For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
1
CHAPTER 1
A framework for business
analysis and valuation using
financial statements
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Key concepts
• Financial statements are an important source of information to the
capital markets and business analysts.
• Financial reporting helps resolve information problems, supported by its core
features and institutional environment.
• Analyzing financial statements addresses variety of questions of
interest to external stakeholders and company insiders.
• If done well, financial statement analysis follows a clear structure.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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How capital markets function
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The role of financial reporting in capital
markets
• Financial reporting provides much-needed information to capital
market participants given:
• Information asymmetry between savers and entrepreneurs.
• Conflicts of interests between savers and entrepreneurs.
• Expertise asymmetry between savers and entrepreneurs.
• Information and financial intermediaries help resolve these issues.
• Their relative importance varies across markets.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
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The role of financial reporting in capital
markets
• Financial reporting provides much-needed information to capital
market participants given:
• Financial intermediaries depend upon the information in financial statements
to evaluate investment opportunities.
• Information intermediaries assure the quality of financial statement
representations.
• Relevant and reliable financial information is essential for the functioning of
capital markets.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
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From business activities to financial
statements
• Financial statements measure and summarize the economic
consequences of business activities.
• Accounting systems facilitate information quality, conditional on
various institutional features:
• Feature 1: The role of accrual accounting.
• Feature 2: The need for accounting conventions and standards.
• Feature 3: Managers’ accounting choices and strategies.
• Feature 4: Auditing, legal liability, and public enforcement.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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From business activities to financial
statements
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Feature 1: Accrual accounting
• Financial reports are prepared using accrual accounting.
• IFRS Standards define the following financial statement elements:
• Assets: Economic resources with measurable future benefits.
• Liabilities: Unavoidable and enforceable economic obligations arising from
past benefits.
• Equity: Assets minus liabilities.
• Income or Revenue: Earned economic resources and settled obligations.
• Expenses: Used economic resources and created obligations.
• Profit or Loss: Income or revenue minus expenses.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Feature 2: International Financial
Reporting Standards (IFRS Standards)
• The EU and other countries have relied on the IASB to set accounting
standards (IFRS Standards); many countries have endorsement procedures.
• IFRS Standards allow for consistency in reporting between firms, and over
different time periods for the same firm.
• Regulators make a trade-off:
• Uniform accounting standards minimize managers’ ability to manipulate financial
statement information.
• However, rigid accounting rules may be dysfunctional; calls for principles-based
accounting standards.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Feature 3: Management’s responsibility
for reporting financial information
• Accrual accounting requires estimates. For example:
• Expected customer defaults.
• Post-employment plan obligations.
• Revenue allocation across elements of bundled sales transactions.
• Applying accounting principles is the responsibility of management, who
has superior knowledge of a firm’s business.
• However, incentives exist for management to distort accounting numbers
in their favor:
• Contracts.
• Reputation.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Feature 4: External auditing of financial
statements
• Required for publicly traded companies; also required for some private
firms within the EU.
• Conducted according to standards:
• EU: minimum standards set by the Revised Statutory Audit Directive and
Regulation (US: Sarbanes-Oxley Act).
• International Standards of Auditing (US: GAAS).
• Auditing has its limitations; it is backed up by legal liability and public
enforcement.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Feature 4 (cont.): Public enforcement
• Most countries have public enforcement bodies to review compliance and
take actions to correct noncompliance.
• Public enforcement cannot ensure full compliance because enforcement
bodies work:
• Proactively on a sampling basis.
• On a complaint basis.
• There is international diversity in enforcement quality; the ESMA
(European Securities and Markets Authority) coordinates enforcement
activities in the EU.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Factors influencing accounting quality
• It is necessary to allow managers some discretion in applying
accounting standards.
• As a result, three potential sources of noise and bias in accounting
data include:
1. Noise from accounting rules.
2. Forecast errors.
3. Managers’ accounting choices.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
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Noise from accounting rules and
forecast errors
• The fit between accounting standards and the nature of the firm’s
transactions may introduce some distortion in the reported financial
statements.
• For example: Off-balance sheet intangibles such as research or customer
acquisition investments.
• Management’s estimates may result in accounting forecasting errors
(or bias) reflected in the financial statements.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
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Alternate forms of investor communication
• Analyst meetings:
• Regular meetings with analysts releases information to these intermediaries.
• Material information released to analysts must also be publicly disclosed.
• Voluntary disclosure:
• Management has the discretion to voluntarily disclose information, though
there are constraints on this type of disclosure.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Non-financial reporting
• Because financial statements focus on economic resources and
obligations, they may ignore some important other resources and
obligations:
• Trust relationships with stakeholders.
• Skilled workforces.
• Investments in environmental pollution reduction.
• Good governance.
• The importance of non-financial disclosures has therefore increased.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Non-financial reporting
• Examples of non-financial disclosures, also known as environmental,
social, and governance (ESG) or sustainability disclosures, include:
• Sustainability strategy discussions.
• Information about labor conditions in the supply chain.
• Information on water and chemicals use or carbon dioxide emissions.
• One of non-financial reporting’s greatest challenges is its strong
industry dependence.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Non-financial reporting
• Important frameworks and standards that have been developed to
improve the quality and comparability of non-financial reporting are:
• The Global Reporting Initiative (GRI)
• The International Integrated Reporting Council (IIRC)
• Now merged with the Sustainability Accounting Standards Board into the Value
Reporting Foundation)
• The European Union Non-Financial Reporting Directive, and its successor, the
Corporate Sustainability Reporting Directive.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Financial statements and business analysis
• Business intermediaries use financial statements to accomplish four
key steps in business analysis and valuation. The order of these steps
matters:
• Step 1: Business strategy analysis
• Step 2: Accounting analysis
• Step 3: Financial analysis
• Step 4: Prospective analysis
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Business strategy analysis
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
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Concluding comments
• Financial statements are a source of widely available data on publicly
traded corporations.
• Accrual accounting attempts to accurately reflect expectations of
economic performance but requires careful analysis.
• This chapter has outlined a useful framework for business analysis
using financial statements.
For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek
(ISBN 9781473779075) © 2022 Cengage EMEA
22