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Chapter 1Chapter 1Overview of Overview of

Financial Financial Reporting, Reporting,

Financial Statement Financial Statement Analysis, and Analysis, and

ValuationValuation

Chapter: 01 2

Six-Step Process

Chapter: 01 3

STEP 1: Identify the Industry Economic Characteristics

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 4

STEP 1: Identify the Industry Economic Characteristics

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 5

Tools for Studying Industry Economics

Value chain analysisPorter’s Five Forces classification

frameworkEconomic Attributes Framework

Chapter: 01 6

Value Chain Analysis

Chapter: 01 7

Porter’s Five Forces Classification Framework

Horizontal competitionRivalry among Existing FirmsThreat of New EntrantsThreat of Substitutes

Vertical competitionBuyer PowerSupplier Power

Chapter: 01 8

Rivalry among Existing FirmsOften 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 9

Threat of New EntrantsHow 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 10

Threat of SubstitutesHow 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 11

Buyer PowerRelates 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 12

Supplier PowerRelates 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.

Chapter: 01 13

Economic Attributes FrameworkDemandSupplyManufacturingMarketingInvesting & Financing

Chapter: 01 14

DemandAre 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?

Chapter: 01 15

SupplyAre suppliers offering similar or unique

products?Are there high barriers to entry?Are there high barriers to exit, such as

environment cleanup costs?

Chapter: 01 16

ManufacturingIs 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?

Chapter: 01 17

MarketingIs 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?

Chapter: 01 18

Investing and FinancingAre 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?

Chapter: 01 19

STEP 2: Identify The Company Strategies

Framework for Strategy AnalysisNature of product or serviceIntegration within value chainGeographical diversificationIndustry diversification

Chapter: 01 20

STEP 2: Identify The Company Strategies

Nature of Product or ServiceProduct differentiation strategy

Unique productsAchieving relatively high profit margins

Low-cost leadership strategyNon-differentiated productsAccepting a lower profit margin in return for a

higher sales volume and market share

Chapter: 01 21

Integration in Value ChainManufacturing: Is the firm conducting all

manufacturing operations itself or 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?

STEP 2: Identify The Company Strategies

Chapter: 01 22

STEP 2: Identify The Company Strategies

Geographical DiversificationIs the firm targeting its products to its

domestic market or integrating horizontally across many countries?

Industry DiversificationIs the firm operating in a single industry or

diversifying across multiple industries?

Chapter: 01 23

STEP 3: Assess The Quality Of The Financial Statements

Income StatementBalance SheetStatement of Cash Flows Statement of Shareholders’ Equity

First three statements are required; most companies include all four.

Chapter: 01 24

Accounting PrinciplesGAAP 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.

Chapter: 01 25

STEP 3: Assess The Quality Of The Financial StatementsBalance 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.

Chapter: 01 26

STEP 3: Assess The Quality Of The Financial Statements 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.

Chapter: 01 27

STEP 3: Assess The Quality Of The Financial Statements

LiabilitiesReflect 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.

Chapter: 01 28

STEP 3: Assess The Quality Of The Financial StatementsShareholders’ 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 of the recognition.

Treasury stock.

Chapter: 01 29

Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position

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.

Chapter: 01 30

Assessing the Quality of the Balance Sheet as a Complete Representation of Economic Position

Analyst recognizes: (Contd.)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.

Chapter: 01 31

STEP 3: Assess The Quality Of The Financial StatementsIncome Statement - Measuring Operating

PerformanceProvides information about the profitability of

a firm for a period of time.Under accrual basis of accounting, revenue

when 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.

Chapter: 01 32

Statement Of Cash FlowsAssesses a firm’s past ability to generate free

cash flows and for predicting future free cash flows.

Categories:Operating InvestingFinancing

Transactions not directly involving cash are disclosed either in a supplementary schedule or in a note to the statement of cash flows.

STEP 3: Assess The Quality Of The Financial Statements

Chapter: 01 33

STEP 4: Analyze Profitability and Risk

Tools:Common-size financial statementsPercentage change financial statementsFinancial Statement Ratios

Profitability: EPS, ROCE etc.Risk: Current Ratio, Debt to Equity Ratio etc.

Chapter: 01 34

STEP 5: Prepare Forecasted Financial StatementsForecasts 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.

Chapter: 01 35

STEP 6: Value the FirmApproaches:

DividendsEarningsCash flowsMarket

First three methods will give same value.

Chapter: 01 36

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 highly efficient capital market is that analysts and investors have more difficulty finding undervalued or overvalued securities.

Chapter: 01 37

The Association between Earnings and Share PricesPerforming financial analysis that relies on

analysis, forecasting, and valuation of key accounting measures can be very rewarding.

To understand the relation 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.

Chapter: 01 38

Sources of Financial Statement InformationAnnual Report to ShareholdersForm 10-K Annual ReportForm 10-Q Quarterly ReportProspectus or Registration Statement