16 PARTI. FRAMEWORK SUMMARY Financial statements provide the most widely available data on public corporations’ economic activities; investors and other stakeholders rely on them to assess the plans and performance of firms and corporate managers. Accrual accounting data in financial statements are noisy, and unsophisticated investors can assess firms’ performance only imprecisely. Financial analysts who understand managers’ disclosure strategies have an opportunity to create inside information from public data, and they play a valuable role in enabling outside partes to evaluate a firm's ‘current and prospective performance, This chapter has outlined the framework for business analysis with financial statements, using the four key steps: business strategy analysis, accounting analysis, financial analysis, and prospective analysis. The remaining chapters in this book describe these steps in greater detail and discuss how they can be used in a variety of business contexts, CORE CONCEPTS Accounting analysis Second step of financial statement analysis, aimed at scrutinizing a firm's accounting poli- cies and estimates and undoing the firm's financial statements from any accounting distortions. Accounting standards Set of rules governing the determination of a company’s revenues, profit and (change in) financial position under a system of accrual accounting, Accrual accounting A system of accounting under which current net profit is derived from past and current as well as expected future cash flows arising from business transactions completed in the current period, Assets Economic resources owned by a firm that are (a) likely to produce future economic benefits and (b) meas- urable with a reasonable degree of uncertainty, Examples of economic resources are inventories and property. plan and equipment. ‘Auditing Certification of financial statements by an independent public accounting firm, aimed at improving the statements’ credibility, Business strategy analysis First step of financial statement analysis, aimed at identifying a firm's key profit driv ers and business risks and qualitatively assessing the firm's profit potential Capital markets Markets where entrepreneurs raise funds to finance their business ideas in exchange for equity or debt securities Expenses Economic resources (¢.g., finished goods inventories) used up in a time period, Financial analysis Third step of financial statement analysis, which goal is to evaluate (the sustainability of) a firm's current and past financial performance using ratio and cash flow analysis. Financial and information intermediaries Capital market participants who help to resolve problems of informa- tion asymmetry between entrepreneurs and investors and, consequently, prevent markets from breaking down, Information intermediaries such as auditors or financial analysts improve the (credibility of) information pro- vided by the entrepreneur. Financial intermediaries such as banks and collective investment funds specialize in collecting. aggregating, and investing funds from dispersed investors. Financial statements Periodically disclosed set of statements showing a company's financial performance and change in financial position during a prespecified period. The statements typically include a balance sheet (fi- nancial position), an income statement and a cash flow statement (financial performance). One of the primary purposes of the financial statements is to inform current or potential investors about management's use of their funds, such that they can evaluate management's actions and value theit current or potential claim on the firm.CHAPTERI A FRAMEWORK FOR BUSINESS ANALYSIS AND VALUATION 17 Institutional framework for financial reporting Institutions that govern public corporations’ financial reporting. ‘These institutions include: ‘a Accounting standards set by public or private sector accounting standard-setting bodies, which limit man- ‘agement’s accounting flexibility. In the BU, public corporations report under International Financial Report- ing Standaeds, set by the International Accounting Standards Boad b. Mandatory external auditing of the financial statements by public accountants. In the EU, the Eighth Com- pany Law Directive has set minimum standards for external audits, © Legal liability of management for misleading disclosures. The Transparency Directive requires that cach EU ‘member state has a statutory civil liability regime. Public enforcement of accounting standards, Enforcement activities of individual European public enforce- ‘ment bodies are coordinated by the Committee of European Securities Regulators. Legal protection of investors’ rights Laws and regulations aiming at providing investors the rights and mecha- nisms to discipline managers who control their funds. Examples of such rights and mechanisms are transparent disclosure requirements, the right fo vote (by proxy) on important decisions or the right to appoint supervisory directors, In countries where small, minority investors lack such rights or mechanisms, financial intermediaries play an important role in channeling investments to entrepreneurs. Lemons problem The problem that arises if entvepreneurs have better information about the quality of their busi- ness ideas than investors but are not able to credibly communicate this information. If this problem becomes severe enough, investors may no longer be willing to provide funds and capital markets could break down, Liabilities Economic obligations of a firm arising from benefits received in the past that (a) are required to be met with a reasonable degree of certainty and (b) whose timing is reasonably well defined. Examples of economic ‘obligations are bank loans and product warranties. Prospective analysis Fourth and final step of financial statement analysis, which focuses on forecasting a firm's future financial performance and position. The forecasts can be used for various purposes, such as estimating firm value or assessing creditworthiness Reporting strategy Set of choices made by managers in using their reporting discretion, shaping the quality of their financial reports. Revenues Economic resources (e.g., cash and receivables) eamed during a time period.CHAPTER2 STRATEGY ANALYSIS 59 SUMMARY ‘Strategy analysis is an important starting point for the analysis of financial statements because it allows the analyst to probe the economics of the firm at a qualitative level. Stategy analysis also allows the identification of the firms profit drivers and key risks, enabling the analyst to assess the sustainability of the firm's performance and make realistic forecasts of future performance,60 PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS Whether a firm is able to earn a return on its capital in excess ofits cost of capital is determined by its own stra legic choices: 1 The choice of an industry or a set of industries in which the firm operates (industry choice), 2. The manner in which the firm intends to compete with other fitms in its chosen industry or industries (competi tive strategy). 13. The way in which the firm expects to create and exploit synergies across the range of businesses in which it ‘operates (corporate strategy), Strategy analysis involves analyzing all three choices. Industry analysis consists of identifying the economic factors that drive the industry profitability. In general, an industry's average profit potential is influenced by the degree of rivalry among existing competitors, the ease with which new firms can enter the industry, the availability of substitute products, the power of buyers, and the power of suppliers. To perform industry analysis, the analyst has to assess the current strength of each of these forces in an industry and make forecasts of any likely future changes. Competitive strategy analysis involves identifying the basis on which the firm intends to compete in its ind: tay, In general, there are two potential strategies that could provide a firm with a competitive advantage: cost lead- cexship and differentiation, Cost leadership involves offering at a lower cost the same product or service that other firms offer. Differentiation involves satistying a chosen dimension of customer need better than the competition, at ‘an incremental cost that is Iess than the price premaium that customers are willing to pay. To perform strategy anal- ysis, the analyst has to identify the firm’s intended strategy, assess whether the firm possesses the competencies required to execute the strategy, and recognize the key tisks thatthe firm has to guatd against. The analyst also has to evaluate the sustainability of the firm’s strategy. Corporate strategy analysis involves examining whether a company is able to create value by being in multiple businesses at the same time. A well-crafted corporate strategy reduces costs or increases revenues from running several businesses in one firm relative to the same businesses operating independently and transacting with each other in the marketplace, These cost savings or revenue increases come from specialized resources that the firm thas that help it to exploit synergies across these businesses, For these resources to be valuable, they must be non- tradable, not easily imitated by competition, and nondivisible, Even when a firm has such resources, it can create value through a multi-business organization only when it is managed so that the information and agency costs inside the organization are smaller than the market transaction costs. The insights gained from strategy analysis can be useful in performing the remainder of the financial statement analysis. In accounting analysis the analyst can examine whether a firm's accounting policies and estimates are ‘consistent with its stated strategy. For example, a firm's choice of functional currency in accounting for its interna- tional operations should be consistent with the level of integration between domestic and international operations that the business strategy calls for. Similarly, a firm that mainly sells housing to low-income customers should have higher than average bad debt expenses. Strategy analysis is also useful in guiding financial analysis. For example, in a cross-sectional analysis the ana lyst should expect firms with cost leadership strategy to have lower gross margins and higher asset turnover than firmas that follow differentiated strategies. In a time series analysis, the analyst should closely monitor any increases in expense ratios and asset turnover ratios for low-cost firms, and any decreases in investments critical to differentiation for firms that follow differentiation strategy Business strategy analysis also helps in prospective analysis and valuation. First, it allows the analyst to assess whether, and for how long, differences between the firm's performance and its industry (or industries) performance are likely to persist. Second, strategy analysis facilitates forecasting investment outlays the firm has to make to ‘maintain its competitive advantage. CORE CONCEPTS Bargaining power in input and output markets One of the two main drivers of an industry's profit potential “The greater the bargaining power of buyers and suppliers, the lower is the industzy’s profit potential Competitive forces Five forces that gether determine an industry’s profit potential through their influence on the degree of actual and potential competition with the industry or the bargaining power in input and output markets.CHAPTER2 STRATEGY ANALYSIS 61 Competitive strategy analysis Analysis of the strategic choices that a firm has made to position itself in the industry. Firms typically choose between two mutually exclusive strategies: (1) cost leadership or (2) differen- tiation, The competitive strategy that a firm has chosen and the industry’s profit potential together affect the ‘firm's profitability Corporate strategy analysis Analysis of a firm’s business structure and processes to establish whether and how the firm has minimized, or can potentially minimize its transaction costs. Cost leadership Stategy in which a firm achieves a competitive advantage by producing and delivering its prod- ‘ucts or services at a lower cost than its competitors. Differentiation Strategy in which a firm achieves a competitive advantage by producing and delivering products ‘or services with unique features at premium prices. Industry analysis Analysis of an industry's profit potential Industry competition One of the two main drivers of an industry's profit potential. The degree of actual and potential competition is determined by three competitive forces: (1) the rivalry among existing firms in the industry; (2) the threat of new entrants to the industry; and (3) the threat of substitute products,106 PART2_ BUSINESS ANALYSIS AND VALUATION TOOLS SUMMARY In summary, accounting analysis is an important step in the process of analyzing corporate financial reports. The purpose of accounting analysis is o evaluate the degree to which a firm's accounting captures the underlying busi- ness reality. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next slep in financial statement analysis. There are six key steps in accounting analysis. The analyst begins by identifying the key accounting policies and estimates, given the firm’s industry and its business strategy. The second step is to evaluate the degree of flexi- bility available to managers, given the accounting rules and conventions. Next, the analyst has to evaluate how managers exercise their accounting flexibility and the likely motivations behind managers’ accounting strategy ‘The fourth step involves assessing the depth and quality of a firm's disclosures. The analyst should next identify any red flags needing further investigation. The final accounting analysis step is to restate accounting numbers to remove any noise and bias introduced by the accounting rules and management decisions. Chapter 4 discusses how to implement these concepts and shows how to make some of the most common types of adjustments CORE CONCEPTS ‘Accounting analysis Evaluation of the potential accounting flexibility that management has and the actual accounting choices that it makes, focusing on the firm's key accounting policies. The accounting analysis con- sists of the following six steps: 1 Identification of the firm’s key accounting policies, Assessment of management's accounting flexibility Evaluation of management's reporting strategy. Evaluation of the quality of management's disclosures. dentifiation of potential red flags or indicators of questionable accounting quality 6 Correction of accounting distortions, 2 3 4 5 Classification of operating expenses by function Classification in which firms distinguish categories of operating expense with reference to the purpose of the expense, This classification typically distinguishes (at least) the following categories of expenses: (a) Cost of Sales and (b) Selling, General, and Administrative Expenses.CHAPTER3 ACCOUNTING ANALYSIS: THE BASICS 107 Classification of operating expenses by nature Classification in which firms distinguish categories of ‘operating expense with reference to the cause of the expense. This classification typically distinguishes the following categories of expenses: (a) Cost of Materials, (b) Personnel Expense, and (c) Depreciation and Amortization Gross profit Difference between Sales and Cost of Sales. Recasting of financial statements Process of standardizing the formats and nomenclature of firms’ financial state ‘ments (income statement, balance sheet, cash flow statement, comprehensive income statement). Sources of noise and bias in accounting data Three potential sources of noise and bias in accounting data are: ‘a. Rigid accounting standards b- Management's forecast errors, ‘© Management's reporting strategy (accounting choices).CHAPTER 4 ACCOUNTING ANALYSIS: ACCOUNTING ADJUSTMENTS 163 SUMMARY ‘Once the financial statements are standardized, the analyst can determine what accounting distortions exist in the firm's assets, liabilities, and equity. Common distortions that overstate assets include delays in recognizing asset impairments, underestimated allowances, aggressive revenue recognition leading to overstated receivables, and op- timistic assumptions on long-term asset depreciation. Asset understatements can arise if managers overstate asset urite-offs, use operating leases to keep assets off the balance sheet, or make conservative assumptions for asset depreciation. They can also arise because accounting rules require outlays for key assets (e.g., research outlays and. brands) to be immediately expensed, For liabilities, the primary concer for the analyst is whether the firm understates its real commitments. This can arise from off-balance liabilities (e.g., operating lease obligations), from understated provisions, from ques- tionable management judgment and limitations in accounting rules for estimating post-employment liabilities, and from aggressive revenue recognition that understates unearned revenue obligations. Equity distortions frequently arise when there are distortions in assets and liabilities. Adjustments for distortions can, therefore, arise because accounting standards, although applied appropriately, do not reflect a firm's economic reality. They can also arise if the analyst has a different point of view than man- agement about the estimates and assumptions made in preparing the financial statements, Once distortions have been identified, the analyst can use cash flow statement information and information from the notes to the financial statements to make adjustments to the balance shect at the beginning and/or end of the current year, as well as any needed adjustments to revenues and expenses in the latest income statement. This ensues that the most recent fi- nancial ratios used to evaluate a firm's performance and to forecast its future results are based on financial data that appropriately reflect its business economics. Several points are worth remembering when undertaking accounting analysis. First, the bulk of the analyst's time and energy should be focused on evaluating and adjusting accounting policies and estimates that describe the firm's key strategic value drivers, Of course this docs not mean that management bias is not reflected in other accounting estimates and policies, and the analyst should certainly examine these. But given the importance of evaluating how the firm is managing its key success factors and tisks, the bulk of the accounting analysis should be spent examining those policies that describe these factors and risks, Similarly, the analyst should focus on adjustments that have a material effect on the firm’s liabilities, equity, or earings. Immaterial adjustments cost time and energy but are unlikely to affect the analyst's financial and prospective analysis, tis also important to recognize that many accounting adjustments can only be approximations rather than pre- cise calculations, because much of the information necessary for making precise adjustments is not disclosed. The analyst should, therefore, try to avoid worrying about being overly precise in making accounting adjustments. By ‘making even crude adjustments, it is usually possible to mitigate some of the limitations of accounting standards and problems of management bias in financial reporting CORE CONCEPTS Examples of asset value distortions Examples of asset value distortions are: a Non-current asset understatement resulting from overstated depreciation or amortization. b {on-current asset understatement resulting from off-balance shect operating leases.164. PART2_ BUSINESS ANALYSIS AND VALUATION TOOLS ‘© Non-current asset understatement resulting from the immediate expensing of investments in intangible assets (such as research) 4 Current asset (receivables) understatement resulting from the sales of receivables. € Current asset (receivables) overstatement resulting from accelerated revenue recognition £ Non-current or current asset overstatement resulting from delayed write-downs, and Cument asset overstatement resulting from underestimated allowances (e.g., for doubtful receivables oF inventories obsolescence), Examples of liability distortions Examples of liability distortions are: 4 Liability understatement resulting from understated unearned revenues (e.g, revenues from long-term serv- ice contracts), Liability understatement resulting from understated provisions. ‘© Liability understatement resulting from the sales of receivables (with recourse) 4 Non-current liability understatement resulting ftom off-balance sheet operating leases. ‘© Liability understatement resulting from post-employment obligations that are (partly) kept off-balance. Sources of asset value distortions Managers may strategically bias or accounting rules may force them to bias the book values of assets if there is uncertainty about a Who owns or controls the economic resources that potentially give rise to the assets b_ Whether the economic resources will provide future economic benefits that can be reliably measured ‘© What the fair value of the assets is, 4. Whether the fair value of the asset is less than its book value Sources of liability distortions Managers may strategically bias or accounting rules may force them to bias the ‘book values of liabilities if there is uncertainty about a Whether an obligation has been occurred. b Whether the obligation can be reliably measured. Sources and examples of equity distortions Distortions in assets and liabilities can lead to equity distortions. However, (a) contingent claims such as employee stock options or convertible debentures as well as (b) the recycling of unrealized fair value gains and losses can directly cause distortions in equity206 PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS SUMMARY ‘This chapter presents two Key tools of financial analysis: ratio analysis and cash flow analysis. Both these tools allow the analyst to examine a firm's performance and its financial condition, given its strategy and goals, Ratio analysis involves assessing the firm’s income statement and balance sheet data. Cash flow analysis relies on the firm's cash flow statement. ‘The starting point for ratio analysis is the company's ROE. The next step is to evaluate the three drivers of ROE, which are net profit margin, asset turnover, and financial leverage, Net profit margin reflects a firms operat- ing management, asset tumover reflects its investment management, and financial leverage reflects its liability ‘management. Each of these areas can be further probed by examining a number of ratios. For example, common- sized income statement analysis allows a detailed examination of a firm's net margins. Similarly, turnover of key ‘working capital accounts like accounts receivable, inventories, and accounts payable, and turnover of the firm's fixed assets allow further examination of a firm's asset tumover. Finally, short-term liquidity ratios, debt policy ratios, and coverage ratios provide a means of examining a firm’s financial leverage A firm's sustainable growth rate ~ the rate at which it can grow without altering its operating, investment, and financing policies ~ is determined by its ROE and its dividend policy. The concept of sustainable growth provides a way to integrate the ratio analysis and to evaluate whether or not a firm's growth strategy is sustainable. If a firm's plans call for growing at a rate above its current sustainable rate, then the analyst can examine which of the firm's ratios is likely to change in the future. Cash flow analysis supplements ratio analysis in examining a firm’s operating activites, investment manage- ‘ment, and financial risks. Firms reporting in conformity with IFRSs are currently required to report a cash flow statement summarizing their operating, investment, and financing cash flows. Since there are wide variations across firms in the way cash flow data are reported, analysts often use a standard format to recast cash flow data ‘We discussed in this chapter one such cash flow model. This model allows the analyst to assess whether a firm's operations generate cash flow before investments in operating working capital, and how much cash is being invested in the firm’s working capital. Ialso enables the analyst to calculate the firm's free cash flow after making long-term investments, which is an indication of the firm's ability to meet its debt and dividend payments. Finally, the cash flow analysis shows how the firm is financing itself, and whether its financing patterns are too risky. The insights gained from analyzing a firm's financial ratios and its cash flows are Valuable in forecasts of the firm's future prospectsCHAPTERS FINANCIALANALYSIS 207 CORE CONCEPTS Alternative approach to ROE decomposition Decomposition of return on equity into NOPAT margin, asset ‘tumover, return on investment assets, financial spread, and net financial leverage. Return on operating assets is the product of NOPAT margin and asset tumover. Return on business assets is the weighted average of the relums on operating and investment assets, The financial leverage gain isthe product of financial spread and fi- nancial leverage. 4 Operating assets NIPAT _] ,, Investment assets ‘Operating assets| “ Business assets” [Tnvestment asseis| Business assets Debt Spread 7 Spread Fy Operating assets stment assets ‘CPSratng ASSETS + Return on investment assets = Return on operating assets X Investment assets “persng Business assets Business assets Debt Equity + Spread x Debt Equity = Return on business assets + Financial leverage gain = Return on business assets + Spread x where Interest expense after tax Spread — Retum on business assots ~ MTES expense afer ex * “ “es Debt Asset turnover analysis Decomposition of asset tumover into its components, wth the objective of identifying the drivers of (changes in) a firm's asset tumover and assessing the efficiency of a firm's investment manage- ment. The asset tumover analysis typically distinguishes between working capital tumover (receivables, inven- tories, and payables) and non-current operating assets turnover (P&E and intangible asses) Cross-sectional comparison Comparison of the ratios of one firm to those of one or more other firms from the same industry. Financial leverage analysis Analysis of the tsk related to a firm's curtent liabilities and mix of non-current debt and equity. The primary considerations in the analysis of finaneial leverage are whether the financing strategy (2) matches the firm’s business risk and (2) optimally balances the risks (e.g, financial distress risk) and bene- fits (eg. tax shields, management discipline). Profit margin analysis Decomposition ofthe profit margin into its components, typically using common-sized income statements, The objective of profit margin analysis isto identify the drivers of (changes in) a firm's ‘margins and assess the efficiency of a firm's operating management. The operating expenses that impact the profit margin can be decomposed by function (eg, cost of sales, SG&A) or by nature (eg, cost of materials, personnel expense, depreciation, and amortization) Ratio analysis Analysis of financial statement ratios to evaluate the four drivers of firm performance: 1 Operating policies. 2 Investment policies. 3 Financing policies. 4 Dividend policies Sustainable growth rate The rate at which a firm can grow while keeping its profitability and financial policies ‘unchanged, Sastinale growth rte = ROEX (1 Cash dividends paid Net profit208 PART2 BUSINESS ANALYSIS AND VALUATION TOOLS ‘Time-series comparison Compaison of the ratios of one firm over time. ‘Traditional approach to ROE decomposition Decomposition of return on equity into profit margin, asset turn- over, and financial leverage: Row — Net profit. Sales Assets Sales Assets“ Sharcholders” equity