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Chapter 1

A Framework for Business Analysis and Valuation
Using Financial Statements

3. Joe Smith argues that “learning how to do business analysis and valuation using financial statements is not very useful, unless you are interested in becoming a financial analyst.” Comment.

Business analysis and valuation skills are useful not only for financial analysts but also for corporate managers and loan officers. Business analysis and valuation skills help corporate managers in several ways. First, by using business analysis for equity security valuation, corporate managers can assess whether the firm is properly valued by investors. With superior information on a firm’s strategies, corporate managers can perform their own equity security analysis and compare their estimated “fundamental value” of the firm with the current market price of share. If the firm is not properly valued by outside investors, corporate managers can help investors to understand the firm’s business strategy, accounting policies, and expected future performance, thereby ensuring that the stock price is not seriously undervalued. Second, using business analysis for mergers and acquisitions, corporate managers (acquiring management) can identify a potential takeover target and assess how much value can be created through acquisition. Using business analysis, target management can also examine whether the acquirer’s offer is a reasonable one. Loan officers can also benefit from business analysis, using it to assess the borrowing firm’s liquidity, solvency, and business risks. Business analysis techniques help loan officers to predict the likelihood of a borrowing firm’s financial distress. Commercial bankers with business analysis skills can examine whether or not to extend a loan to the borrowing firm, how the loan should be structured, and how it should be priced.

4.  Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each of the four steps is a critical part of your job, and how they relate to one another.

Managers have better information on a firm’s strategies relative to the information that outside financial analysts have. Superior financial analysts attempt to discover “inside information” from analyzing financial statements. The four steps for business analysis help outside analysts to gain valuable insights about the firm’s current performance and future prospects.

1. Business strategy analysis is an essential first step because it enables the analysts to frame the subsequent accounting, financial, and prospective 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 strategy analysis enables the analysts to make sound assumptions in forecasting a firm’s future performance.

2. Accounting analysis enables the analysts to “undo” any accounting distortion by recasting a firm’s accounting numbers. Sound accounting analysis improves the reliability of conclusions from financial analysis.

3. The goal of financial analysis is to use financial data to evaluate the performance of a firm. The outcome from financial analysis is incorporated into prospective analysis, the next step in financial statement analysis.

4. Prospective analysis synthesizes the insights from business strategy analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future. 1
Chapter 2

Strategy Analysis

4. Rate the pharmaceutical and lumber industries as high, medium, or low on the following dimensions of industry structure.

Pharmaceutical firms historically have had some of the highest rates of return in the economy, whereas timber firms have had relatively low...
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