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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
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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.
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Economic Attributes FrameworkDemandSupplyManufacturingMarketingInvesting & Financing
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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