Introduction to Business Analysis and

Valuation using Financial Statements

The contents of this presentation are based on Palepu & Healy (2015) and Dey (2015)

Dr. Vinodh Madhavan

Assistant Professor Finance
IMT Ghaziabad
Contact Details: vmadhavan@imt.edu | vinodh.madhavan@gmail.com

Why study Business Analysis and Valuation

using Financial Statements?
Business Analysis using Financial Statements helps in answering the

following questions.
How well is the firm performing ? What is the value of the firms stock given
its current and future performance?
What is the credit risk involved in lending to a firm? How well is the firm
managing its liquidity and solvency.
What is the structure of the industry in which a firm is operating? How do the
strategies adopted by different players in the market place affect the
relative performance of players in the industry?
Are the accounting policies and accrual estimates in a companys financial
statements consistent with ones understanding of the firms business and
its recent performance?
Do the financial statements communicate the current status and significant
risks of the business?

Capitalism vs. Central Planning

Structure of economies in general can be classified into two broad

categories.
Capitalism
The capitalistic model relies on the market mechanism to govern
economic activity and decisions regarding investments are made
privately.
Central Planning
The centrally planned economies use central planning and
government agencies to pool national savings and to direct
investments in business enterprises.
Most (if not all) of the economies in the world have partly or entirely abandoned

central planning in favor of market model. Consequently capital markets play

an instrumental role in channeling the financial resources from the savers
of capital to business enterprises that need capital.

Information Asymmetry
Managers of a corporation have in-depth information of the firms

strategies and its performance.

However managers of the firm are not in a position to fully disclose all

available information owing to a variety of institutional factors.

In light of this ever-lasting information asymmetry, professional analysts

undertake financial statement analysis in an effort to create (uncover)

insider-information that would offer valuable insights on the firms
current performance and its future prospects.

In a nutshell, as much as financial statements help in mitigating information

asymmetry, financial statement analysis helps uncover further not-so-obvious

information that is hidden within the financial statements.

A world in which there are no Financial Statements

In the absence of financial statements, we have a world wherein savers

and entrepreneurs who would like to do business with one another face
the following complications.
Entrepreneurs have better information than savers on the value of the
business investment opportunities
Communication by entrepreneurs is not credible since entrepreneurs
have an incentive to inflate the value of their ideas.
Savers lack the financial sophistication needed to analyze and
differentiate among various entrepreneurs.
The above complications lead to what is termed as lemons problem which

in turn leads to break down of capital markets.

Key Institutional Players in a capital market system

Institutions such as venture capital firms, private equity firms, banks,

mutual funds, and insurance companies that focus on aggregating funds

from individual investors and distributing those to businesses seeking
capital, play an instrumental role in preventing the break down of capital
markets.
Other notable intermediaries that make a difference in this regard are
Auditors and in-company (in-house) audit committee

Financial Analysts, Credit Rating Agencies, and Financial press

Stock Exchanges and Brokerage houses
Regulators such as FASB, SEC, IASB, MCA, SEBI
Courts

Business Activities to Financial Statements

Corporate managers are responsible for acquiring physical and financial

resources from the firms environment and using them appropriately to

create value of firms investors.

Value is created when firms earn a return on its investment in excess of the cost of

capital.

Managers formulate business strategies to achieve this goal and constantly

strive to implement firm strategy through mutually reinforcing business

activities.

The economic environment of the firm firms inputs, firms output

markets, the industry to which the firm belongs to, and the regulations
under which the firm operates influences the business activities of the
firm.

Business Activities to Financial Statements

The firms business strategy determines how the firm positions itself in the

environment to achieve competitive advantage.

Financial Statements summarize the economic consequences of the firms

business activities.

The accounting system provides a mechanism by which the firms business

activities are selected, measured, and aggregated into financial statement

data.

A key aspect of Financial Statement Analysis involves understanding the

influence of accounting system on the quality of financial statements that

are generated.

Business Activities to Financial Statements

Financial Statements to Business Analysis

Corporate managers insider knowledge manifests in the financial

statements of the firm and it constitutes both value as well as distortion.

External users of financial statements experience difficulty in discerning

valuable information from noise and distortion in the financial

statements.
Consequently, the financial statements of a firm are imprecise

assessments of the firms performance.

In an effort to accommodate for their inability to discern and undo

accounting distortions, investors discount the firms reported accounting

performance.

Financial Statements to Business Analysis

Effective financial statement analysis is valuable because it attempts to

uncover managers insider-information from financial statements.

Since financial intermediaries such as analysts and credit rating

agencies do not have access to the corporation to the extent the

managers of the firm have, they are more objective in evaluating the
economic consequences of the firms investment and operating
decisions.
Financial Statements Analysis involves four steps: (1) business strategy

analysis, (2) accounting analysis, (3) financial analysis, and (4)

prospective analysis.

Business Strategy Analysis

Business Strategy analysis is aimed at identifying a key profit drivers

business risks and profit potential of a firm at a qualitative level.

Identification of key profit drivers and business risks helps in identification

of key accounting policies.

Assessment of a firms competitive strategy facilitates evaluating if the

current profitability of the firm is sustainable.

The above actions help an analyst in making sound assumptions while

forecasting future firm performance.

Accounting Analysis
This phase of financial statements analysis is aimed at evaluating the extent

to which the financial statements of a firm capture its underlying business

economics.

An experienced analyst would be able to readily identify instances of

accounting flexibility and in-turn evaluate the appropriateness of firms

accounting policies and estimates .

Consequently the analyst would be able to undo accounting distortions by

recasting a firms accounting numbers to create unbiased accounting data.

Without unbiased accounting data, conclusions based on subsequent

financial analysis would be unreliable.

Financial Analysis
The goal of financial analysis is to use the financial data to evaluate the

current and past performance of a firm and to assess its sustainability.

Ratio analysis and cash flow analysis are two most commonly used

financial tools.
Ratio analysis focuses on evaluating a firms product market performance

and financial policies while cash flow analysis focuses on a firms liquidity
and financial flexibility.

Prospective Analysis
Prospective Analysis, which focuses on forecasting a firms future is the final

step in business analysis.

Two commonly used techniques in prospective analysis are financial statement

forecasting and valuation. These techniques facilitate synthesis of insights

derived from business strategy analysis, accounting analysis and financial
analysis.
The intrinsic value of a firm is a function of the firms future cash flows. The

intrinsic value could also be derived based on current book value of equity
and firms future return on equity (ROE) and growth.
Strategy analysis, accounting analysis and financial analysis help in assessing

potential changes in the firms competitive advantage and the implications of

such a change when it comes to future ROE and growth.

Need for Business Analysis in broad areas

Predictions derived from effective financial statement analysis are useful to a

variety of parties and can be applied in various contexts such as, but not
limited to, Security Analysis, Credit Evaluation, Mergers and Acquisitions
(M&As) and Assessment of Corporate Communication Strategies.
Notwithstanding prevalence of reasonable market efficiency, financial

statement analysis (FSA) does add value in areas outside capital markets credit analysis, competitive benchmarking, and M&As.
Over time market become efficient precisely because market participants

rely on analytical tools such as FSA to analyze information and make

investment decisions.
Such actions by market participants impose greater discipline on corporate

managers to develop appropriate disclosure and communication strategy.

Accounting Standards
The set of conventions, rules, procedures which define accepted accounting

practice in USA constitute Generally Accepted Accounting Principles

(GAAP)

GAAP represents the fundamental positions that have been agreed upon

often tacitly by accountants and encompasses contemporary permissible

accounting practice in USA.

Competing set of accounting standards issued by International Accounting

Standards Board (IASB) are referred to as International Financial Reporting

Standards (IFRS) or International Accounting Standards (IAS).

The IASB works with national accounting standard-setters to achieve

convergence in accounting standards around the world.

Accounting Standards
Although Indian companies currently prepare financial statements

accordance with Indian GAAP (IGAAP), India has committed that its
national accounting standards will converge with IFRS in the near
future.

Unlike European countries that follow IFRS standards in its entirety

(adoption), India would maintain certain carve out exceptions in its

transition to IFRS (convergence). Converged Indian IFRS Standards are
referred to as Ind-AS.

Ministry of Corporate Affairs (MCA) came out with 35 Ind-AS

standards in Feb 2011. However the initial plans laid out by MCA for
Indian companies to make the transition from IGAAP to Ind-AS for
financial reporting were deferred.

Ind-AS
With the formation of new government in 2014, there was a flurry of

activities in-connection with transition from IGAAP to Ind-AS that

culminated in notification of 39 Ind-AS standards coupled with the
implementation roadmap.
The National Advisory Committee on Accounting Standards (NACAS) was

set up under the Companies Act 1956 to advise the Indian government on
formulating and laying down accounting standards.
From 2016-2017, it will be mandatory for all companies, both listed and

unlisted, with net worth of at least Rs. 500 crore to transition to adopt
Ind-AS.
From FY 18, Ind-AS will be mandatory for all listed entities with net

worth of 250-500 crore.

Ind AS
Banks , Non-banking financial companies (NBFCs) and insurance companies

are likely to become Ind-AS compliant in FY 19, subject to approval by RBI

and IRDA.
As far as 2015-2016 is concerned. Adoption of Ind-AS is voluntary.
The following are certain unresolved concerns in Industry circles when it

comes to adoption of Ind-AS.

Request for deferment of Ind-AS 115 (revenue recognition) to 2018-2019.
Implications of Ind-AS in relation to direct taxes, indirect taxes, and
disclosures by companies going for Initial public offerings (IPOs).
The manner of implementation of Ind-AS for an NBFC should (a) an NBFC
be a holding company or (b) should an NBFC be a subsidiary of a holding
company that has to be Ind-AS compliant from 2016-2017 onwards.

Financial Statements
Financial statements of a firm can be classified as Stock or status

reports and flow reports

Stock reports are reports as of a specified instant in time. For instance,

the balance sheet is a stock report that offers a snapshot of the assets,
liabilities and Stockholder Equity of a reporting entity.
Flow reports are reports that pertain to a period of time. Notable

Examples: Income Statement, Statement of Cash Flows.