Summary Business Analysis and Valuation
Content
, Chapter 1 A framework for business analysis and
valuation using financial statements
In almost all countries in the world today, capital markets play an important role in channeling financial
resources from savers to business enterprises that need capital. Financial statement analysis is a
valuable activity when managers have complete information on a firm’s strategies, and a variety of
institutional factors make it unlikely that they fully disclose this information to suppliers of capital.
The role of financial reporting in capital markets
Figure 1.1 provides a schematic representation of how capital markets typically work. While both
savers and entrepreneurs would like to do business with each other, matching savings to business
investment opportunities through the use of capital markets is complicated for at least three reasons:
● Information asymmetry between savers and entrepreneurs. Entrepreneurs typically have better
information than savers on the value of business investment opportunities.
● Potentially conflicting interests – credibility problems. Communication by entrepreneurs to
savers is not completely credible because savers know that entrepreneurs have an incentive to inflate
the value of their ideas.
● Expertise asymmetry. Savers generally lack the financial sophistication needed to analyze and
differentiate between the various business opportunities.
The information and incentive issues lead to what economists call the lemons problem, which can
potentially break down the functioning of the capital market. The lemons problem refers to issues that
arise regarding the value of an investment or product due to asymmetric information possessed by the
buyer and the seller.
Financial intermediaries, such as venture capital firms, banks, collective investment funds, pension
funds, and insurance companies, focus on aggregating funds from individual investors and analyzing
different investment alternatives to make investment decisions. Information intermediaries, such as
auditors, financial analysts, credit-rating agencies, and the financial press, focus on providing or
assuring information to investors (and to financial intermediaries who represent them) on the quality of
various business investment opportunities.
,Over the past decade, many countries in Europe have been moving towards a model of strong legal
protection of investors’ rights to discipline entrepreneurs and well-developed stock exchanges. In this
model, financial reporting plays a critical role in the functioning of both the information intermediaries
and the financial intermediaries. Information intermediaries add value either by enhancing the credibility
of financial reports (as auditors do) or by analyzing the information in the financial statements (as
analysts and rating agencies do).
From business activities to financial statements
As shown in Figure 1.2, a firm’s financial statements summarize the economic consequences of its
business activities.
On a periodic basis, firms typically produce five financial reports:
1. An income statement that describes the operating performance during a time period.
2. A balance sheet that states the firm’s assets and how they are financed.
3. A cash flow statement that summarizes the cash flows of the firm.
4. A statement of other comprehensive income that outlines the sources of changes in equity that
are (a) not the result of transactions with the owners of the firm and (b) not included in the income
statement.3
5. Statement of changes in equity that summarizes all sources of changes in equity during the
period between two consecutive balance sheets, consisting of (a) total comprehensive income – being
the sum of profit or loss [item 1] and other comprehensive income [item 4] – and (b) the financial effects
of transac- tions with the owners of the firm.
, Influences of the accounting system on information quality
Intermediaries using financial statement data to do business analysis have to be aware that financial
reports are influenced both by the firm’s business activities and by its accounting system. The
institutional features of accounting systems discussed next determine the extent of that influence.
FEATURE 1: ACCRUAL ACCOUNTING
Unlike cash accounting, accrual accounting distinguishes between the recording of costs or benefits
associated with economic activities and the actual payment or receipt of cash. Profit or loss is the
primary periodic performance index under accrual accounting.
While many rules and conventions govern a firm’s preparation of financial statements, only a few
conceptual building blocks form the foundation of accrual accounting. Starting from the balance sheet,
the principles that define a firm are: assets, liabilities, and equity.
FEATURE 2: ACCOUNTING CONVENTIONS AND STANDARDS
A number of accounting conventions have been implemented to ensure that managers use their
account- ing flexibility to summarize their knowledge of the firm’s business activities, and not to disguise
reality for self-serving purposes. For example, in most countries financial statements are prepared
using the concept of prudence, where caution is taken to ensure that assets are not recorded at values
above their fair values and liabilities are not recorded at values below their fair values. This reduces
managers’ ability to overstate the value of the net assets that they have acquired or developed.
Accounting standards and rules also limit management’s ability to misuse accounting judgment by
regulating how particular types of transactions are recorded. For example, accounting standards for
leases stipulate how firms are to record contractual arrangements to lease resources. Similarly, post-
employment benefit standards describe how firms are to record commitments to provide pensions and
other post-employment benefits for employees.
FEATURE 3: MANAGERS’ REPORTING STRATEGY
A firm’s reporting strategy – that is, the manner in which managers use their accounting discretion –
has an important influence on the firm’s financial statements.
Corporate managers can choose accounting and disclosure policies that make it more or less difficult
for exter- nal users of financial reports to understand the true economic picture of their businesses.
FEATURE 4: AUDITING, LEGAL LIABILITY, AND PUBLIC ENFORCEMENT
Auditing
Broadly defined as a verification of the integrity of the reported financial statements by someone other
than the preparer, auditing ensures that managers use accounting rules and conventions consistently
over time and that their accounting estimates are reasonable. Therefore auditing improves the quality of
accounting data.
Content
, Chapter 1 A framework for business analysis and
valuation using financial statements
In almost all countries in the world today, capital markets play an important role in channeling financial
resources from savers to business enterprises that need capital. Financial statement analysis is a
valuable activity when managers have complete information on a firm’s strategies, and a variety of
institutional factors make it unlikely that they fully disclose this information to suppliers of capital.
The role of financial reporting in capital markets
Figure 1.1 provides a schematic representation of how capital markets typically work. While both
savers and entrepreneurs would like to do business with each other, matching savings to business
investment opportunities through the use of capital markets is complicated for at least three reasons:
● Information asymmetry between savers and entrepreneurs. Entrepreneurs typically have better
information than savers on the value of business investment opportunities.
● Potentially conflicting interests – credibility problems. Communication by entrepreneurs to
savers is not completely credible because savers know that entrepreneurs have an incentive to inflate
the value of their ideas.
● Expertise asymmetry. Savers generally lack the financial sophistication needed to analyze and
differentiate between the various business opportunities.
The information and incentive issues lead to what economists call the lemons problem, which can
potentially break down the functioning of the capital market. The lemons problem refers to issues that
arise regarding the value of an investment or product due to asymmetric information possessed by the
buyer and the seller.
Financial intermediaries, such as venture capital firms, banks, collective investment funds, pension
funds, and insurance companies, focus on aggregating funds from individual investors and analyzing
different investment alternatives to make investment decisions. Information intermediaries, such as
auditors, financial analysts, credit-rating agencies, and the financial press, focus on providing or
assuring information to investors (and to financial intermediaries who represent them) on the quality of
various business investment opportunities.
,Over the past decade, many countries in Europe have been moving towards a model of strong legal
protection of investors’ rights to discipline entrepreneurs and well-developed stock exchanges. In this
model, financial reporting plays a critical role in the functioning of both the information intermediaries
and the financial intermediaries. Information intermediaries add value either by enhancing the credibility
of financial reports (as auditors do) or by analyzing the information in the financial statements (as
analysts and rating agencies do).
From business activities to financial statements
As shown in Figure 1.2, a firm’s financial statements summarize the economic consequences of its
business activities.
On a periodic basis, firms typically produce five financial reports:
1. An income statement that describes the operating performance during a time period.
2. A balance sheet that states the firm’s assets and how they are financed.
3. A cash flow statement that summarizes the cash flows of the firm.
4. A statement of other comprehensive income that outlines the sources of changes in equity that
are (a) not the result of transactions with the owners of the firm and (b) not included in the income
statement.3
5. Statement of changes in equity that summarizes all sources of changes in equity during the
period between two consecutive balance sheets, consisting of (a) total comprehensive income – being
the sum of profit or loss [item 1] and other comprehensive income [item 4] – and (b) the financial effects
of transac- tions with the owners of the firm.
, Influences of the accounting system on information quality
Intermediaries using financial statement data to do business analysis have to be aware that financial
reports are influenced both by the firm’s business activities and by its accounting system. The
institutional features of accounting systems discussed next determine the extent of that influence.
FEATURE 1: ACCRUAL ACCOUNTING
Unlike cash accounting, accrual accounting distinguishes between the recording of costs or benefits
associated with economic activities and the actual payment or receipt of cash. Profit or loss is the
primary periodic performance index under accrual accounting.
While many rules and conventions govern a firm’s preparation of financial statements, only a few
conceptual building blocks form the foundation of accrual accounting. Starting from the balance sheet,
the principles that define a firm are: assets, liabilities, and equity.
FEATURE 2: ACCOUNTING CONVENTIONS AND STANDARDS
A number of accounting conventions have been implemented to ensure that managers use their
account- ing flexibility to summarize their knowledge of the firm’s business activities, and not to disguise
reality for self-serving purposes. For example, in most countries financial statements are prepared
using the concept of prudence, where caution is taken to ensure that assets are not recorded at values
above their fair values and liabilities are not recorded at values below their fair values. This reduces
managers’ ability to overstate the value of the net assets that they have acquired or developed.
Accounting standards and rules also limit management’s ability to misuse accounting judgment by
regulating how particular types of transactions are recorded. For example, accounting standards for
leases stipulate how firms are to record contractual arrangements to lease resources. Similarly, post-
employment benefit standards describe how firms are to record commitments to provide pensions and
other post-employment benefits for employees.
FEATURE 3: MANAGERS’ REPORTING STRATEGY
A firm’s reporting strategy – that is, the manner in which managers use their accounting discretion –
has an important influence on the firm’s financial statements.
Corporate managers can choose accounting and disclosure policies that make it more or less difficult
for exter- nal users of financial reports to understand the true economic picture of their businesses.
FEATURE 4: AUDITING, LEGAL LIABILITY, AND PUBLIC ENFORCEMENT
Auditing
Broadly defined as a verification of the integrity of the reported financial statements by someone other
than the preparer, auditing ensures that managers use accounting rules and conventions consistently
over time and that their accounting estimates are reasonable. Therefore auditing improves the quality of
accounting data.
