This provides a framework on which new and upcoming enterprises and startups can build there financial analysis and asset management systems, essential for the function and presentation of the business to potential stakeholders

1. •INTERNAL
A framework for Business Analysis
and Valuation Using Financial
Statements

2. •INTERNAL
Why FSA is important?
 To outline a comprehensive framework
for financial statement analysis
 Financial statements provide the most widely
available data on public corporations’ economic
activities
 So, investors and other stakeholders rely on
financial reports to assess the plans and
performance of firms and corporate managers.

3. •INTERNAL
Functions of business analysis
We can address quite a few questions by business
analysis using financial statements…
 From a security analyst’s perspective: “ How well is
the firm performing? What is the value of the firm’s
stock given its current and future performance?”
 A loan officer may be interested in knowing the
credit risk of the firm
 A management consultant might be interested in
the structure of the industry to which the firm
belongs
 A corporate manager may ask whether the firm is a
potential take over target and so on

4. •INTERNAL
Functions of business analysis
(cont….)
 Financial statement analysis is a valuable tool since
it enables the outside analysts create ‘inside
information’ there by gaining valuable insights about
current performance and future prospects.
 The assumption is managers have complete
information on a firm’s strategies and current state
of the art.

5. •INTERNAL
Functions of business analysis
(cont….)
Question is: how much information can one garner
from FSA?
In order to answer this question, we need to
understand the role of financial reporting in the
functioning of capital markets and the institutional
forces that shape financial statements.
That takes us to the next section…

6. •INTERNAL
Analysis using Financial Statements
Financial Statements
•Managers’ superior
information on business
activities
•Noise from estimating errors
•Distortions from managers’
accounting choices
Other public Data
•Industry and Firm data
•Outside Financial Statements
Business Application
context
•Credit analysis
•Securities analysis
•M&A analysis
•Debt/Dividend analysis
•Corporate communication
strategy analysis
•General business analysis
ANALYSIS TOOLS
Business Strategy
Analysis
Generate performance
expectations thru industry
analysis and competitive
strategy analysis
Accounting Analysis
Evaluate accounting quality by
assessing accounting policies
and estimates
Financial Analysis
Evaluate performance using
ratios and cash flow analysis
Prospective Analysis
Make forecasts and value
business

7. Purpose of Accounting Analysis
 To evaluate the degree to which a firm’s
accounting captures its underlying business reality.
 To assess the degree of distortion in a firm’s
accounting numbers by evaluating the
appropriateness of the firm’s accounting policies
and estimates.
 To undo any accounting distortions to improve
the reliability of accounting numbers.

8. The Institutional Framework for
Financial Reporting
 Usually three (or four) financial statements:
- Balance Sheet/Statement of Financial Position
- Income Statement/Statement of Comprehensive Income
- Statement of Cash Flow
- Statement of the SH Equity/Retained Earnings
These are accompanied by footnotes and management discussion.
 Building blocks of accrual accounting
-Economic transactions are recorded on the basis of
expected, not necessarily actual, cash receipts and
payments
- There are a few building blocks that form the foundation of
accrual accounting
- Assets are economic resources that produce future

9. The Institutional Framework for
Financial Reporting
economic benefits and are measurable with reasonable
certainty.
- Liabilities are economic obligations of a firm that are
required to be met with a reasonable degree of certainty and
within well defined time in the future.
- Equity is the difference between a firm’s net assets and its
liabilities.
- Revenues are economic resources earned during a time
period whose recognition is governed by the Realization
principle.
- Expenses are economic resources used in a time period.
Its recognition is governed by the matching and the
conservatism principles.
- Profit is the difference between a firm’s revenues and
expenses in a time period.

10. The Institutional Framework for
Financial Reporting
 Delegation of Reporting to Management
 GAAP
- The FASs in the US issued by FASB
- The IFRS in the rest of the world
 External Auditing
 Legal Liability

11. Factors influencing Accounting
Quality
 Accounting Rules
- Uniform accounting may not be able to capture the nature
of the firm’s transactions.
 Forecast errors
- Managers cannot predict future consequences fo current
transactions perfectly.
 Managers’ accounting choices
- Accounting-based covenants
- Management compensation
- Corporate control contests
- Tax considerations
- Regulatory considerations

12. Factors influencing Accounting
Quality
 Managers’ accounting choices (cont’d)
- Capital market considerations
- Stakeholder considerations
- Competitive considerations

13. Doing Accounting Analysis
 Identify key accounting policies
- Identify and evaluate the policies and the estimates the
firms uses to measure its critical factors and risk
 Assess Accounting Flexibility
- If managers have little flexibility in choosing accounting
policies and estimates related to key success factors, the
accounting numbers are likely to be less informative
- If managers have flexibility, accounting numbers are likely
to be informative provided…
- Some flexibility common to all: depreciation, inventory,
amortization, pension and so on.

14. Doing Accounting Analysis
 Evaluate Accounting Strategy
- How do the firm’s accounting policies compare to the
norms in the industry?
- Does management face strong incentives to use accounting
discretion for earnings management?
- Has the firm changed any of its policies or estimates? What
is the justification?
- Have the company’s policies and estimates been realistic in
the past?
- Does the firm structure any significant business
transactions so that it can achieve certain accounting
objectives?

15. Doing Accounting Analysis
 Evaluate the Quality of Disclosure
- Does the company provide adequate disclosures to assess
the firm’s business strategy and its economic consequences?
- Do the footnotes adequately explain the key accounting
policies and assumptions and their logic?
- Does the firm adequately explain its current performance?
- If accounting rules and conventions restrict the firm from
measuring its key success factors, does the firm provide
adequate disclosure to address the issue?
- What is the quality of segment disclosure?
- How forthcoming is the management with the bad news?
- How good is the firm’s investor relations program?

16. Doing Accounting Analysis
 Identify the Potential Red Flags
- Unexplained changes in accounting, especially when the
performance is poor
- Unexplained transactions that boost profit
- Unusual increases in accounts receivables in relation to
sales increase
- Unusual increases in inventories in relation to sales increase
- An increasing gap between a firm’s reported income and its
operating cash flow
- An increasing gap between a firm’s reported income and its
tax income
- Large fourth quarter adjustments
- Qualified audit opinion or changes in independent auditors
that are not well justified
- Related party transactions or transactions between related
entities

17. Doing Accounting Analysis
 Undo accounting distortions
- Cash flow statement provides a reconciliation of its
performance based on accrual accounting and cash
accounting.
- It’s not possible to undo all distortions. However, footnotes
may provide significant guidelines in this regard.

18. Accounting Analysis Pitfalls
 Conservative accounting is not same as good accounting
 Unusual accounting is not necessarily questionable accounting
 Not all accounting changes are attributable to earnings
management motives