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Business Analysis and Valuation
KG Palepu，PM Healy
From the literature of the first chapter of the Fifth Edition “Business Analysis and Valuation”
1. Introduction
The purpose of this chapter is to outline a comprehensive framework for financial statement analysis. Because financial statements provide the most widely available data on public corporations’ economic activities, investors and other stake- holders rely on financial reports to assess the plans and performance of firms and corpo- rate managers.
A variety of questions can be addressed by business analysis using financial state- ments, as shown in the following examples:
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A security analyst may be interested in asking: “How well is the firm I am follow- ing performing? Did
the firm meet my performance expectations? If not, why not? What is the value of the firm’s stock given my assessment of the firm’s current and future performance?”
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A loan officer may need to ask: “What is the credit risk involved in lending a certain amount of money
to this firm? How well is the firm managing its liquidity and sol- vency? What is the firm’s business risk? What is the additional risk created by the firm’s financing and dividend policies?”
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A management consultant might ask: “What is the structure of the industry in which the firm is
operating? What are the strategies pursued by various players in the in- dustry? What is the relative performance of different firms in the industry?”
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A corporate manager may ask: “Is my firm properly valued by investors? Is our in- vestor
communication program adequate to facilitate this process?”
Financial statement analysis is a valuable activity when managers have complete in- formation on a firm’s strategies and a variety of institutional factors make it unlikely that they fully disclose this information. In this setting, outside analysts attempt to create “in- side information” from analyzing financial statement data, thereby gaining valuable in- sights about the firm’s current performance and future prospects.
To understand the contribution that financial statement analysis can make, it is im- portant to understand the role of financial reporting in the functioning of capital markets and the institutional forces that shape financial
statements. Therefore, we present first a brief description of these forces; then we discuss the steps that an analyst must perform to extract information from financial statements and provide valuable forecasts.
2.From business activities to financial statements
Corporate managers are responsible for acquiring physical and financial resources from the firm’s environment and using them to create value for the firm’s investors. Value is created when the firm earns a return on its investment in excess of the cost of capital. Managers formulate business strategies to achieve this goal, and they implement them through business activities. A firm’s business activities are influenced by its economic environment and its own business strategy. The economic environment includes the firm’s industry, its input and output markets, and the regulations under which the firm operates. The firm’s business strategy determines how the firm positions itself in its en- vironment to achieve a competitive advantage.
2.1 Accounting System Feature 1: Accrual Accounting
One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. Unlike cash accounting, accrual accounting distinguishes between the recording of costs and benefits associated with economic ac- tivities and the actual payment and receipt of cash. Net income is the primary periodic performance index under accrual accounting. To compute net income, the effects of eco- nomic transactions are recorded on the basis of expected, not necessarily actual, cash re- ceipts and payments. Expected cash receipts from the delivery of products or services are recognized as revenues, and expected cash outflows associated with these revenues are recognized as expenses.
The need for accrual accounting arises from investors’ demand for financial reports on a periodic basis. Because firms undertake economic transactions on a continual basis, the arbitrary closing of accounting books at the end of a reporting period leads to a fun- damental measurement problem. Since cash accounting does not report the full eco- nomic consequence of the transactions undertaken in a given period, accrual accounting is designed to provide more complete information on a firm’s periodic performance.
2.2 Accounting System Feature 2: Accounting Standards and Auditing
The use of accrual accounting lies at the center of many important complexities in cor- porate financial reporting. Because accrual accounting deals with expectations of future cash consequences of current events, it is subjective and relies on a variety of assump- tions. Who should be charged with the primary responsibility of making these assump- tions? A firm’s managers are entrusted with the task of making the appropriate estimates and assumptions to prepare the financial statements because they have intimate knowl- edge of their firm’s business.
The accounting discretion granted to managers is potentially valuable because it al- lows them to reflect inside information in reported financial statements. However, since investors view profits as a measure of managers’ performance, managers have incentives to use their accounting discretion to distort reported profits by making biased assump- tions. Further, the use of accounting numbers in contracts between the firm and outsiders provides another motivation for management manipulation of accounting numbers. In- come management distorts financial accounting data, making them less valuable to ex- ternal users of financial statements. Therefore, the delegation of financial reporting decisions to corporate managers has both costs and benefits.
A number of accounting conventions have evolved to ensure that managers use their accounting flexibility to summarize their knowledge of the firm’s business activities, and not to disguise reality for self-serving purposes. For example, the measurability and con- servatism conventions are accounting responses to concerns about distortions from man- agers’ potentially optimistic bias. Both these conventions attempt to limit managers’ optimistic bias by imposing their own pessimistic bias.
Accounting standards (Generally Accepted Accounting Principles), promulgated by the Financial Accounting Standards Board (FASB) and similar standard-setting bodies in other countries, also limit potential distortions that managers can introduce into reported numbers. Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways, either over time or across firms.
Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility for managers to reflect genuine business differences in their firm’s fi- nancial statements. Rigid accounting standards work best for economic transactions whose accounting treatment is not predicated on managers’ proprietary information. However, when there is significant business judgment involved in assessing a transac- tion’s economic consequences, rigid standards which prevent managers from using their superior business knowledge
would be dysfunctional. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting result.
Auditing, broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are rea- sonable. Therefore, auditing improves the quality of accounting data.
Third-party auditing may also reduce the quality of financial reporting because it constrains the kind of accounting rules and conventions that evolve over time. For ex- ample, the FASB considers the views of auditors in the standard-setting process. Auditors are likely to argue against accounting standards producing numbers that are difficult to audit, even if the proposed rules produce relevant information for investors.
The legal environment in which accounting disputes between managers, auditors, and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties have the beneficial effect of im- proving the accuracy of disclosure. However, the potential for a significant legal liability might also discourage managers and auditors from supporting accounting proposals re- quiring risky forecasts, such as forward-looking disclosures.
2.3 Accounting System Feature 3: Managers’ Reporting Strategy
Because the mechanisms that limit managers’ ability to distort accounting data add noise, it is not optimal to use accounting regulation to eliminate managerial flexibility completely. Therefore, real-world accounting systems leave considerable room for managers to influence financial statement data. 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 external users of financial reports to understand the true economic picture of their businesses. Accounting rules often provide a broad set of alternatives from which managers can choose. Further, managers are entrusted with making a range of estimates in implementing these accounting policies. Accounting regulations usually prescribe minimum disclosure requirements, but they do not restrict managers from vol- untarily providing additional disclosures.
A superior disclosure strategy will enable managers to communicate the underlying business reality to outside investors. One important constraint on a firm’s disclosure strategy is the competitive dynamics in product markets. Disclosure of proprietary infor- mation about business strategies and their expected economic consequences may hurt the firm’s competitive position. Subject to this constraint, managers can use financial statements to provide information useful to investors in assessing their firm’s true eco- nomic performance.
Managers can also use financial reporting strategies to manipulate investors’ percep- tions. Using the discretion granted to them, managers can make it difficult for investors to identify poor performance on a timely basis. For example, managers can choose ac- counting policies and estimates to provide an optimistic assessment of the firm’s true performance. They can also make it costly for investors to understand the true perfor- mance by controlling the extent of information that is disclosed voluntarily.
The extent to which financial statements are informative about the underlying busi- ness reality varies across firms—and across time for a given firm. This variation in ac- counting quality provides both an important opportunity and a challenge in doing business analysis. The process through which analysts can separate noise from informa- tion in financial statements, and gain valuable business insights from financial statement analysis, is discussed next.
3. From financial statements to bussiness analysis
Because managers’ insider knowledge is a source both of value and distortion in account- ing data, it is difficult for outside users of financial statements to separate true information from distortion and noise. Not being able to undo accounting distortions completely, in- vestors “discount” a firm’s reported accounting performance. In doing so, they make a probabilistic assessment of the extent to which a firm’s reported numbers reflect economic reality. As a result, investors can have only an imprecise assessment of an individual firm’s performance. Financial and information intermediaries can add value by improving inves- tors’ understanding of a firm’s current performance and its future prospects.
Effective financial statement analysis is valuable because it attempts to get at managers’ inside information from public financial statement data. Because intermediaries do not have direct or complete access to this information, they rely on their knowledge of the firm’s industry and its competitive strategies to interpret financial statements. Successful intermediaries have at least as good an understanding of the industry economics as do the firm’s managers, and a reasonably good understanding of the firm’s competitive strategy. Although outside