analysts have an information disadvantage relative to the firm’s manag- ers, they are more objective in evaluating the economic consequences of the firm’s invest- ment and operating decisions. Figure 1-3 provides a schematic overview of how business intermediaries use financial statements to accomplish four key steps: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis, and (4) prospective analysis.
3.1 Analysis Step 1: Business Strategy Analysis
The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the company’s profit potential at a qualitative level. Business strategy analysis involves analyzing a firm’s industry and its strategy to create a sustainable com- petitive advantage. This qualitative analysis is an essential first step because it enables the analyst to frame the subsequent accounting and financial analysis better. For exam- ple, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates eval- uating whether current profitability is sustainable. Finally, business analysis enables the analyst to make sound assumptions in forecasting a firm’s future performance.
3.2 Analysis Step 2: Accounting Analysis
The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business reality. By identifying places where there is account- ing flexibility, and by evaluating the appropriateness of the firm’s accounting policies and estimates, analysts can assess the degree of distortion in a firm’s accounting numbers. Another important step in accounting analysis is to “undo” any accounting dis- tortions by recasting a firm’s accounting numbers to create unbiased accounting data. Sound accounting analysis improves the reliability of conclusions from financial analy- sis, the next step in financial statement analysis.
3.3 Analysis Step 3: Financial Analysis
The goal of financial analysis is to use financial data to evaluate the current and past per- formance of a firm and to assess its sustainability. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use financial data to explore business issues. Ratio analysis and cash flow analysis are the two most commonly used financial tools. Ratio
analysis focuses on evaluating a firm’s product market performance and financial poli- cies; cash flow analysis focuses on a firm’s liquidity and financial flexibility.
3.4 Analysis Step 4: Prospective Analysis
Prospective analysis, which focuses on forecasting a firm’s future, is the final step in business analysis. Two commonly used techniques in prospective analysis are financial statement forecasting and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis, and financial analysis in order to make pre- dictions about a firm’s future.
While the value of a firm is a function of its future cash flow performance, it is also possible to assess a firm’s value based on the firm’s current book value of equity, and its future return on equity (ROE) and growth. Strategy analysis, accounting analysis, and financial analysis, the first three steps in the framework discussed here, provide an ex- cellent foundation for estimating a firm’s intrinsic value. Strategy analysis, in addition to enabling sound accounting and financial analysis, also helps in assessing potential changes in a firm’s competitive advantage and their implications for the firm’s future ROE and growth. Accounting analysis provides an unbiased estimate of a firm’s current book value and ROE. Financial analysis allows you to gain an in-depth understanding of what drives the firm’s current ROE.
The predictions from a sound business analysis are useful to a variety of parties and can be applied in various contexts. The exact nature of the analysis will depend on the context. The contexts that we will examine include securities analysis, credit evaluation, mergers and acquisitions, evaluation of debt and dividend policies, and assessing corpo- rate communication strategies. The four analytical steps described above are useful in each of these contexts. Appropriate use of these tools, however, requires a familiarity with the economic theories and institutional factors relevant to the context.
4.Summary
Financial statements provide the most widely available data on public corporations’ eco- nomic activities; investors and other stakeholders rely on them to assess the plans and performance of firms and corporate managers. Accrual accounting data in financial statements are noisy, and unsophisticated investors can assess firms’ performance only imprecisely. Financial analysts who understand managers’ disclosure strategies have an
opportunity to create inside information from public data, and they play a valuable role in enabling outside parties to evaluate a firm’s current and prospective performance.
This chapter has outlined the framework for business analysis with financial state- ments, using the four key steps: business strategy analysis, accounting analysis, financial analysis, and prospective analysis. The remaining chapters in this book describe these steps in greater detail and discuss how they can be used in a variety of business contexts.