Ch 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation

financial statement analysis building blocks

economics

strategy

financial statements

represents effective analysis based on:

1. identifying economic characteristics of the industries in which a firm competers and mapping those characteristics into determinants of profitability, growth, and risk

2. describing the strategies that a firm pursues to differentiate itself from competitors as a basis for evaluating a firm's competitive advantages, the sustainability and potential growth of a firm's earnings and its risks

3. evaluating the firms financial statements, including the accounting concepts and methods that underlie them and the quality of the information they provide

Six interrelated sequential steps in financial statement analysis

1. identify economic characteristics and competitive dynamics in the industry

2. identify company strategies

3. assess the quality of the financial statements

4. analyze profitability, growth, and risk

5. project future financial statements

6. value of the firm

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

For example, does the industry include a large number of firms selling similar products, such as grocery stores

Asset Turnover (T/O)

is the ratio of total sales or revenue to average assets. Helps investors understand how effectively companies are using their assets to generate sales. Investors use ratio to compare similar companies in the same group of sector

ROA (return on assets):

is an indicator of how profitable a company is relative to its total assets. Give an idea of how efficient a company's management is at using the assets to generate earnings. Displayed as a percentage

LDT/TA

?

tools for studying industry economics

- Porter's five forces classification framework

- value chain analysis

- economic attributes framework

Porter's five forces classification framework

suggest that five forces influence the level of competition and the profitability of firms in the industry

horizotional competition

- rivalry among existing firms

- threat of new entrants

- threat substitutes

vertical competition

- buyer power

- supplier power

Rivarly among existing firms

- often the first order of completion

- 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

Economists often assess the level of competition with industry concentration ratios, such as a four-firm concentration index that measures the proportion of industry sales controlled by the four largest competitors

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

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

Buyer power

- relates to the relative number of buyers and sellers in the industry and 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?

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 supplier will have greater power in setting prices and generating profits

value chain analysis

value chain for the coffee beverage industry

green coffee beans are grown and harvested> coffee beans are shipped, roasted, and packaged> packaged coffee beans are distributed to retail sales locations>retail sales are made to consumers through grocery stores and coffee shops

econonomic atrributes framework

- demand

- supply

- manufacturing

- marketing

- investing & financing

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?

supply

-are suppliers offering similar or unique products?

- are the high barriers to entry?

- are there high barriers to exit, such as environment cleanup cost?

manufacturing

- is the manufactoring process capital-intensice 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?

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?

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?

Step 2: identify the company strategies

Framework for strategy analysis

- nature of product or service

- integration within value chain

- geographical diversification

- industry diversification

(Understanding the firm's strategy and the sustainability of its competitive advantages provides the necessary firm-specific context to evaluate the firm's accounting information; assess profitability, growth, and risk; and project the firm's future business activities)

nature of product or service

product differentiation strategy

- unique products

- achieving relatively high profits margins

low cost leadership strategy

- non-differentiated products

- accepting a lower profit margin in return for a higher sales volume and market share

integration in value chain

- manufacturing: is the firm conducting all manufactoring operations itself, outsourcing all manufacturing of components but conducting the assembly operation in house?

-distribution: is the firm maintaining control over the distribution function or outsourcing it?

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?

Step 3: assess the quality of the financial statements

- income statement

- balance sheet

- statement of cash flows

- statement of shareholders' equity

- statement of comprehensive income

first four statements are required; most companies include all five

(It is essential to understand the quality of the firm's accounting information to effectively analyze the firm's profitability, growth, and risk and to project its future balance sheets, income statements, and cash flows)

accounting quality

accounting info should

- be fair and complete representation of the firm's economic performance, financial position, and risk

- provide relevant info to forecast the firm's expected future earnings and cash flows

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 U.S., but has delegated that authority to the FASB

balance sheer or statement of financial position

assets = liability + 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 firms' operating and financing desicions

assets

- a firm can recognize as assets only those resources:

1. for which it has the right to future economic benefits as a result of a part transaction or event

2. for whihc the firm can predict and measure, the future benefits within reasonable degree of precision and reliability

- categorized into current assets, investments, property, plant, and equipment and intangibles

liabilities

- reflect managers' expectations of future sacrifices of resources to satify existing obligations

- categorized into:

- current liabilities: includes obligations a firm expects to settle within one year

- noncurrent liabilities: includes long-term debt obligations, other liabilitiesm and deferred income taxes

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 the recognition or valuation of certain assets or liabilities

treasury stock

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

- rights to use resources and commitment to make future payments may not appear as assets and liabilities

- noncurrent liabilites appear at the PV of expected cash flows discounted at an interest rate prevailing when the liability initially arose

income statement - measuring operating perfromance

- provides info about the profitability of a firm for a period of time

- under accrual basis of accounting, revenue 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

statement of cash flows

- assess a firm's past ability to generate free cash flows and 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

Step 4: analyze profitability and risk

using info in the financial statements

tools:

- common-size financial statements

- percentage change financial statements

- financial statements ratios

- profitability: EPS, ROCE etc

- risk: current ratio, debt to equity ratio, ect

(By understanding the firm's current and past profitability, growth, and risk, you will establish important information you will use in projecting the firm's future profitability, growth, and risk and in valuing its shares)

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 in assumptions the analyst makes about the future

- amounts from the forecasted financial statements serve as the bases for the valuation models

(Forecasted financial statements that project the firm's future operating, investing, and financing activities provide the basis for projecting future profitability, growth, and risk, which provide the basis for financial decision making, including valuation)

Step 6: value the firm

approaches:

- dividends

- earnings

- cash flows

- market

first three methods will give the same value

(Financial analysts use their estimates of share value to make recommendations for buying, selling, or holding the equity securities of firms when market price is too low, too high, or about right)

role of financial statment analysis in an efficient capital market

benefits

- stock market prices react with a high degree of efficiency to published info about a firm

- an implication of a highly efficient capital market is that analyst and investors have more difficulty finding undervalued or overvalued securities

the association between earnings and share prices

- performing financial anaylsis that relies on analysis, forecasting, and valuation of key accounting measures can be very rewarding

- to understand the relationship 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

Sources of financial statement information

- annual report to shareholders

- Form 10K annual report

- form 10-Q quarterly report

- prospectus or registration statement