Bavaluation

The profitability of a firm is influenced not only by its industry structure but also by the strategic choices it makes in positioning itself in the industry. While there are many ways to characterize a firm’s business strategy, there are two generic competitive strategies:

1- Cost Leadership
2- Differentiation

Both these strategies can potentially allow a firm to build a sustainable competitive advantage.

1- Cost Leadership

Supply same product or service at a lower cost.

• Economies of scale and scope
• Efficient production
• Simpler product designs
• Lower input costs
• Low-cost distribution
• Little research and development or brand advertising
• Tight cost control system

2- Differentiation

Supply a unique product or ser-vice at a cost lower than the price premium customers will pay.

• Superior product quality
• Superior product variety
• Superior customer service
• More flexible delivery
• Investment in brand image
• Investment in research and development
• Control system focus on creativity and innovation

Strategy researchers have traditionally viewed cost leadership and differentiation as mutually exclusive strategies. Firms that straddle the two strategies are considered to be “stuck in the middle” and are expected to earn low profitability. These firms run the risk of not being able to attract price conscious customers because their costs are too high; they are also unable to provide adequate differentiation to attract premium price customers.

In analyzing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in which the firm is competing, because the profitability of various industries differs systematically and predictably over time. For example, the ratio of earnings before interest and taxes to the book value of assets for all U.S. companies between1981 and 1997 was 8.8 percent. However, the average returns varied widely across specific industries: for the bakery products industry, the profitability ratio was 43 percentage points greater than the population average, and 23 percentage points less than the population average for the silver ore mining industry.

What causes these profitability differences? There is a vast body of research in industrial organization on the influence of industry structure on profitability.

Relying on this research, strategy literature suggests that the average profitability of an industry is influenced by the “five forces” are as follows:

Degree Of Actual And Potential Competition

1- Rivalry AmongExisting Firms
2- Threat of New Entrants
3- Threat of Substitute Products

Bargaining Power In Input And Output Markets

4- Bargaining Power of Buyers
5- Bargaining Power of Suppliers

According to this framework, the intensity of competition determines the potential for creating abnormal profits by the firms in an industry. Whether or not the potential profits are kept by the industry is determined by the relative bargaining power of the firms in the industry and their customers and suppliers.

Strategy analysis is an important starting point for the analysis of financial statements. Strategy analysis allows the analyst to probe the economics of the firm at a qualitative level so that the subsequent accounting and financial analysis is grounded in business reality. Strategy analysis also allows the identification of the firm’s profit drivers and key risks. This, in turn, enables the analyst to assess the sustainability of the firm’s current performance and make realistic forecasts of future performance.

A firm’s value is determined by its ability to earn a return on its capital in excess of the cost of capital. What determines whether or not a firm is able to accomplish this goal? While a firm’s cost of capital is determined by the capital markets, its profit potential is determined by its own strategic choices:

1- The choice of an industry or a set of industries in which the firm operates (industry choice).

2- The manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive positioning).

3- The way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy).

Strategy analysis, therefore, involves industry analysis, competitive strategy analysis, and corporate strategy analysis.

Because managers’ insider knowledge is a source both of value and distortion in accounting data, it is difficult for outside users of financial statements to separate true information from distortion and noise. Not being able to undo accounting distortions completely, investors “discount” a firm’s reported accounting performance. In doing so, they make a probabilistic assessment of the extent to which a firm’s reported numbers reflect economic reality. As a result, investors can have only an imprecise assessment of an individual firm’s performance. Financial and information intermediaries can add value by improving investors’ understanding of a firm’s current performance and its future prospects.

Effective financial statement analysis is valuable because it attempts to get at managers inside information from public financial statement data. Because intermediaries do not have direct or complete access to this information, they rely on their knowledge of the firm’s industry and its competitive strategies to interpret financial statements. Successful intermediaries have at least as good an understanding of the industry economics as do the firm’s managers, and a reasonably good understanding of the firm’s competitive strategy. Although outside analysts have an information disadvantage relative to the firm’s managers, they are more objective in evaluating the economic consequences of the firm’s investment and operating decisions.

Business intermediaries use financial statements to accomplish four key steps: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis, and (4) prospective analysis.

1: Business Strategy Analysis

The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the company’s profit potential at a qualitative level. Business strategy analysis involves analyzing a firm’s industry and its strategy to create a sustainable competitive advantage. This qualitative analysis is an essential first step because it enables the analyst to frame the subsequent accounting and financial analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business analysis enables the analyst to make sound assumptions in forecasting a firm’s future performance.

2: 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. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in financial statement analysis.

3: 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. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. 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.

4: 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 financial statement forecasting and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future.

Corporate managers are responsible for acquiring physical and financial resources from the firm’s environment and using them to create value for the firm’s investors. Value is created when the firm earns a return on its investment in excess of the cost of capital. Managers formulate business strategies to achieve this goal, and they implement them through business activities. A firm’s business activities are influenced by its economic environment and its own business strategy. The economic environment includes the firm’s industry, its input and output markets, and the regulations under which the firm operates. The firm’s business strategy determines how the firm positions itself in its environment to achieve a competitive advantage.

For Example: A firm’s financial statements summarize the economic con-sequences of its business activities. The firm’s business activities in any time period are too numerous to be reported individually to outsiders. Further, some of the activities undertaken by the firm are proprietary in nature, and disclosing these activities in detail could be a detriment to the firm’s competitive position. The firm’s accounting system provides a mechanism through which business activities are selected, measured, and aggregated into financial statement data.

Intermediaries using financial statement data to do business analysis have to be aware that financial reports are influenced both by the firm’s business activities and by its accounting system. A key aspect of financial statement analysis, therefore, involves understanding the influence of the accounting system on the quality of the financial statement data being used in the analysis. The institutional features of accounting systems discussed below determine the extent of that influence.

A critical challenge for any economy is the allocation of savings to investment opportunities. Economies that do this well can exploit new business ideas to spur innovation and create jobs and wealth at a rapid pace. In contrast, economies that manage this process poorly dissipate their wealth and fail to support business opportunities.

In the twentieth century, we have seen two distinct models for channeling savings into business investments. Communist and socialist market economies have used central planning and government agencies to pool national savings and to direct investments in business enterprises. The failure of this model is evident from the fact that most of these economies have abandoned it in favor of the second model—the market model. In al-most all countries in the world today, capital markets play an important role in channel-ing financial resources from savers to business enterprises that need capital.

For example: how capital markets typically work. Savings in any economy are widely distributed among households. There are usually many new entrepreneurs and existing companies that would like to attract these savings to fund their business ideas. While both savers and entrepreneurs would like to do business with each other, matching savings to business investment opportunities is com-licated for at least two reasons. First, entrepreneurs typically have better information than savers on the value of business investment opportunities. Second, communication by entrepreneurs to investors is not completely credible because investors know entrepreneurs have an incentive to inflate the value of their ideas.

These information and incentive problems lead to what economists call the “lemons” problem, which can potentially break down the functioning of the capital market.

It works like this. Consider a situation where half the business ideas are “good” and the other half are “bad.” If investors cannot distinguish between the two types of business ideas, entrepreneurs with “bad” ideas will try to claim that their ideas are as valuable as the “good” ideas. Realizing this possibility, investors value both good and bad ideas at an average level. Unfortunately, this penalizes good ideas, and entrepreneurs with good ideas find the terms on which they can get financing to be unattractive. As these entrepreneurs leave the capital market, the proportion of bad ideas in the market increases. Over time, bad ideas“ crowd out” good ideas, and investors lose confidence in this market.

The emergence of intermediaries can prevent such a market breakdown. Intermediaries are like a car mechanic who provides an independent certification of a used car’s quality to help a buyer and seller agree on a price. There are two types of intermediaries in the capital markets. Financial intermediaries, such as venture capital firms, banks, mutual funds, and insurance companies, focus on aggregating funds from individual investors and analyzing different investment alternatives to make investment decisions. In-formation intermediaries, such as auditors, financial analysts, bond-rating agencies, and the financial press, focus on providing information to investors (and to financial intermediaries who represent them) on the quality of various business investment opportunities. Both these types of intermediaries add value by helping investors distinguish “good” investment opportunities from the “bad” ones.

Financial reporting plays a critical role in the functioning of both the information intermediaries and financial intermediaries. Information intermediaries add value by either enhancing the credibility of financial reports (as auditors do), or by analyzing the information in the financial statements (as analysts and the rating agencies do). Financial intermediaries rely on the information in the financial statements, and supplement this information with other sources of information, to analyze investment opportunities. In the following section, we discuss key aspects of the financial reporting system design that enable it to play effectively this vital role in the functioning of the capital markets.

The purpose of this chapter is to outline a comprehensive framework for financial statement analysis. Because financial statements provide the most widely available data on public corporations’ economic activities, investors and other stake-holders rely on financial reports to assess the plans and performance of firms and corporate managers.

A variety of questions can be addressed by business analysis using financial statements, as shown in the following examples:

• A security analyst may be interested in asking: “How well is the firm I am following performing? Did the firm meet my performance expectations? If not, why not? What is the value of the firm’s stock given my assessment of the firm’s current and future performance?”

• A loan officer may need to ask: “What is the credit risk involved in lending a certain amount of money to this firm? How well is the firm managing its liquidity and sol-vency? What is the firm’s business risk? What is the additional risk created by the firm’s financing and dividend policies?”

• A management consultant might ask: “What is the structure of the industry in which the firm is operating? What are the strategies pursued by various players in the industry? What is the relative performance of different firms in the industry?”

• A corporate manager may ask: “Is my firm properly valued by investors? Is our investor communication program adequate to facilitate this process?”

• A corporate manager could ask: “Is this firm a potential takeover target? How much value can be added if we acquire this firm? How can we finance the acquisition?”

• An independent auditor would want to ask: “Are the accounting policies and accru-al estimates in this company’s financial statements consistent with my understanding of this business and its recent performance? Do these financial reports communicate the current status and significant risks of the business?”

Financial statement analysis is a valuable activity when managers have complete in-formation on a firm’s strategies and a variety of institutional factors make it unlikely that they fully disclose this information. In this setting, outside analysts attempt to create “in-side information” from analyzing financial statement data, thereby gaining valuable in-sights about the firm’s current performance and future prospects.

To understand the contribution that financial statement analysis can make, it is important to understand the role of financial reporting in the functioning of capital markets and the institutional forces that shape financial statements. Therefore, we present first a brief description of these forces; then we discuss the steps that an analyst must perform to extract information from financial statements and provide valuable forecasts.

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