BUSINESS ANALYSIS AND VALUATION
QUESTIONS WITH COMPLETE
SOLUTION
dBusiness strategy analysis - Analysis to identify key profit drivers, business risks, and assess the
company's profit potential at a qualitative level
- Analyzing its industry, competitive advantage, and corporate strategy
- Gives context to frame the subsequent accounting, financial, and prospective analysis better, and thus
to provide much better inputs into valuation
Accounting analysis - Analysis to evaluate the degree to which a firm's accounting captures the
underlying business reality
- Identifies accounting flexibility + distortions
- Undo numbers for comparability and better reflect business economy
- Improves reliability of conclusions from financial analysis
Financial analysis - Analysis to judge the current/past performance of a firm and to assess its
sustainability
- Ratio and cash flow analysis to understand components of ROE, assess liquidity/solvency, differences in
strategy
Prospective Analysis - Analysis that focuses on forecasting a firm's future
overstate earnings - Reasons a firm would ___:
1. Compensation contracts
2. Debt covenants
3. Ownership of stocks/bonds
4. Raising debt/equity
5. Reputation
6. Empire building
understate earnings - Reasons a firm would ___:
1. Taxation purposes
2. Hide profitable segments from competitors
, 3. Labor union negotiation
4. Big bath accounting
5. Cookie jar accounting
6. Insider trading
Red flags - 1. Unexplained changes in accounting, especially when performance is poor
2. Unexplained transactions that boost profits
3. Unusual increases in receivables in relation to sales
4. Unusual increases in inventory in relation to sales
5. Increases in the gap between net profit and cash flows
6. R&D partnerships, SPEs, sale of receivables
7. Unexpected large asset write-offs
8. Large year end adjustments
9. Qualified audit opinions/auditor changes
10. Poor internal governance
11. Related-party transactions
Lemons problem - Problem in securities markets; if investors can't distinguish between good and bad
securities, willing to pay only average of good and bad securities' value
- Causes:
- Information asymmetry
- Different incentives for buyers and sellers
- Result: Good securities undervalued and firms won't issue them; bad securities overvalued so too many
issued
- Solution: increased disclosure, regulation, guarantees/warranties, third-party certification, licensing,
liabilities laws
- Financial intermediaries (e.g. venture capital firms, banks, funds, insurance firms etc.)
- Information intermediaries (e.g. auditors, analysts, credit rating agencies etc.)
Financial reporting - Provides much-needed information to capital market participants
- Financial intermediaries depend upon the information in financial statements to evaluate investment
opportunities
• Banks and other lenders
QUESTIONS WITH COMPLETE
SOLUTION
dBusiness strategy analysis - Analysis to identify key profit drivers, business risks, and assess the
company's profit potential at a qualitative level
- Analyzing its industry, competitive advantage, and corporate strategy
- Gives context to frame the subsequent accounting, financial, and prospective analysis better, and thus
to provide much better inputs into valuation
Accounting analysis - Analysis to evaluate the degree to which a firm's accounting captures the
underlying business reality
- Identifies accounting flexibility + distortions
- Undo numbers for comparability and better reflect business economy
- Improves reliability of conclusions from financial analysis
Financial analysis - Analysis to judge the current/past performance of a firm and to assess its
sustainability
- Ratio and cash flow analysis to understand components of ROE, assess liquidity/solvency, differences in
strategy
Prospective Analysis - Analysis that focuses on forecasting a firm's future
overstate earnings - Reasons a firm would ___:
1. Compensation contracts
2. Debt covenants
3. Ownership of stocks/bonds
4. Raising debt/equity
5. Reputation
6. Empire building
understate earnings - Reasons a firm would ___:
1. Taxation purposes
2. Hide profitable segments from competitors
, 3. Labor union negotiation
4. Big bath accounting
5. Cookie jar accounting
6. Insider trading
Red flags - 1. Unexplained changes in accounting, especially when performance is poor
2. Unexplained transactions that boost profits
3. Unusual increases in receivables in relation to sales
4. Unusual increases in inventory in relation to sales
5. Increases in the gap between net profit and cash flows
6. R&D partnerships, SPEs, sale of receivables
7. Unexpected large asset write-offs
8. Large year end adjustments
9. Qualified audit opinions/auditor changes
10. Poor internal governance
11. Related-party transactions
Lemons problem - Problem in securities markets; if investors can't distinguish between good and bad
securities, willing to pay only average of good and bad securities' value
- Causes:
- Information asymmetry
- Different incentives for buyers and sellers
- Result: Good securities undervalued and firms won't issue them; bad securities overvalued so too many
issued
- Solution: increased disclosure, regulation, guarantees/warranties, third-party certification, licensing,
liabilities laws
- Financial intermediaries (e.g. venture capital firms, banks, funds, insurance firms etc.)
- Information intermediaries (e.g. auditors, analysts, credit rating agencies etc.)
Financial reporting - Provides much-needed information to capital market participants
- Financial intermediaries depend upon the information in financial statements to evaluate investment
opportunities
• Banks and other lenders
