Financial Statement Analysis
University of Groningen, EBB116A05
Academic year: 2022-2023
Chapter 1-10
Lecture notes
,Week 1: Framework and Strategy Analysis
Chapter 1:
A framework for business analysis and valuation using financial
statements
Financial statement analysis
Investors and other stakeholders rely on financial statements to assess the plans and performance of
firms. Financial statement analysis is a valuable activity, in which outside analysts attempt to create
“inside information” from analyzing financial statement data, thereby gaining valuable insights about
the firm’s current performance and future prospect.
Financial statement analysis has two big components:
- Business analysis using financial statements;
the assessment of the company while putting it into context
- Valuation;
determining the actual value of the company based on the first step. How much money is the
company actual worth? If it’s worth more than the market price, you should invest in the
company, if it’s not you should sell the shares.
Purposes:
- Security analysis: determine the actual price to see if we have to invest or sell (Chapter 9)
- Credit analysis: determine if the particular entity is able to get more loan (banks do this)
(Chapter 10)
- Merger and acquisitions analysis: assessment of companies in order to perform mergers and
acquisitions. If a company is undervalued, a bigger company is acquiring it, solve the issues of
the company, and then sell the company with a big profit.
- General business analysis
- Audit risk analysis; very important one! An auditing team is going to audit the financial
statements to establish the audit risk. To what extend is the company likely to require a lot of
effort to determine if they follow the rules of not. Based on this audit risk analysis, auditors
charge fees or decide to refuse the company from the audit.
The functioning of capital markets: from saving to business ideas
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. Capital
markets are markets
where entrepreneurs raise
funds to finance their
business ideas in exchange
for equity or debt securities. Companies would like to attract the savings from households to fund
their business ideas.
There are a couple of ‘problems’ in this setting:
- Information asymmetry
, insiders of the company know more than the outsiders. By using the financial statement and
different types of contracting, we try to minimize the information asymmetry between the
internals and externals ((un)informed investors). --> therefore, information intermediaries
- Incentive problems
managers or the insiders of the company might have a lot of incentives to manipulate the
way the company looks like for externals.
- Expertise asymmetry
Outsiders don’t have any idea about what the insider is telling them, because they have no
knowledge about the products etc. --> therefore, financial intermediaries
The information and incentive issues lead to the so-called lemons problem (lemons refers to used
cars)
[Als kopers geen onderscheid zien tussen slechte en goede auto's, zijn ze slechts bereid om een
gemiddelde prijs te betalen, waardoor verkopers van goede auto's geen correcte prijs krijgen en de
markt verlaten. Na een tijdje blijven dus enkel nog slechte auto's over.]
The emergence of intermediaries can prevent such a market breakdown.
- Financial intermediaries, such as venture capital firms, banks, collective invest funds,
pension funds, 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 1 and
the financial press focus on providing information to investors.
From business activities to financial statements
A firm’s business activities are influenced by its economic environment and its business strategy. The
economic environment includes the firm’s industry, its unput and output markets, and the
regulations under which the firm operates.
A firm’s financial statement summarize the economic consequences of its business activities. Firms
typically produce 5 financial reports:
- An income statement operating performance
- A balance sheet assets and how they’re financed
- A cash flow statement
- A statement of other comprehensive income outlines the sources of changes in equity
that are not (1) transactions with the owners of the firm and (2) not included in the income
statement
- A statement of changes in equity
The financial statements are a result of the mapping of business activities. There are 3 sorts of
business activities: operating, investment and financing.
The accounting system measures and reports economic consequences of the business activities. The
result of this (financial statements) is never perfect because of estimation errors and personal
interests of managers which differ from the ones of other stakeholders. You need to analyze the
business environment, business strategy, accounting environment and accounting strategy to get the
financial statements from the business activities.
1
Credit rating: credit risk is high or low based on credit rating systems which will be discussed in chapter 10. For
example: Moody’s, which rates credit risks from Aaa, Aa, A, Baa, Ba, B, Caa, Ca to C.
, Influences of the accounting system on information quality
Ad. 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 or cash. Net profit is the
primary periodic performance index under accrual accounting. This is based on the expected, not
necessarily actual cash receipts and payments. Accrual accounting --> more estimates and more
flexibility.
[Accrual accounting komt voor uit het vereiste om elke periode een verslag af te geven. Aangezien
cashaccounting (inkomen en uitgaven worden pas geregistreerd als het geld binnen is) niet de volle
impact van een boeking weergeeft.]
Ad. 2 Accounting conventions and standards ( IFRS or US GAAP)
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 stimulate how firms are to record contractual arrangements to lease resources. These
accounting standards, which are designed to convey quantitative information on a firm’s
performance, are complemented by a set of disclosure principles. The disclosure principles guide the
amount and kinds of information that are disclosed and require a firm to provide qualitative
information related to assumptions, policies, and uncertainties that underlie the quantitative data
presented.
For example, a difference between standards of IFRS and US GAAP regarding to R&D:
- Under the US GAAP, companies are obligated to expense Research and Development (R&D)
expenditures in the same fiscal year they are spent.
- Under IFRS rules, research spending is treated as an expense each year, just as with GAAP. By
contrast, though, development costs can be capitalized if the company can prove that the
asset in development will become commercially viable (meaning the technology or product
in development is likely to make it through the approval process and generate revenue).
University of Groningen, EBB116A05
Academic year: 2022-2023
Chapter 1-10
Lecture notes
,Week 1: Framework and Strategy Analysis
Chapter 1:
A framework for business analysis and valuation using financial
statements
Financial statement analysis
Investors and other stakeholders rely on financial statements to assess the plans and performance of
firms. Financial statement analysis is a valuable activity, in which outside analysts attempt to create
“inside information” from analyzing financial statement data, thereby gaining valuable insights about
the firm’s current performance and future prospect.
Financial statement analysis has two big components:
- Business analysis using financial statements;
the assessment of the company while putting it into context
- Valuation;
determining the actual value of the company based on the first step. How much money is the
company actual worth? If it’s worth more than the market price, you should invest in the
company, if it’s not you should sell the shares.
Purposes:
- Security analysis: determine the actual price to see if we have to invest or sell (Chapter 9)
- Credit analysis: determine if the particular entity is able to get more loan (banks do this)
(Chapter 10)
- Merger and acquisitions analysis: assessment of companies in order to perform mergers and
acquisitions. If a company is undervalued, a bigger company is acquiring it, solve the issues of
the company, and then sell the company with a big profit.
- General business analysis
- Audit risk analysis; very important one! An auditing team is going to audit the financial
statements to establish the audit risk. To what extend is the company likely to require a lot of
effort to determine if they follow the rules of not. Based on this audit risk analysis, auditors
charge fees or decide to refuse the company from the audit.
The functioning of capital markets: from saving to business ideas
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. Capital
markets are markets
where entrepreneurs raise
funds to finance their
business ideas in exchange
for equity or debt securities. Companies would like to attract the savings from households to fund
their business ideas.
There are a couple of ‘problems’ in this setting:
- Information asymmetry
, insiders of the company know more than the outsiders. By using the financial statement and
different types of contracting, we try to minimize the information asymmetry between the
internals and externals ((un)informed investors). --> therefore, information intermediaries
- Incentive problems
managers or the insiders of the company might have a lot of incentives to manipulate the
way the company looks like for externals.
- Expertise asymmetry
Outsiders don’t have any idea about what the insider is telling them, because they have no
knowledge about the products etc. --> therefore, financial intermediaries
The information and incentive issues lead to the so-called lemons problem (lemons refers to used
cars)
[Als kopers geen onderscheid zien tussen slechte en goede auto's, zijn ze slechts bereid om een
gemiddelde prijs te betalen, waardoor verkopers van goede auto's geen correcte prijs krijgen en de
markt verlaten. Na een tijdje blijven dus enkel nog slechte auto's over.]
The emergence of intermediaries can prevent such a market breakdown.
- Financial intermediaries, such as venture capital firms, banks, collective invest funds,
pension funds, 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 1 and
the financial press focus on providing information to investors.
From business activities to financial statements
A firm’s business activities are influenced by its economic environment and its business strategy. The
economic environment includes the firm’s industry, its unput and output markets, and the
regulations under which the firm operates.
A firm’s financial statement summarize the economic consequences of its business activities. Firms
typically produce 5 financial reports:
- An income statement operating performance
- A balance sheet assets and how they’re financed
- A cash flow statement
- A statement of other comprehensive income outlines the sources of changes in equity
that are not (1) transactions with the owners of the firm and (2) not included in the income
statement
- A statement of changes in equity
The financial statements are a result of the mapping of business activities. There are 3 sorts of
business activities: operating, investment and financing.
The accounting system measures and reports economic consequences of the business activities. The
result of this (financial statements) is never perfect because of estimation errors and personal
interests of managers which differ from the ones of other stakeholders. You need to analyze the
business environment, business strategy, accounting environment and accounting strategy to get the
financial statements from the business activities.
1
Credit rating: credit risk is high or low based on credit rating systems which will be discussed in chapter 10. For
example: Moody’s, which rates credit risks from Aaa, Aa, A, Baa, Ba, B, Caa, Ca to C.
, Influences of the accounting system on information quality
Ad. 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 or cash. Net profit is the
primary periodic performance index under accrual accounting. This is based on the expected, not
necessarily actual cash receipts and payments. Accrual accounting --> more estimates and more
flexibility.
[Accrual accounting komt voor uit het vereiste om elke periode een verslag af te geven. Aangezien
cashaccounting (inkomen en uitgaven worden pas geregistreerd als het geld binnen is) niet de volle
impact van een boeking weergeeft.]
Ad. 2 Accounting conventions and standards ( IFRS or US GAAP)
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 stimulate how firms are to record contractual arrangements to lease resources. These
accounting standards, which are designed to convey quantitative information on a firm’s
performance, are complemented by a set of disclosure principles. The disclosure principles guide the
amount and kinds of information that are disclosed and require a firm to provide qualitative
information related to assumptions, policies, and uncertainties that underlie the quantitative data
presented.
For example, a difference between standards of IFRS and US GAAP regarding to R&D:
- Under the US GAAP, companies are obligated to expense Research and Development (R&D)
expenditures in the same fiscal year they are spent.
- Under IFRS rules, research spending is treated as an expense each year, just as with GAAP. By
contrast, though, development costs can be capitalized if the company can prove that the
asset in development will become commercially viable (meaning the technology or product
in development is likely to make it through the approval process and generate revenue).
