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CHAPTER I

OVERVIEW OF BUSINESS ANALYSIS

OVERVIEW
Financial statement analysis is an integral and important part of the broader
field of business analysis. Business analysis is the process of evaluating a
company’s economic prospects and risks. This includes analyzing a company’s
business environment, its strategies, and its financial position and performance.
Business analysis is useful in a wide range of business decisions such as whether to
invest in equity or in debt securities, whether to extend credit through short- or long-
term loans, how to value a business in an initial public offering (IPO), and how to
evaluate restructurings including mergers, acquisitions, and divestitures.

LESSON I - BUSINESS ANALYSIS


Introduction to Business Analysis
Financial statement analysis is part of business analysis. Business analysis is
the evaluation of a company’s prospects and risks for the purpose of making
business decisions. These business decisions extend to equity and debt valuation,
credit risk assessment, earnings predictions, audit testing, compensation
negotiations, and countless other decisions. Business analysis aids in making
informed decisions by helping structure the decision task through an evaluation of a
company’s business environment, its strategies, and its financial position and
performance.
An initial step in business analysis is to evaluate a company’s business
environment and strategies. Financial statements provide a rich and reliable source
of information for such financial analysis. The statements reveal how a company
obtains its resources (financing), where and how those resources are
deployed (investing), and how effectively those resources are deployed
(operating profitability).
Many individuals and organizations use financial statements to improve
business decisions.
 Investors and creditors use them to assess company prospects for
investing and lending decisions.
 Boards of directors, as investor representatives, use them to monitor
managers’ decisions and actions.
 Employees and unions use financial statements in labor negotiations.
 Suppliers use financial statements in setting credit terms.
 Investment advisors and information intermediaries use financial
statements in making buy-sell recommendations and in credit rating.
 Investment bankers use financial statements in determining company
value in an IPO, merger, or acquisition.

Types of Business Analysis


Financial statement analysis is an important and integral part of business
analysis. The goal of business analysis is to improve business decisions by
evaluating available information about a company’s financial situation, its
management, its plans and strategies, and its business environment. This section
considers major types of business analysis.

a. Credit Analysis
Creditors lend funds to a company in return for a promise of
repayment with interest. This type of financing is temporary since creditors
expect repayment of their funds with interest. Creditors lend funds in many
forms and for a variety of purposes.
 Trade (or operating) creditors deliver goods or services to a company
and expect payment within a reasonable period, often determined by
industry norms. Most trade credit is short term, ranging from 30 to 60
days, with cash discounts often granted for early payment.
 Nontrade creditors (or debtholders) provide financing to a company in
return for a promise, usually in writing, of repayment with interest on
specific future dates. This type of financing can be either short or long
term and arises in a variety of transactions.
In pure credit financing, an important element is the fixed nature of
benefits to creditors. That is, should a company prosper, creditors’ benefits
are limited to the debt contract’s rate of interest or to the profit margins on
goods or services delivered.
However, creditors bear the risk of default. This means a creditor’s
interest and principal are jeopardized when a borrower encounters financial
difficulties. This asymmetric relation of a creditor’s risk and return has a major
impact on the creditor’s perspective, including the manner and objectives of
credit analysis.
 Credit analysis is the evaluation of the creditworthiness of a company.
Creditworthiness is the ability of a company to pay its obligations.
Accordingly, the main focus of credit analysis is on risk, not
profitability. Variability in profits, especially the sensitivity of profits to
downturns in business, is more important than profit levels. Profit levels
are important only to the extent they reflect the margin of safety for a
company in meeting its obligations. Credit analysis focuses on
downside risk instead of upside potential. This includes analysis of both
liquidity and solvency.
 Liquidity is a company’s ability to raise cash in the short term to meet
its obligations. Liquidity depends on a company’s cash flows and the
makeup of its current assets and current liabilities.
 Solvency is a company’s long run viability and ability to pay long-term
obligations. It depends on both a company’s long-term profitability and
its capital (financing) structure.

b. Equity Analysis
 Equity investors provide funds to a company in return for the risks
and rewards of ownership. Equity investors are major providers of
company financing. Equity financing, also called equity or share
capital, offers a cushion or safeguard for all other forms of financing
that are senior to it. This means equity investors are entitled to the
distributions of a company’s assets only after the claims of all other
senior claimants are met, including interest and preferred dividends. As
a result, equity investors are said to hold a residual interest. This
implies equity investors are the first to absorb losses when a
company liquidates, although their losses are usually limited to the
amount invested. However, when a company prospers, equity
investors share in the gains with unlimited upside potential. Because
equity investors are affected by all aspects of a company’s financial
condition and performance, their analysis needs are among the most
demanding and comprehensive of all users.
 Individuals who apply active investment strategies primarily use
technical analysis, fundamental analysis, or a combination. Technical
analysis, or charting, searches for patterns in the price or volume
history of a stock to predict future price movements.
 Fundamental analysis, which is more widely accepted and applied, is
the process of determining the value of a company by analyzing and
interpreting key factors for the economy, the industry, and the
company. A main part of fundamental analysis is evaluation of a
company’s financial position and performance. A major goal of
fundamental analysis is to determine intrinsic value, also called
fundamental value. Intrinsic value is the value of a company (or its
stock) determined through fundamental analysis without reference to
its market value (or stock price).
 An investor’s strategy with fundamental analysis is straightforward: buy
when a stock’s intrinsic value exceeds its market value, sell when a
stock’s market value exceeds its intrinsic value, and hold when a
stock’s intrinsic value approximates its market value.

Other Uses of Business Analysis


Business analysis and financial statement analysis are important in a number
of other contexts.
 Managers. Analysis of financial statements can provide managers with clues
to strategic changes in operating, investing, and financing activities. Managers
also analyze the businesses and financial statements of competing
companies to evaluate a competitor’s profitability and risk. Such analysis
allows for inter-firm comparisons, both to evaluate relative strengths and
weaknesses and to benchmark performance.
 Mergers, acquisitions, and divestitures. Business analysis is performed
whenever a company restructures its operations, through mergers,
acquisitions, divestitures, and spin-offs. Investment bankers need to identify
potential targets and determine their values, and security analysts need to
determine whether and how much additional value is created by the merger
for both the acquiring and the target companies.
 Financial management. Managers must evaluate the impact of financing
decisions and dividend policy on company value. Business analysis helps
assess the impact of financing decisions on both future profitability and
risk.
 Directors. As elected representatives of the shareholders, directors are
responsible for protecting the shareholders’ interests by vigilantly overseeing
the company’s activities. Both business analysis and financial statement
analysis aid directors in fulfilling their oversight responsibilities.
 Regulators. The Internal Revenue Service applies tools of financial statement
analysis to audit tax returns and check the reasonableness of reported
amounts.
 Labor unions. Techniques of financial statement analysis are useful to labor
unions in collective bargaining negotiations.
 Customers. Analysis techniques are used to determine the profitability (or
staying power) of suppliers along with estimating the suppliers’ profits from
their mutual transactions.

LESSON II – COMPONENTS OF BUSINESS ANALYSIS


Components of Business Analysis
Business analysis encompasses several interrelated processes. Exhibit 1.4
identifies these processes in the context of estimating company value—one of the
many important applications of business analysis. This section discusses each of
these component processes in the context of business analysis.

a. Business Environment and Strategy Analysis


Analysis of a company’s future prospects is one of the most important
aims of business analysis. This includes attention to analysis of the business
environment and strategy.
 Analysis of the business environment seeks to identify and assess
a company’s economic and industry circumstances. This includes
analysis of its product, labor, and capital markets within its economic
and regulatory setting.
 Analysis of business strategy seeks to identify and assess a
company’s competitive strengths and weaknesses along with its
opportunities and threats.
Business environment and strategy analysis consists of two parts—
industry analysis and strategy analysis.
 Industry analysis is the usual first step since the prospects and
structure of its industry largely drive a company’s profitability. Industry
analysis is often done using the framework proposed by Porter (1980,
1985) or value chain analysis. Under this framework, an industry is
viewed as a collection of competitors that jockey for bargaining power
with consumers and suppliers and that actively compete among
themselves and face threats from new entrants and substitute
products. Industry analysis must assess both the industry prospects
and the degree of actual and potential competition facing a company.
 Strategy analysis is the evaluation of both a company’s business
decisions and its success at establishing a competitive advantage. This
includes assessing a company’s expected strategic responses to its
business environment and the impact of these responses on its future
success and growth. Strategy analysis requires scrutiny of a
company’s competitive strategy for its product mix and cost
structure.
 Business environment and strategy analysis requires knowledge of
both economic and industry forces. It also requires knowledge of
strategic management, business policy, production, logistics
management, marketing, and managerial economics.

b. Accounting Analysis
 Accounting analysis is a process of evaluating the extent to which a
company’s accounting reflects economic reality. This is done by
studying a company’s transactions and events, assessing the effects of
its accounting policies on financial statements, and adjusting the
statements to both better reflect the underlying economics and make
them more amenable to analysis.
 Financial statements are the primary source of information for financial
analysis. This means the quality of financial analysis depends on the
reliability of financial statements that in turn depends on the quality of
accounting analysis. Accounting analysis is especially important for
comparative analysis.
 Comparability problems arise when different companies adopt
different accounting for similar transactions or events. Comparability
problems also arise when a company changes its accounting across
time, leading to difficulties with temporal comparability. Second,
discretion and imprecision in accounting can distort financial statement
information.
 Accounting distortions are deviations of accounting information from
the underlying economics. These distortions occur in at least three
forms.
o Managerial estimates can be subject to honest errors or
omissions. This estimation error is a major cause of accounting
distortions.
o Managers might use their discretion in accounting to
manipulate or window-dress financial statements. This
earnings management can cause accounting distortions.
o Accounting standards can give rise to accounting distortions
from a failure to capture economic reality.
These three types of accounting distortions create accounting
risk in financial statement analysis.
 Accounting risk is the uncertainty in financial statement analysis due
to accounting distortions. A major goal of accounting analysis is to
evaluate and reduce accounting risk and to improve the economic
content of financial statements, including their comparability.
 Accounting analysis also includes evaluation of earnings
persistence, sometimes called sustainable earning power.
Accounting analysis is often the least understood, appreciated, and
effectively applied process in business analysis. Part of the reason
might be that accounting analysis requires accounting knowledge.
Analysts that lack this knowledge have a tendency to brush accounting
analysis under the rug and take financial statements as reported. This
is a dangerous practice because accounting analysis is crucial to any
successful business or financial analysis.

c. Financial Analysis
 Financial analysis is the use of financial statements to analyze a
company’s financial position and performance, and to assess future
financial performance. Several questions can help focus financial
analysis.
For example:
 Does a company have the resources to succeed and
grow?
 Does it have resources to invest in new projects?
 What are its sources of profitability?
 What is the company’s future earning power?
 How strong is the company’s financial position?
 How profitable is the company?
 Did earnings meet analyst forecasts?
 Financial analysis consists of three broad areas—profitability analysis,
risk analysis, and analysis of sources and uses of funds.
1. Profitability analysis is the evaluation of a company’s return on
investment. It focuses on a company’s sources and levels of
profits and involves identifying and measuring the impact of
various profitability drivers. It also includes evaluation of the two
major sources of profitability—margins (the portion of sales not
offset by costs) and turnover (capital utilization). Profitability
analysis also focuses on reasons for changes in profitability and the
sustainability of earnings.
2. Risk analysis is the evaluation of a company’s ability to meet its
commitments. Risk analysis involves assessing the solvency and
liquidity of a company along with its earnings variability. Because
risk is of foremost concern to creditors, risk analysis is often
discussed in the context of credit analysis. Still, risk analysis is
important to equity analysis, both to evaluate the reliability and
sustainability of company performance and to estimate a company’s
cost of capital.
3. Analysis of cash flows is the evaluation of how a company is
obtaining and deploying its funds. This analysis provides insights
into a company’s future financing implications.
 For example, a company that funds new projects from
internally generated cash (profits) is likely to achieve
better future performance than a company that either
borrows heavily to finance its projects or, worse, borrows
to meet current losses.

d. Prospective Analysis
Prospective analysis is the forecasting of future payoffs—typically earnings,
cash flows, or both. This analysis draws on accounting analysis, financial analysis,
and business environment and strategy analysis. The output of prospective
analysis is a set of expected future payoffs used to estimate company value.
While quantitative tools help improve forecast accuracy, prospective analysis
remains a relatively subjective process. This is why prospective analysis is
sometimes referred to as an art, not a science. Still, there are many tools we can
draw on to help enhance this analysis.

e. Valuation
Valuation is a main objective of many types of business analysis. Valuation
refers to the process of converting forecasts of future payoffs into an estimate
of company value. To determine company value, an analyst must select a valuation
model and must also estimate the company’s cost of capital. While most valuation
models require forecasts of future payoffs, there are certain ad hoc approaches that
use current financial information.

Scope and Roles of Financial Statement Analysis


Financial statements involves reviewing and analyzing a company's financial
documents to make better financial decisions for the future. These documents
include the income statement, balance sheet, statement of cash flows, and notes to
accounts. Financial statement analysis is a method that uses specific techniques to
evaluate risks, performance, valuation, financial health, and prospects of an
organization.
Major Financial Statements and other Information Sources
 Balance Sheet provides information on what the company is worth from a
book value perspective. The balance sheet is broken into three categories
and provides summations of the company's assets, liabilities, and
shareholders' equity on a specific date.
 Cash Flow provides a view of a company’s overall liquidity by showing cash
transaction activities. It reports all cash inflows and outflows over the course
of an accounting period with a summation of the total cash available.
 Income Statement provides details on the revenue a company earns and the
expenses involved in its operating activities. Overall, it provides more granular
detail on the holistic operating activities of a company. Broadly, the income
statement shows the direct, indirect, and capital expenses a company incurs.
Alternative Sources of Information Other Than Financial Reports:
 Income tax returns:
Filed by the companies gives the creditors and investors a detailed
understanding of the profitability of the company. If the organization is
partnership and corporation the balance sheet is attached to it, but in the case
of sole proprietorship balance sheet is not attached.
 Internal sources:
a. Sales reports: The selling procedure involves individuals like
customers, salesmen, and wholesalers. The seller has a budget with
the estimations of sale in the coming future. The seller can provide a
detailed estimation of products that are ready for sale.
b. Purchase reports: These reports are further detailed in products
purchased, category types, types of commodity and types of the
vendor. The purchaser has detailed information of costs related to
overhead, material, labor, scrap and defective items.
 External sources:
a. Vendors can provide information about the organizations purchasing
and how the financial relations are maintained by the organization.
b. Customers: Demand and feedbacks from the customers can provide
projections of the business growth.
c. Bankers: Bankers can provide data regarding cash handling and credit
management. Although, some of them may be reluctant to provide this
information as it is confidential but, this information may help investors
and creditors.
Conceptual Framework of Financial Statements Analysis
The conceptual framework of financial statement analysis serves as a guide
to understanding, interpreting, and utilizing financial statements
1. Purpose: Define the main objective of the analysis, such as evaluating the
company’s financial health, identifying trends, or making investment
decisions.
2. Context: Consider the industry, market conditions, and any unique
circumstances affecting the company.
o Industry: The company operates within the [specific industry], which is
currently experiencing [describe any relevant trends or conditions, such
as growth, disruption, regulatory changes.
o Market Conditions: The market is [describe current market conditions,
such as bullish, bearish, volatile, stable], influenced by factors such as
[list key influencing factors, such as economic indicators, competitive
landscape, technological advancements].
o Unique Circumstances: The Company is facing unique
circumstances, such as [any notable events or conditions affecting the
company, e.g., mergers, new product launches, legal challenges, or
economic conditions].
3. Target Audience: Identify who will use the analysis, such as investors,
management, creditors, or regulatory bodies.
o Investors: To inform investment decisions and assess the potential
return on investment.
o Management: To provide strategic insights for improving financial
performance and operational efficiency.
o Creditors: To evaluate the company's creditworthiness and risk profile.
o Regulatory Bodies: To ensure compliance with industry regulations and
standards.
4. End Product: Determine the format of the final output, which could be a
detailed report, a presentation, or a summary of findings.
o Detailed Report: A comprehensive document including analysis,
charts, and recommendations.
o Presentation: A concise PowerPoint presentation highlighting key
findings and insights.
o Summary of Findings: An executive summary for quick reference by
stakeholders. Time Frame: Set the period for the analysis and the
deadline for its completion.
5. Period for Analysis: The analysis will cover the period from [start date] to
[end date].
6. Deadline for Completion: The final deliverables will be completed and
presented by [specific deadline].
7. Resources and Constraints: List available resources (data, tools, expertise)
and acknowledge any limitations (time, data access, financial resources).
o Data: Access to financial statements, market research reports, industry
data.
o Tools: Financial analysis software, data visualization tools, statistical
analysis packages.
o Expertise: A team of financial analysts, industry experts, and data
scientists.
o Time: Limited time to complete the analysis by the deadline.
o Data Access: Potential limitations in accessing real-time or proprietary
data.
o Financial Resources: Budgetary constraints affecting the scope and
depth of the analysis.
Analyzing and Interpreting the Processed Data Assessment:
Evaluate the processed data to understand the company's performance and
financial health.
 Financial Performance: Reviewing key financial statements such as income
statement, balance sheet, and cash flow statement to assess profitability,
liquidity, and solvency.
 Key Performance Indicators (KPIs): Analyzing relevant KPIs specific to the
industry and company’s objectives, such as revenue growth rate, return on
equity (ROE), and debt-to-equity ratio.
 Market Positioning: Assessing the company’s market share, competitive
positioning, and customer satisfaction metrics if available.
 Operational Efficiency: Examining efficiency ratios like asset turnover and
inventory turnover to gauge operational effectiveness. Interpretation: Interpret
the results, identifying key trends, strengths, weaknesses, opportunities, and
threats.
 Trends: Identifying trends in financial performance over the analyzed period,
such as increasing revenue, declining profitability, or fluctuating cash flows.
 Strengths: Highlighting areas where the company excels, such as strong
brand equity, innovative products, or robust cash reserves.
 Weaknesses: Identifying areas needing improvement, such as high debt
levels, low profit margins, or operational inefficiencies.
 Opportunities: Identifying external opportunities the company can capitalize
on, such as emerging markets, technological advancements, or regulatory
changes.
 Threats: Assessing external threats that could impact the company’s
performance, such as economic downturns, competitive pressures, or changes
in consumer preferences. Supporting Conclusions: Use the interpreted data to
support conclusions about the company’s current status and future prospects.
 Financial Health: Summarizing the company’s financial health based on the
assessed data, indicating whether it is stable, improving, or deteriorating.
 Strategic Recommendations: Providing actionable recommendations based
on the SWOT analysis and financial assessment to enhance strengths, mitigate
weaknesses, seize opportunities, and counter threats.
 Future Outlook: Projecting the company’s future performance based on the
identified trends and strategic actions recommended, considering potential
scenarios and risks

Financial Statement Analysis and Business Analysis


Exhibit 1.4 and its discussion emphasizes that financial statement analysis is
a collection of analytical processes that are part of business analysis. These
separate processes share a common bond in that they all use financial statement
information, to varying degrees, for analysis purposes. While financial statements do
contain information on a company’s business plans, analysis of a company’s
business environment and strategy is sometimes viewed outside of conventional
financial statement analysis.
Also, prospective analysis pushes the frontier of conventional financial
statement analysis. Yet most agree that an important part of financial statement
analysis is analyzing a company’s business environment and strategy. Most also
agree that valuation, which requires forecasts, is part of financial statement analysis.
Therefore, financial statement analysis should be, and is, viewed as an important
and integral part of business analysis and all of its component analyses. At the same
time, it is important to understand the scope of financial statement analysis.

REFERENCES
Subramanyam, K.R. & Wild, J.J. (2009). Financial Statement Analysis (10th ed.).
McGraw-Hill/Irwin.
https://madnanarshad.files.wordpress.com/2014/02/fsa- by-john-j-wild-
10th-wdition.pdf
Easton, P.D., McAnally, M.L, Sommers, G.A., & Xiao, J.Z. (2018). Financial
Statement Analysis and Valuation (5th ed.). Cambridge Business
Publishers, LLC. https://www.scribd.com/document/389680583/Financial-
Statement-Analysis-and-Valuation-5th-pdf
Anastacio, M.L., Dacanay, R.C. & Aliling, L.E. (2016). Fundamentals of Financial
Management. Rex Book Store Inc.

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