Financial Analysis

Lecture I
Academic Year 2010-11
Trimester II
 Study Plan
• Textbook
Business Analysis & Valuation using financial
statements
Palepu, Healy & Bernard
Others:
1. Charles H Gibson – Analysis of Financial
Statements
2. George Foster - Financial Statement Analysis
3. Stickney, Brown & Wahlen - Financial Reporting
and Statement Analysis: A Strategic Perspective
• Financial Analysis of companies, in groups
 The Companies for Financial Analysis
• Group 1: Airtel
• Group 2: Biocon
• Group 3: DLF
• Group 4: Hero Honda
• Group 5: ITC
• Group 6: Moser Baer
• Group 7: Network 18
• Group 8: ONGC
• Group 9: Suzlon
• Group10:Tata Steel
 Key components of Analysis
• Business Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Prospective Analysis
 Business Strategy Analysis
• The purpose of business strategy analysis is:
1. to identify key profit drivers and business
risks, and
2. to assess the company’s profit potential at a
qualitative level.
• Business strategy analysis involves analyzing:
1. a firm’s industry, and
2. its strategy to create a sustainable
competitive advantage.
 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 accounting 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 distortions by recasting a firm’s
accounting numbers to create unbiased accounting data.
 Financial Analysis
• The goal of financial analysis is to use financial data to
evaluate the current and past performance of a firm and
to assess its sustainability.
• 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 policies.
• Cash flow analysis focuses on a firm’s liquidity and
financial flexibility.
 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:
1. financial statement forecasting, and
2. valuation.
 Prospective Analysis …. Contd.
• 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 excellent
foundation for estimating a firm’s intrinsic
value.
 Influence of the accounting system on
the quality of the financial statements
• A key aspect of financial statement analysis, involves
understanding the influence of the accounting system on
the quality of the financial statement data being used in
the analysis.
• One of the fundamental features of corporate financial
reports is that they are prepared using accrual rather
than cash accounting. The use of accrual accounting lies
at the center of many important complexities in
corporate financial reporting.
• Because accrual accounting deals with expectations of
future cash consequences of current events, it is
subjective and relies on a variety of assumptions.
 Influence of the accounting system … contd.
Accounting Standards & Auditing
• 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 conservatism conventions
are accounting responses to concerns about distortions from
managers’ potentially optimistic bias.
• Both these conventions attempt to limit managers’ optimistic
bias by imposing their own pessimistic bias.
• 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 reasonable.
 Influence of the accounting system … contd.
Managers’ Reporting Strategy
• 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.
• 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 information 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 economic performance.
 The Context
• The exact nature of the analysis depends on the
context.
• The contexts that you might examine include:
1. securities analysis,
2. credit evaluation,
3. mergers and acquisitions,
4. evaluation of debt and dividend policies, and
5. assessing corporate communication strategies.
• The four analytical steps discussed today are
useful in each of these contexts.