Business Analysis and Valuation
Instructor - Dr. Mohit Kumar
Nokia (2011)
What Went Wrong: Nokia's management and analysts failed to foresee the rapid
shift in consumer preferences towards smartphones and the importance of
software ecosystems. They underestimated the threat posed by competitors like
Apple and Android.
Blockbuster (2010)
What Went Wrong: Business analysts and executives at Blockbuster failed to
recognize the disruptive potential of digital streaming services like Netflix. They
continued to invest in physical rental stores instead of developing a robust digital
strategy.
Kodak (2012)
What Went Wrong: Kodak's business analysis underestimated the speed and
impact of the shift from film to digital photography. The company was too focused
on protecting its traditional film business and did not invest sufficiently in digital
technologies.
Who you are?
• Investor
• Management
• Regulator
• Auditor
• Consultant
Module 1: Framework
for Business Analysis
and Valuation
• Introduction
• Role of financial reporting in capital
markets
• Business activities to financial statement
• Financial statement of business analysis
The Role of Financial Reporting in Capital Markets
Capital Markets
Entrepreneurs
Individual 1. Financial Institutions
2. Information analyzer Business
• Doubt 3. Transaction ideas
• Lack of resources to Facilitators
Objectives of issues
find out Accounting Analysis 4. Regulators
• Lack of information
Accounting Analysis - Goal
Challenges in Capital Markets
• Imperfection from financial intermediaries.
• The governance issues
• Conflict of interest
Introduction
The Enron scandal was a major corporate fraud that led to the bankruptcy of Enron
Corporation, an energy, commodities, and services company, in 2001. It also caused the
dissolution of Arthur Andersen LLP, one of the world's largest auditing firms. This scandal
had widespread repercussions and led to significant changes in accounting and corporate
governance practices.
Founding and Growth of Enron
•1985: Enron was founded by Kenneth Lay through the merger of Houston Natural Gas
Corporation and InterNorth, Inc.
•Transformation: Under Jeffrey Skilling, Enron shifted from operating pipelines to trading
energy derivative contracts, allowing producers to stabilize prices.
•Aggressive Culture: Skilling created a competitive environment focused on rapid trading
and high profits. Andrew Fastow, the CFO, developed complex financial instruments to
support this strategy.
•Diversification: Enron expanded its trading to include a variety of commodities and
launched Enron Online for online trading.
Downfall and Bankruptcy
•Increased Competition: Enron's profits began to decline due to increased competition in the energy trading market.
•Dubious Accounting Practices: Executives used "mark-to-market accounting" to record projected profits as current income,
creating an illusion of higher profits. Troubled assets were hidden in special purpose entities (SPEs), keeping them off Enron's
balance sheet.
•Leadership Changes: In 2001, Skilling became CEO but resigned shortly after. Kenneth Lay resumed the CEO role.
•Financial Troubles: Enron announced significant losses and shareholder equity reductions in 2001, leading to SEC
investigations and document shredding by Arthur Andersen.
Impact and Aftermath
•Bankruptcy: Enron's stock plummeted, and the company filed for Chapter 11 bankruptcy in December 2001.
•Legal Consequences: Many executives were convicted of fraud and conspiracy. Arthur Andersen was indicted for
obstruction of justice and lost its auditing license.
•Regulatory Changes: The Sarbanes-Oxley Act (2002) was enacted to improve financial reporting accuracy and impose
stricter penalties for corporate fraud. It also restricted auditing firms from providing consulting services to their audit clients.
From Business Activities to Financial Statements
Managerial Responsibilities and Value Creation
Objectives of Accounting Analysis
•Resource Acquisition: Corporate managers are tasked with acquiring both
physical and financial resources from the external environment.
•Value Creation: The goal is to create value for investors by earning returns
on investment
Accounting Analysis -that
Goalexceed the cost of capital.
•Business Strategies: Managers develop and implement business strategies
to achieve this goal through various business activities.
Accounting Analysis
Objectives of Accounting Analysis
Accounting Analysis - Goal
Accounting Analysis
• Role of Financial Statements: These documents summarize the economic outcomes of
a firm’s numerous and varied business activities over a specific period.
• Proprietary Activities: Some business activities are proprietary and cannot be disclosed
Objectives of Accounting Analysis
in detail without harming the firm’s competitive position.
• Accounting System: This system selects, measures, and aggregates business activities
into financial statement data.
InfluenceAnalysis
Accounting of the Accounting
- Goal System
• Intermediaries' Awareness: Those using financial statement data for business analysis
must understand how the firm's accounting system influences the quality of this data.
• Institutional Features: The inherent characteristics and rules of the accounting system
impact how business activities are reflected in financial statements.
The Institutional Features of Accounting Systems
Accounting System Feature 1: Accrual Accounting
• Accrual vs. Cash Accounting: Corporate financial reports are prepared using accrual
Objectives of Accounting
accounting, Analysis
which records costs and benefits of economic activities based on expectations,
not just actual cash flows. This contrasts with cash accounting, which only records cash
transactions.
• Net Income Measurement: Net income is computed by recognizing expected cash receipts
Accounting Analysisand
as revenues - Goal
associated expected cash outflows as expenses.
• Periodic Reporting: Investors demand periodic financial reports, leading to the need for
accrual accounting to provide a more complete picture of a firm’s performance than cash
accounting can.
Accounting System Feature 2: Accounting Convention, Standards and Auditing
Complexity of Accrual Accounting Accrual accounting is subjective and relies on estimates and assumptions.
Managerial discretion in accounting allows reflection of inside information but
Accounting Discretion also poses the risk of profit distortion due to biases and incentives.
Objectives of Accounting Analysis Measurability and conservatism conventions help mitigate optimistic biases by
Accounting Conventions imposing a pessimistic bias
Generally Accepted Accounting Principles (GAAP) and similar standards reduce
Uniform Standards potential distortions
Accounting Analysis - Goal
Rigid standards are useful for straightforward transactions but can be
Rigid vs. Flexible Standards dysfunctional for complex ones requiring business judgment
External auditing ensures consistency and reasonableness in the use of
Auditing accounting rules and estimates, improving data quality.
The threat of legal liability improves disclosure accuracy but may deter support
Legal Environment
for proposals requiring risky forecasts.
The Institutional Features…
Accounting System Feature 3: Managers’ Reporting Strategy
• Balance of Regulation and Flexibility: Complete elimination of managerial flexibility through regulation is not
optimal. Real-world systems allow managerial influence on financial data.
Objectives of Accounting Analysis
• Reporting Strategy: Managers' accounting and disclosure choices significantly affect financial statements,
offering varying degrees of clarity regarding the firm’s economic reality.
• Disclosure Policies: Managers can select from a broad set of accounting alternatives and are responsible for a
rangeAnalysis
Accounting of estimates.
- GoalMinimum disclosure requirements are prescribed, but voluntary disclosures are not
restricted.
• Superior Disclosure Strategy: Effective disclosure communicates the business reality, while competitive
dynamics may limit the extent of disclosure to protect the firm’s position.
• Manipulative Reporting Strategies: Managers may use their discretion to obscure poor performance, making it
costly for investors to understand the true performance.
• Variability in Informative Quality: The extent to which financial statements reflect true business reality varies
across firms and over time, presenting both opportunities and challenges in business analysis.
FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS
Objectives of Accounting Analysis
Accounting Analysis - Goal
1.Business Strategy Analysis 2. Accounting
Analysis
1.Purpose: Identify key profit drivers and business
1.Purpose: Evaluate how well a firm's accounting
risks, and assess the company's profit potential
captures underlying business reality.
qualitatively.
2.Accounting Flexibility: Identify areas of accounting
2.Industry
Objectives of and Competitive
Accounting Strategy: Analyze the
Analysis
flexibility and assess the appropriateness of
firm's industry and strategy to create a sustainable
accounting policies and estimates.
competitive advantage.
3.Distortion Correction: Recast accounting numbers to
3.Framework: This qualitative analysis helps frame
eliminate distortions and create unbiased data.
subsequent accounting and financial analyses,
4.Outcome: Improved reliability of conclusions derived
guiding assumptions for future performance
from financial analysis.
forecasts.
4.Output: Understanding key success factors and
business risks, and evaluating the sustainability of
current profitability.
3. Financial Analysis 4. Prospective Analysis
•Objective: The final step in business analysis, prospective analysis,
1.Purpose: Evaluate a firm's current and past
focuses on forecasting a firm's future performance.
performance, and assess its sustainability.
•Techniques:
2.Skills Required: Conduct systematic and efficient • Financial Statement Forecasting: Project future financial
Objectives
analysis,of Accounting
and Analysis
use financial data to explore business performance based on historical data and analysis.
issues. • Valuation: Estimate the firm's intrinsic value by synthesizing
3.Tools: insights from business, accounting, and financial analyses.
1.Ratio Analysis: Evaluate product market Framework for Estimating Firm Value
performance and financial policies. •Future Cash Flow Performance: The primary determinant of a
2.Cash Flow Analysis: Assess liquidity and firm's value is its future cash flows.
financial flexibility. •Book Value of Equity and ROE: It is also possible to assess value
based on the firm's current book value of equity, future return on
4.Output: A comprehensive understanding of the
equity (ROE), and growth.
firm’s financial health.
Foundation from Previous Analyses
•Strategy Analysis: Accounting Analysis: Financial Analysis:
