Chapter 1
Overview of
Financial
Reporting,
Financial Statement
Analysis, and
Valuation
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Six-Step Process
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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.
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STEP 1: Identify the Industry Economic
Characteristics
Profit
Margin Asset T/O
Grocery
3.5%
2.900
Pharmaceutical 12.1%
0.678
Utility
10.5%
0.495
Bank
13.0%
0.090
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ROA
10.15%
8.20%
5.20%
1.20%
LTD/TA
29.8%
25.3%
65.6%
8.7%
4
Tools for Studying Industry Economics
 Value chain analysis
 Porter’s Five Forces classification
framework
 Economic Attributes Framework
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Value Chain Analysis
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Porter’s Five Forces Classification
Framework
 Horizontal competition
 Rivalry among Existing Firms
 Threat of New Entrants
 Threat of Substitutes
 Vertical competition
 Buyer Power
 Supplier Power
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Rivalry among Existing Firms
 Often 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.
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Threat of New Entrants
 How 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.
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Threat of Substitutes
 How 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.
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Buyer Power
 Relates 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?
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Supplier Power
 Relates 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 Framework
 Demand
 Supply
 Manufacturing
 Marketing
 Investing & Financing
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Demand
 Are 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?
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Supply
 Are suppliers offering similar or unique
products?
 Are there high barriers to entry?
 Are there high barriers to exit, such as
environment cleanup costs?
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Manufacturing
 Is 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?
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Marketing
 Is 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?
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Investing and Financing
 Are 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?
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STEP 2: Identify The Company
Strategies
Framework for Strategy Analysis
 Nature of product or service
 Integration within value chain
 Geographical diversification
 Industry diversification
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STEP 2: Identify The Company
Strategies
 Nature of Product or Service
 Product differentiation strategy
 Unique products
 Achieving relatively high profit margins
 Low-cost leadership strategy
 Non-differentiated products
 Accepting a lower profit margin in return for a
higher sales volume and market share
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STEP 2: Identify The Company
Strategies
 Integration in Value Chain
 Manufacturing: 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?
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STEP 2: Identify The Company
Strategies
 Geographical Diversification
 Is the firm targeting its products to its
domestic market or integrating horizontally
across many countries?
 Industry Diversification
 Is the firm operating in a single industry or
diversifying across multiple industries?
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STEP 3: Assess The Quality Of The
Financial Statements
 Income Statement
 Balance Sheet
 Statement of Cash Flows
 Statement of Shareholders’ Equity
First three statements are required; most
companies include all four.
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Accounting Principles
 GAAP 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.
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STEP 3: Assess The Quality Of The
Financial Statements
 Balance 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.
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STEP 3: Assess The Quality Of The
Financial Statements
 Assets
 A firm can recognize as assets only those
resources:
1.
2.
for which it has the rights to future economic
benefits as a result of a past transaction or event.
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.
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STEP 3: Assess The Quality Of The
Financial Statements
 Liabilities
 Reflect managers’ expectations of future
sacrifices of resources to satisfy existing
obligations.
 Categorized into:


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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.
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STEP 3: Assess The Quality Of The
Financial Statements
 Shareholders’ 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.
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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.
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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.
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STEP 3: Assess The Quality Of The
Financial Statements
 Income Statement - Measuring Operating
Performance
 Provides information about the profitability of
a firm for a period of time.
 Under accrual basis of accounting, revenue
when is recognized when:


Chapter: 01
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.
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STEP 3: Assess The Quality Of The
Financial Statements
 Statement Of Cash Flows
 Assesses a firm’s past ability to generate free
cash flows and for predicting future free cash
flows.
 Categories:



Operating
Investing
Financing
Transactions not directly involving cash are disclosed either in a
supplementary schedule or in a note to the statement of cash flows.
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STEP 4: Analyze Profitability and Risk
 Tools:
 Common-size financial statements
 Percentage change financial statements
 Financial Statement Ratios
 Profitability: EPS, ROCE etc.
 Risk: Current Ratio, Debt to Equity Ratio etc.
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STEP 5: Prepare Forecasted Financial
Statements
 Forecasts 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.
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STEP 6: Value the Firm
 Approaches:
 Dividends
 Earnings
 Cash flows
 Market
First three methods will give same value.
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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.
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The Association between Earnings and
Share Prices
 Performing 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.
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Sources of Financial Statement
Information
 Annual Report to Shareholders
 Form 10-K Annual Report
 Form 10-Q Quarterly Report
 Prospectus or Registration Statement
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