Financial Statement Analysis and Business Valuation

(07 36334)

Lecture 1:
Introduction of Accounting Information and Analysis

By Dr. Chun Yu Mak

Assistant Professor in Accounting & Finance
[email protected]

Week 1
 Lecture summary

Part I
 The role of financial accounting information in the capital market

 Business analysis

 Financial statement analysis and its role in the capital markets

 Stakeholders’ purposes

 Information sources

Part II
 Accounting concepts, Financial Accounting vs. Management
Accounting.
 IFRS accounting framework, regulators of stock exchanges, and
government
 Recording financial transactions and preparation of financial
statements
 Principles of Accounting
 Learning outcomes:

After this lecture, you must know:

 What is the role of financial accounting information

 What is financial statement analysis? What is its relationship

with business analysis?
 Why should we study financial statement analysis?

 What financial information do we rely on?

 Accounting concepts

 Recording financial transactions-the effect of each

transactions on assets, liabilities and equity.
 Construction of financial statements.
Part I. Concepts of Financial Statement Analysis
“Now, the share price of Telsa’s ordinary share
is US $260.46 per share. Will you buy it?”
 The role of accounting information in capital market

Capital market under Capitalism

Investors Listed firms

(1)Searching for opportunity of money
(1) Managers need funding for
increasing wealth; (2) security
investment projects; (2) they
valuation Shares/bonds selectively disclosure material
information
Share/bond
price
Financial Information &
Other Information
(analysts’ forecasts, corporate announcements
economic environment, (annual/quarterly financial reports,
govt. policy, IFRS/US earnings announcements,
GAAP, etc.) predictions, dividend policy,
auditors’ reports, business plans,
M&A, restructuring, management
turnover, IPO/SEC, etc.)
Q1. What are business analysis and financial
statement analysis?

Business analysis (Porter 1985):

 To maintain a company’s competitive advantages &
development
 Analysis of industrial and economic changes (threats &
opportunities)
 The company’s competitive strategy, internal operations and
financial situation (strengths & weaknesses)
 Q1. (cont.)
Financial statement analysis (fundamental analysis):
 An essential part of business analysis
 A process of applying analytical techniques systematically on a
company’s financial statements and related information in order to
evaluate the company current financial performance--drivers of
profitability, financial position, to derive forecasts and
intrinsic/fundamental value of the company.
 Shows strengths and weaknesses of internal operations
 Consists of accounting, financial and prospective analysis.
 Financial statement analysis is for calculating the intrinsic(or
fundamental) value of a company’s assets, equity or debts , called
“fundamental analysis”.

 So, fundamental analysis explains the valuation. We adopt it to

compare with the existing market investors’ valuation in order to
explore under(over)-valuated investment opportunities, as we
assume that the market is temporary inefficient!
Q2. Why studying financial statement analysis?

Reason 1: Different concerned parties have different

purposes of analysing financial statements

 Managers/directors
 Investors (shareholders, commercial banks, financial analysts etc.)
 Competitors
 Creditors (trade & non-trade)
 Debtors (trade & non-trade)
 Government
 Labour union & employees
 Lawyer
 External/internal auditors
 Academics

To which of these parties do you belong ?

Q2. (cont.)
Reason 2: According to the studies of Bath et al. (2008 JAR),
Penman and Sougiannis (1998, CAR), Penman (2001, CAR), Lundholm
and Keefe (2001, CAR), Lundholm (2001, CAR), Francis et al. (2000, JAR)
and other studies, there is a relationship between stock prices and
accounting numbers. This
relationship reflect which information adopted by investors at evaluating
the value of a firm’s assets, equity or debts. This relationship is helpful
for valuation of equity or assets of a company.
𝑃𝑖,𝑡 = 𝛼𝑖,𝑡 + 𝛽1𝑡 𝐵𝑉𝐸𝑃𝑆𝑖,𝑡 + 𝛽2 𝐸𝑃𝑆𝑖,𝑡 + 𝜀𝑗 𝑖,𝑡
 Q2. cont.
Relation between stock price, net income, and free cash flows
 Q2. cont.

Relation between stock prices, various income and cash flow

In addition, intangible assets (Barth et al. 2023, TAR; Barth 2024, JIAR)
 Q2. cont.: Accruals--The
Accruals Cornerstone
and Cash Flows --- Truths
• Truth: Accrual accounting (income) is more relevant to
forecasting income and equity valuation, than cash flow.
.
• Truth: Cash flows are more reliable than accruals.
• Truth: Accrual accounting numbers are subject to accounting
distortions, because managers adopt favorable accounting
standard as their accounting policy.
• Truth: Company value can be determined by using accrual
accounting numbers, because accrual accounting reflects the
target firm’s financial performance and can for predict the
financial performance in the future.
Reason 3: Financial statement analysis results can be used to
challenge the existing market share price of a listed company,
which represent investors’ valuations on the listed company’s
equity. Financial statement analysis helps to identify the
undervalued or overvalued investment opportunities, in return
maintain the market efficiency.
Efficient market hypothesis (EMH)
 Efficient Market Hypothesis (EMH):

 Investors (market stock prices) react to the information disclosed by

the listed firms in an unbiased way instantly
1) weak form EMH
2) semi-strong form EMH
3) strong form EMH (lack of empirical evidence support)
 Extreme proponents of EMH claim that if all information is instantly
reflected in prices, attempts to reap consistent rewards through
financial statement analysis is futile because intrinsic value = market
value!
 Conditions: (i) information availability

 (ii) personal interpretation of investors

 Intrinsic value V.S. Market value
 Intrinsic value
-the worth of a firm that is justified by the information about its
forecasted earnings.

 Market value
-represents the present value of investors’ expectation of a
firm’s future earnings.
 could be mis-priced under the effect of misinterpretation of
information and bubbles (i.e. Internet Mania of 1998-1999).

 Intrinsic value > Market value, buy.

 Intrinsic value < Market value, sell.
 Intrinsic value = Market value, hold.
Information sources for financial statement analysis

 Company’s financial reports (in the US: Form 10-K, 10-Q, 20-F, 8-K,
Regulation 14-A):
 financial statements, notes to the accounts, segmental data,
 the accounting policies adopted by the companies,
 reports of directors and auditors,
 company’s history, products/services, etc.
 voluntary corporate disclosures: earnings announcements, plans of
investment or internal management change, corporate events (i.e. IPO,
SEO, M&A, corporate restructuring and reorganisation, management
turnover)
 Financial analysts’ reports
 Accounting Standard bodies (ASB in the UK, FASB in the US and
IASB) and accounting standard changes (i.e. further development
of FRS 3 by ASB)
 News:
 Economic and political environments and changes
 Industry statistics & economics indicators
 What is your purpose of undertaking financial
statement analysis? Penman (2013 Ch.3)
1. Debt valuation?
 The payments of Interest and principle in the period of debt
contract.
 Target of analysis: interest payment on income statement &
debt on B/S

2. Equity valuation?
 The payments of dividend payments/earnings/free cash flows
overall the holding period.
 Target of analysis: dividend, profits and free cash flow on
income statement & equity value on B/S

3. Asset valuation?
 The payments of earnings/free cash flows overall the holding
period.
 Target of analysis: profits and free cash flow on income
statement & equity value on B/S
 What is your purpose of undertaking financial
statement analysis? Penman (2013 Ch.3) cont.
1. Debt valuation?
𝐼𝑛𝑡𝑖,1 𝐼𝑛𝑡𝑖,2 𝐼𝑛𝑡𝑖,3 𝐼𝑛𝑡𝑖,𝑡
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡𝑖,0 = + + +. . + + 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑙𝑒𝑖,𝑡
(1 + 𝑘𝐷 ) (1 + 𝑘𝐷 )2 (1 + 𝑘𝐷 )3 (1 + 𝑘𝐷 )𝑡

2. Equity valuation?
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒𝑠𝑖,0
𝑅𝐸𝑖,1 𝑅𝐸𝑖,2 𝑅𝐸𝑖,3 𝑅𝐸𝑖,𝑡
= 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦𝑖,0 + + + +. . +
(1 + 𝑘𝑒 ) (1 + 𝑘𝑒 )2 (1 + 𝑘𝑒 )3 (1 + 𝑘𝑒 )𝑡

3. Asset valuation?
𝑅𝑒𝑂𝐼𝑖,1 𝑅𝑒𝑂𝐼𝑖,2 𝑅𝑒𝑂𝐼𝑖,3 𝑅𝑒𝑂𝐼𝑖,𝑡
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑖,0 = 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑖,0 + + 2
+ 3
+. . +
(1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶)𝑡
 Part II.
Accounting Concepts,
Accounting Theoretical Framework and
Preparation of Financial Statements
 Accounting

• ‘the process of • Accounting as a

identifying, measuring process
and communicating – Capturing, recording,
economic information summarising, reporting,
to permit informed interpreting
judgements and • Economic information
decisions by users of the – Financial & non-financial
information’ • Decision usefulness
– American Accounting – Broad spectrum of users
Association

22
 Accountability

• ‘the capacity and • accountability entails both a

willingness to give narration of what transpired
explanations for conduct, and a reckoning of money
stating how one has – Boland & Schultze
discharged one’s
responsibilities … an
• Accountability to:
explaining of conduct with a
credible story of what  Shareholders & financiers
happened, and a calculation  Stakeholders
and balancing of competing – Competitors, Customers,
obligations, including moral debtors, suppliers, creditors,
ones’ employees/labour union,
government, lawyer,
– Boland & Schultze investors, academics.
“The objective of general purpose financial reporting is to
provide financial information about the reporting entity
that is useful to existing and potential equity investors,
lenders, and other creditors in making decisions relating to
providing resources to the entity.”
Source: IASB, Conceptual Framework for Financial Reporting, para 1.2, issued
March 2018
 Financial accounting

• the recording of financial transactions, aimed

principally at reporting performance to those
outside the organization, with a primary focus on
shareholders at each financial year end.
• Annual Report to shareholders, which comprises
– the Statement of Comprehensive Income (or Income
Statement;
– the Statement of Financial Position (or Balance Sheet);
– the Statement of Changes in Equity; and
– the Statement of Cash Flows

25
 Financial accounting

 Legislation
 accounting standards, and
 independent audit
 Limitations :
• produced only once per year,
• highly aggregated and
• provides no comparison to target
 Management accounting

Provides financial and non-financial information to

– develop and implement strategy by planning for
the future (budgeting);
– make decisions about products, services, prices
and what costs to incur (decision-making);
– ensure that plans are put into action and are
achieved (control).
– Management accounting information is timely,
daily base.
 Differences between financial accounting and
management accounting

The major differences concern:

Nature of the reports produced

Level of detail

The existence of regulations

Reporting interval

Time orientation

Range and quality of information

Source: Aerts and Walton (2020). Global Financial Accounting and Reporting:
Principles and Analysis, 5th Ed. Cengage, ISBN: 9781473767126
 Accounting Regulation
 Accounting regulation disciplines accounting
choices – accounting policy – the way recording the
transactions
 Types of regulatory body:
Government
Stock exchange
Private sector body
Professional accountants
Specialist industry organizations

 Separate rules for banks and insurance companies

 Government as accounting regulator

 Regulation of accounting designed to ensure that the

markets can operate free from fraud and
misrepresentation
Accounting laws
Commercial codes (Companies Act 2006 in the UK)
Government regulatory agencies

 Regulation of accounting for tax collection purposes

 Stock exchange as accounting regulator
 Stock exchange regulates the financial information to
be provided by listed companies, e.g. requirement to
publish quarterly figures

 In some countries this is done by a government

regulator
o US: Securities and Exchange Commission (SEC) as
accounting regulator
o UK: London Stock Exchange (LSE)
 EU: national regulators coordinated through the
European Securities and Markets Authority (ESMA)
Private sector as accounting regulator
 Delegation of responsibility of writing detailed accounting
rules to private sector bodies, financed by contributions
from companies, audit industry, etc.
– US: Financial Accounting Standards Board
(FASB)
– Global: International Accounting Standards
Board (IASB)
 Flexible and rapid rule-making, as opposed to governmental
rule-making
 Technical committees from professional accounting bodies
may function as catalyst
 International bodies
 International Accounting Standards Board (IASB)
o The world’s leading accounting standards-setter
o Issues the International Financial Reporting Standards
(IFRS)
o IFRS either compulsory or allowed in more than 130
countries
 Intergovernmental Working Group of Experts on
International Standards of Accounting and Reporting
(ISAR)
o Under the auspices of the UN Conference on Trade and
Development (UNCTAD)
o Commissions research reports into current accounting
problems
 International Federation of Accountants (IFAC)
o International representative of the accounting profession
PROCEDURES OF RECORDING TRANSACTIONS
AND FINANCIAL STATEMENT PREPARATION
FOR AN ENTITY – THE FIRM

34
Journals:
It is the book of original entries of transactions when these transactions happened.
It includes the data of transactions. No need to be balance.

Ledgers:
T-accounts, which is for formal recording of the transactions via double entries.
Balance of each pair of accounts is required.

Trial balance:
 A trial balance is the listing of all the balances on all the general ledger accounts
at the end of the accounting period

 At year-end, the trial balance data will be refined through the year-end
adjustments

 In the extended trial balance, the ledger balances and adjustments are added
mathematically and the adjusted balance is entered in the statement of profit or
loss column or in the statement of financial position column.

Preparation of financial statements: balance sheet, income statement and cash flow
statements, based on the trail balance.
Recording
accounting
information
 Recording Accounting Information

Asset (International Financial Reporting Standard, IFRS here after, S2, p 2.6-2.36):
A resource (or a claim to resources) controlled by the entity as a result of past
Events and from which future economic benefits are expected to flow to the entity.

Liability (IFRS S2, p 2.6-2.36):

A present obligation of the entity arising from past events, the settlement of which is
Expected to result in an outflow from the entity of resources embodying economic
benefits.

Equity (IFRS 1, 27 and 32):

The residual interest in the entity’s assets after deducting all its liabilities.

Statement of Financial Position(IFRS 1, 27 and 32):

Assets = Liability + Equity
 Recording Accounting Information (cont.)

Income:
It is increases in economic benefits during the accounting period in the form of inflows
or enhancements of assets or decreases of liabilities that result in increases in equity,
Other than those relating to contributions from equity participants.
Expenses:
They are decreases in economic benefits during the accounting period in the form of
Outflows or depletions of assets or incurrences of liabilities that result in decreases in
Equity, other than those relating to distributions to equity participants.

Conditions of recognition:
a) it is probable that any future economic benefit associated with the item will flow to
or from the entity,
a) The item has a cost or value that can be measured with reliability.

Statement of Financial Performance(IFRS 1, 27 and 32):

Profit = Income - Expenses
 2-step process for recording transactions
Double entries:
1. identify which pair of accounts are affected (assets, liability,
income, expense or equity) by a transaction; and
2. determine whether the transaction increases or decreases those
accounts

Cash or credit ?
• Transactions may be cash or credit
• Selling goods on credit: Receivables (debtors)
• Buying goods on credit: Payables (creditors)
 Cash or credit (cont.)
• When an inventory are bought in cash , they become an asset
called Inventory. At the same time, there is decrease in cash
(asset account).
• When goods are bought in credit , they become an asset called
Inventory. At the same time, there is increase in creditor
account (liability account).

• When the same goods are sold, the related transactions are:
1. If the sale is in cash, then, increase in cash account (asset
account), reduce in inventory account (asset account).
2. If the sales is in credit, then, increase in debtor account (asset
account), reduce in inventory account (asset account)
3. The transfer of the cost of those goods, now sold, from
inventory to an expense, called cost of sales, or cost of goods
sold.
See examples in MS Excel.
 Mornington Crescent Emporium SA
Worked Trial balance as at 31 December 20X1
€
example –Trial Assets
balance Premises 30,000
Equipment (at cost) 15,000
Accumulated depreciation -4,500
Inventory at 1 Jan. X1 13,250
Trade receivables 23,000
Bank 18,560
95,310
Equity and Liabilities
Share capital 50,000
Retained profits 10,500
Trade payables 16,850
Sales 193,000
Purchases –145,000
Salaries and wages –15,325
Rent –10,000
Insurance –2,500
Legal & professional expenses –1,250
Telephone –345
Light and heat –620
95,310
 Statement of profit or loss for the year ended 31
December 20X1 (format for internal use)
Mornington Crescent Emporium SA
€ €
Sales 193,000
Cost of goods sold (144,100)
48,900
Salaries and wages 15,325
Rent 8,000
Insurance 2,000
Light and heat 670
Depreciation expense 1,500
Provision expense 1,000
Legal and professional 1,250
Telephone 425
Audit 2,000 (32,170)
Profit for year 20X1 16,730
Statement of profit or loss for the year ended 31 December 20X1
(published format)

Mornington Crescent Emporium SA

€ €
Revenue 193,000
Cost of goods sold (144,100)
48,900
Personnel costs 15,325
Other operating expenses
(excluding depreciation and provisions) 14,345
Depreciation expense 1,500
Provision expense 1,000 (32,170)
Profit for year 20X1 16,730
Statement of financial position as at 31 December 20X1
Mornington Crescent Emporium SA
€ €
Non-current assets
Premises 30,000
Equipment (at cost) 15,000
less accumulated depreciation (6,000) 9,000
39,000
Current assets
Inventory 14,150
Trade receivables 23,000
Prepaid expenses 2,500
Bank 18,560 58,210
Total Assets 97,210
Equity
Share capital 50,000
Retained earnings 10,500
16,730 27,230
77,230
Current liabilities
Short-term provisions 1,000
Trade payables 16,850
Accrued expenses 2,130
Total equity and liabilities 97,210
 Principles of accounting

• Accounting entity • Historic cost vs. Fair

• Accounting period value
• Going concern • All inclusive
• Conservatism • Reliability
• Matching principle (or • Relevance
accrual concept) • Materiality
• Consistency
• Monetary
measurement
46
 Learning outcomes:

After this lecture, you must know:

 What is the role of financial accounting information

 What is financial statement analysis? What is its relationship

with business analysis?
 Why should we study financial statement analysis?

 What financial information do we rely on?

 Accounting concepts

 Recording financial transactions-the effect of each

transactions on assets, liabilities and equity.
 Construction of financial statements.
References:
 Subramanyam K.R. (2014), Financial Statement Analysis, 11th Ed.
McGraw Hill, ISBN 978-0-07-811096-2 Chs. 1, 2 .

 Collier, P. M. (2015), Accounting for Managers: interpreting accounting

information for decision making, 5th Ed., Wiley, ISBN: 978-1-119-00294-
9, Ch.3

 Aerts and Walton (2020). Global Financial Accounting and Reporting:

Principles and Analysis, 5th Ed. Cengage, ISBN: 9781473767126, Ch.
1.
Class questions:
At the book of Collier, P. M. (2015), Accounting for Managers,
Ch.1 Q. 1.1, Ch.3 Qs. 3.6, 3.7

Canvas:
All handouts, tutorial class questions and answers are available on
Canvas page - modules.
 Useful Web links
 International organisations
IFRS Foundation / International Accounting Standards
Board
http://www.ifrs.org
International Federation of Accountants
http://www.ifac.org
European Financial Reporting Advisory Group
http://www.efrag.org

 IFRS Information and Resource Centres

IAS plus
http://iasplus.com