Overview of Financial Statement Analysis
We view effective financial statement analysis as a three-legged stool, as Exhibit 1.1 depicts. The three legs of the stool in the figure represent effective analysis based on thefollowing:
- . Identifying the economic characteristics of the industries in which a firm competes and mapping those characteristics into determinants of profitability and risk
- Describing the strategies that a firm pursues to differentiate itself from competitors as a basis for evaluating a firm’s competitive advantages, the sustainability and potential growth of a firm’s earnings, and its risks
Approach to effective analysis of financial statements for valuation and many other decisions involves six interrelated sequential steps, depicted in Exhibit 1.2.
1. Identify the economic characteristics and competitive dynamics of the industry in which a particular firm participates. What dynamic forces drive competition in the industry? For example, does the industry include a large number of firms selling similar products, such as grocery stores, or only a small number of competitors selling unique products, such as pharmaceutical companies? Does technological change play an important role in maintaining a competitive advantage, as in computer software? Understanding the competitive forces in the firm’s industry in the first step establishes the economic foundation and context for the remaining steps in the process.
2. Identify strategies the firm pursues to gain and sustain a competitive advantage. What business model is the firm executing to be different and successful in its industry? Does the firm have competitive advantages? If so, how sustainable are they? Are its products designed to meet the needs of specific market segments, such as ethnic or health foods, or are they intended for a broader consumer market, such as typical grocery stores and family restaurants? Has the firm integrated backward into the growing or manufacture of raw materials for its products, such as a steel company that owns iron ore mines? Is the firm diversified across several geographic markets or industries? Understanding the firm’s strategy and the sustainability of its competitive advantages provides the necessary firm-specific context to evaluate the firm’s accounting information, assess profitability and risk, and to project the firm’s future business activities
3. Assess the quality of the firm’s financial statements and, if necessary, adjust them for such desirable characteristics as sustainability or comparability. Do the firm’s financial statements provide an informative and complete representation of the firm’s economic performance, financial position, and risk? Has the firm prepared its financial statements in accordance with U.S. GAAP or are they prepared in accordance with the IFRS established by the International Accounting Standards Board (IASB)? Do earnings include nonrecurring gains or losses, such as a write-down of goodwill, which you should evaluate differently from recurring components of earnings? Has the firm structured transactions or commercial arrangements or selected accounting methods so as to make the firm appear more profitable or less risky than economic conditions otherwise suggest? It is essential to understand the quality of the firm’s accounting information in order to effectively analyze the firm’s profitability and risk and to project its future balance sheets, income statements, and cash flows.
4. Analyze the current profitability and risk of the firm using information in the financial statements. Most financial analysts assess the profitability of a firm relative to the risks involved. What rate of return is the firm generating from the use of its assets? What rate of return is the firm generating for its common equity shareholders? Is the firm’s profit margin increasing or decreasing over time? Are returns and profit margins higher or lower than those of its key competitors? How much leverage does the firm have in its capital structure? Ratios that reflect relations among particular items in the financial statements are the tools you can use to analyze profitability and risk. By understanding the firm’s current and past profitability and risk, you will establish important information you will use in projecting the firm’s future profitability and risk and in valuing its shares.
5. Prepare forecasted financial statements. What will be the firm’s future resources, obligations, investments, cash flows, revenues, and expenses? What will be the likely future profitability and risk and, in turn, the likely future returns from investing in the company? Forecasted financial statements that rely on projections of the firm’s future operating, investing, and financing activities provide the basis for projecting future profitability and risk, which provide the basis for financial decision making, including valuation.
3. Assess the quality of the firm’s financial statements and, if necessary, adjust them for such desirable characteristics as sustainability or comparability. Do the firm’s financial statements provide an informative and complete representation of the firm’s economic performance, financial position, and risk? Has the firm prepared its financial statements in accordance with U.S. GAAP or are they prepared in accordance with the IFRS established by the International Accounting Standards Board (IASB)? Do earnings include nonrecurring gains or losses, such as a write-down of goodwill, which you should evaluate differently from recurring components of earnings? Has the firm structured transactions or commercial arrangements or selected accounting methods so as to make the firm appear more profitable or less risky than economic conditions otherwise suggest? It is essential to understand the quality of the firm’s accounting information in order to effectively analyze the firm’s profitability and risk and to project its future balance sheets, income statements, and cash flows.
4. Analyze the current profitability and risk of the firm using information in the financial statements. Most financial analysts assess the profitability of a firm relative to the risks involved. What rate of return is the firm generating from the use of its assets? What rate of return is the firm generating for its common equity shareholders? Is the firm’s profit margin increasing or decreasing over time? Are returns and profit margins higher or lower than those of its key competitors? How much leverage does the firm have in its capital structure? Ratios that reflect relations among particular items in the financial statements are the tools you can use to analyze profitability and risk. By understanding the firm’s current and past profitability and risk, you will establish important information you will use in projecting the firm’s future profitability and risk and in valuing its shares.
5. Prepare forecasted financial statements. What will be the firm’s future resources, obligations, investments, cash flows, revenues, and expenses? What will be the likely future profitability and risk and, in turn, the likely future returns from investing in the company? Forecasted financial statements that rely on projections of the firm’s future operating, investing, and financing activities provide the basis for projecting future profitability and risk, which provide the basis for financial decision making, including valuation.
6. Value the firm. What is the firm worth? Financial analysts use their estimates of share value to make recommendations for buying, selling, or holding the equity securities of various firms whose market price they think is too low, too high, or about right. Similarly, an investment banking firm that underwrites the initial public offering of a firm’s common stock must set the initial offering price, and an analyst in a corporation considering whether to acquire a company (or to divest a subsidiary or division) must assess a reasonable range of values to bid in order to acquire the target (or to expect to receive from the divestiture These six steps provide a logical, powerful sequence that will enable you to address very important and difficult questions, such as how to analyze and value a firm.
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