A Framework for Business Analysis and Valuation Using Financial Statements


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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