Financial Analysis

Topics: Financial statements, Financial statement analysis, Business Pages: 6 (1248 words) Published: September 6, 2013
Accounting and Finance
Tutorial Solutions
Week 2
John, who has just completed his first finance course, is unsure whether he should take a course in Busine
ss Analysis and Valuation Using Financial Statements, since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to John when financial analysis can add value, even if capital markets are efficient. The e

fficient market hypothesis states that security prices reflect all available information, as if such information could be costlessly digested and translated immediately into demands for buys or sells. The efficient market hypothesis implies that there is no further need for analysis

involving a search for mispriced securities.
However, if all investors adopted this attitude, no equity analysis would be conducted, mispricing would go uncorrected, and markets would no longer be efficient. This is why there must be just enough mispricing to provide incentives for the investment of resources in security analysis.

Even in an extremely efficient market, where information is fully impounded in prices within minutes of its revelation (i.e., where mispricing exists
only for minutes), John can get rewards
with strong financial analysis skills if:
John can interpret the newly
announced financial data faster than others and trade on it within minutes; and
financial analysis helps John to understand the firm bet
ter, placing him in a better position to
interpret other news more accurately as it arrives.
The market may not be efficient under certain circumstances. Mispricing of securities may exist even days or months after the public revelation of a financial sta tement when the following three

conditions are satisfied:
relative to investors, managers have superior information on their firms’ business strategies and operations;
managers’ incentives are not perfectly aligned with all shareholders’ interests; a nd
accounting rules and auditing are imperfect.
When these conditions exist, John could profitably use trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price -
setting process
Capital market efficiency is not relevant in some areas. John can get benefits by using financial analysis skills in those areas. For example, he can assess how much value can be created through acquisition of a target company, estimate the stock price of a company considering

initial public offering, and predict the likelihood of a firm’s future financial distress. Q2.
Accounting statements rarely report financial performance without error. List three types of errors that can arise in financial report
Three types of potential errors in financial reporting include: 1.
errors introduced by rigidity in accounting rules;
random forecast errors; and
systematic reporting choices made by corporate managers to achieve specific objectives. Accounting
. Uniform accounting standards may introduce errors because they restrict management discretion in terms of accounting choice, limiting the opportunity for managers’ superior knowledge to be represented through accounting choice. For example, SFAS N o. 2

requires firms to expense all research and development expenditures when they are inccurred. Note that some research expenditures have future economic value (and should be capitalized) while others do not (and should be expensed). SFAS No. 2 does not allow managers, who know

the firm better than outsiders, to distinguish between the two types of expenditures. Uniform accounting rules may restrict managers’ discretion, forgoing the opportunity to better portray the economic reality of the firm and, th

us, result in errors.
Forecast Errors
. Random forecast errors may arise because managers cannot predict the future...
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