability and Risk
• Tools:
– Common-size financial statements
– Percentage change financial statements
– Financial Statement Ratios
• Profitability: EPS, ROCE, etc.
• Risk: Current Ratio, Debt to Equity Ratio, etc.
STEP 5: Prepare Forecasted Financial
Statements
• Forecasts are the inputs into valuation models,

and the quality of the decisions rests on the
reliability of the forecasts.
• Forecasted financial statements rely on
assumptions the analyst makes about the
future.
• Amounts from the forecasted financial
statements serve as the basis for the valuation
models.
STEP 6: Value the Firm
• Approaches:
– Dividends
– Earnings
– Cash flows
– Market
First three methods will give same value.
Role Of Financial Statement Analysis In An
Efficient Capital Market
• Benefits:
– Stock market prices react with a high degree of
efficiency to published information about a firm.
– An implication of a highly efficient capital market
is that analysts and investors have more difficulty
finding undervalued or overvalued securities.
The Association between Earnings and
Share Prices
• Performing financial analysis that relies on analysis,

forecasting, and valuation of key accounting
measures can be very rewarding.
• To understand the relationship between accounting
earnings and stock returns, and to foreshadow the
potential to generate positive excess returns through
analysis and forecasting, consider the results from
empirical research by D. Craig Nichols and James
Wahlen.
Sources of Financial Statement Information
• Annual Report to Shareholders

• Form 10-K Annual Report
• Form 10-Q Quarterly Report
• Prospectus or Registration Statement

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Chapter 1

• Economic characteristics and competitive

• Often the first order of competition.

• How easily can new firms enter a market?

• How easily can customers switch to substitute

• Relates to the relative number of buyers and

• Relates to leverage in negotiating input prices

• Are customers highly price-sensitive or

• Are suppliers offering similar or unique

• Is the manufacturing process capital-intensive

• Is the product promoted to other businesses

• Are the assets of firms in the industry

Framework for Strategy Analysis

• Nature of Product or Service

• Integration in Value Chain

Accounting information should

• GAAP determines the valuation and

• Balance Sheet or Statement of Financial

• Analyst recognizes (cont’d):

• Income Statement - Measuring Operating

Statement Of Cash Flows

• Forecasts are the inputs into valuation models,

• Performing financial analysis that relies on analysis,

• Annual Report to Shareholders

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