Test Bank For Business Analysis and Valuation Using Financial Statements, 3rd Edition Krishna G. PalepuPaul M. HealySue WrightMichael BradburyJeff Coulton
All for this textbook (2)
Written for
University of Sydney (USYD
)
ACCT3013 Financial Statement Analysis (ACCT3013)
All documents for this subject (1)
Seller
Follow
biancakeating
Content preview
ACCT3013 NOTES
WEEK 1: BUSINESS AND STRATEGY ANALYSIS
FINANCIAL STATEMENTS
• FSA views financial statements as a key source of information to all business stakeholders and the capital markets in
particular
• Both internal stakeholders (company management) and external stakeholders (everyone else) rely on financial statement
information
• Financial statements are the primary means of communication between internal and external stakeholders
• Financial statements form part of a greater information process and affect the processing of information
• The accounting information system identifies, measures and summarises the economic consequences of business
activities in published financial statements
• Hence, the primary role of financial statements is to convey the impact of business fundamentals to and its
implications to external stakeholders
• Business fundamentals characterise the raison d’etre of a business
o E.g. product quality, customer base, pricing, innovation, supply chain, market share, IP, employees etc
FINANCIAL ACCOUNTING
• So accounting is assigned with the task of measuring the monetary effect of these business fundamentals
• But accounting is largely a subjective process due to accrual accounting, which can be a double-edged sword:
o It is a powerful tool for recognising the timely allocation of resources and reflecting expectations of economic
performance
o But the underlying flexibility gives the opportunity for misrepresentation, intentional or non-intentional
o E.g. ask two accountants to value the same intellectual property and they will come up with different answers
• Accruals accounting also allows management to be selective to what is reported, according to their interpretation of what
is reliable and relevant information
o Reliability is the extent to which information is verifiable, representationally faithful and neutral
o Relevance is the extent to which information has an impact to timely decision making, and possesses predictive
value and/or feedback value
• Signaling problem: the management must also find a balance between conveying significant valuation information
without giving away too much proprietary data
• The question arises how much can we trust accounting’s representation of business fundamentals? Are financial
statements a true and fair representation?
• As you have learned in other units, there are many ways of measuring the value of an asset or liability so it is critical to
first understand the impact of accounting policies and the expectations imbedded in accrual accounting
• The interaction of companies with markets is a complex ‘game’ that is strongly characterised by an information
feedback loop:
o Financial statements affects market opinion but markets affect business fundamentals and determine managerial
action
INFORMATION PROCESS AND INTERMEDIARIES
INFORMATION PROCESS
• Even though the underlying Business Fundamentals are very much an
objective representation of reality ...
• Accounting is a mere interpretation of this reality that represents the subjective
view of the management and its accountants
• Business stakeholders and the market must then make sense of this filtered
information
• They are faced with two difficult tasks:
o Evaluate the impact of changing business fundamentals
o Decipher the management’s view and signals
1
, • Information process and the process of information
• Information (from fundamentals to decision making) is processed by two classes of agents, in the following order:
o Information intermediaries who enhance/adjust/interpret the information content of financial statements
§ These are auditors, financial analysts, credit rating agencies, financial press, regulators
o Financial intermediaries who identify worthwhile investment opportunities on the basis of this data and rely
heavily on the work of information intermediaries
§ These are superannuation funds, banks, insurance companies, managed funds, etc
INTERMEDIARIES
• Intermediaries cannot observe all business fundamentals in the same
way as the company, simply because company sensitive fundamentals are
hidden from public view
• Intermediaries rely on financial statements as their primary source of
information of business fundamentals, and then match their understanding
of fundamentals with the information released by management
• Financial statements are key input to business analysis
COURSE OUTLINE
• FSA is largely structured around this information process
• First we demonstrate tools for analysis:
o Business strategy analysis
o Accounting analysis
o Financial analysis
o Prospective analysis
o Then we apply the analysis to answer questions of: Equity valuation and security analysis
o Credit analysis and distress
o Financial policy etc
BUSINESS ANALYSIS
• Business strategy analysis identifies the risk/return profile of a business in terms of
its fundamentals
• How does strategy affect performance – think of company failures such as Kodak or
Lehman Brothers
• Michael Porter’s 5-forces framework is a conceptual framework for understanding
the impact of the business environment particularly with respect to competition and
industry positioning
PORTER’S 5-FORCES
• The key in understanding competitive forces and the risk-return profile of a business in
terms of fundamentals is its relative standing within the industry
INDUSTRY ANALYSIS AND COMPETITION
• The key in understanding competitive forces and the risk-return profile of a business in terms of fundamentals is its
relative standing within the industry
F1: RIVALRY AMONGST EXISTING COMPETITORS
• A critical factor that determines rivalry is product differentiation
• Retailers function by reselling processed products, so unless the retailer has exclusive access to a product or service then
there would be intense price war amongst retailers selling the same product
• In this case, by-products or services surrounding become critical
o E.g. airlines which compete for the same flight route at similar prices, would differentiate on the basis of safety
record, seat space, in-flight entertainment etc
• Non-differentiable retailers therefore have competitive prices with low switching costs
o The Internet makes it easy to switch airlines on the basis of cost, everything else held equal
2
, o Insurance brokers (e.g. iSelect) makes it easy to choose from rival insurance companies
o Did you notice that wherever there is a Woolworths supermarket right next to it there is a Coles, IGA or ALDI
supermarket, and wherever there is a David Jones store there is next to is a Myer’s store? This is specifically to
enable low switching costs!
• The industry growth rate will also determine the degree of rivalry ® the bigger the market the more there is to share
o In fast growing industries (e.g. computer technology, renewable energy, finance) it is urgent for rivals to
compete on existing market shares but could focus on attracting new customers, perhaps through specialising in
demographics
• The economies of scale determine the cost advantage from the increasing size of the corporation.
F2: THREAT OF NEW ENTRANTS
• The greater the economic rent (maximum possible market profit) the greater the attraction to new entrants
• Rivals are therefore mindful not only of existing competition but also of potential competition
• Most factors analysed in ‘Force 1: Rivarly’ also determine the extent of potential threat from new entrants
o Industry growth ( growth = threat of new entries)
o Excess capacity ( capacity = threat new entries), where excess capacity is excess available demand volume
• Asset base profile and economies of scale of industry will largely determine the time it takes for a new entrant to become
competitive
• The lower the scale and the lower the ratio of fixed to variable assets = more new entries and quicker for them to become
competitive
o Energy industry is a fixed-assets intensive industry with investments predominantly in property, plant and
equipment (infrastructure)
o It is extremely hard to build up competition from scratch, and this is why it is generally preferable to enter such
industries through mergers and acquisitions
FIRST MOVER ADVANTAGE
• A unique feature of this force is the power and brand awareness that is attached to the first entry (or first few entries) in
a new market – known as First Mover Advantage
• First movers create markets and create industries, so they have the advantage to determine the ‘rules of the game’
• The First Mover Advantage gives the upper hand to the first entries and the opportunity to grow fast before the new
entries build capacity
• First movers are ahead of regulators who must then work together to set up new accounting standards, consumer
protection mechanisms, environmental regulations etc
o E.g. in the 1990s’ the DotCom boom took regulators by surprise, and by the time it caught up the boom turned
into a bubble that eventually burst and wiped out $5 billion of market value
• First movers also have the opportunity to determine industry standards that are hard to replace
o E.g. the QWERTY keyboard layout was developed in 1870s as a prototype for typing machines, and later
adopted by the first IBM computers terminals. QWERTY is a standard that is extremely costly to replace.
• Other examples?
o Digial cameras (Kodak ended up bankrupt!)
o Portable computers (bad for IBM who were in mainframes)
o iPhones, iWatches etc
• Legal barriers to entry is a key factor that determines whether the market is open to new entrants
• Certain markets or industries are protected by patents
o Barriers to entry are strong in many R&D intensive industries that are protected by patents and copyrights, but
also in highly regulated/monitored industries such as defense and national security, but even taxi services whose
number of permits are capped by law
F3: THREAT OF SUBSTITUTE PRODUCTS
• Substitute products can be non-differentiated products that serve the same function
o E.g. substitute office supplies, in which case they would compete on the basis of pricing
• The most severe form of substitute products, are those which make existing products (or services) redundant by shifting
demand to the new, more advanced product
o E.g. some years ago the floppy disk was seen as a marvel, then it was replaced by the CD, then by the DVD
drive, then by the USB drive. Now the focus is cloud technology!
3
, F4: BARGAINING POWER OF BUYERS
• Bargaining power describes the extent to which one agent can influence the actions of another agent
• Under equal bargaining power all parties have equal influence and there is a perfect competitive equilibrium where no
one wins or loses ® neutral outcome
• However, in real applications someone always gains the upper hand, most notably because of two reasons:
o Asymmetry in information between supply chain nodes
o Cost structure and how the price of a product is determined (how does it add up to the total cost)
• Asymmetry in information can be a key advantage to sellers (not always though) who like to be a step ahead of
customers...
o E.g. it is said that the next generation laptops has already been developed, but it is not released because the
demand for this generation has yet to saturate, and also the inventory stock has not depleted yet
• Competition kicks in when a rival introduces features of the next generation product, and suddenly all rivals have no
choice but to release similar competitive features
• Buyers have strong bargaining power when switching costs are low and can see through the cost structure of a
product
o E.g. much of the consumables today focus their strategy to attracting customers by clever marketing and
packaging
• Once the consumer realises that a big portion of the product’s price is due to expensive marketing and packaging and not
due to quality or quantity, then the consumer will simply switch to less expensive product
F5: BARGAINING POWER OF SUPPLIERS
• Suppliers have strong bargaining power when they have access to a unique node in the supply chain
o E.g. to manufacture a new table you need (simplified):
§ Extraction ® Transport ® Design ® Processing ® Marketing ® Retail ® Business services ®
Customer
• If a forestry company has unique access to mahogany wood then it can choose its customers who require access to this
resource on the basis of favourable trading agreements
• If the table manufacturer has a patented design then the uniqueness (differentiation) and degree of demand of its product
will determine its power to bargain with retailers
• Non-differentiable suppliers have lower bargaining power and as their number increases their bargaining power
decreases
o E.g. Australian dairy farmers (suppliers of milk and dairy product) have been under a lot of pressure the last few
years, and many of them have been forced to shut down or merge into cooperatives
o Lost bargaining power by comparison to Woolworths and Coles who are the no.1 sellers of dairy product
o These supermarkets exerted unbearable trading agreements to suppliers and also introduced their own very
cheap brands of similar quality...
COMPREHENSIVE BUSINESS ANALYSIS
• Industry analysis explains the force exerted on the business and the business’s calculative response to surviving the
pressure and grow (in the long run, growth is key)
o “A smart analyst anticipates changes in strategy and the value that might create or destroy”
o (Penman S., 2013, FSA and Security Valuation, McGrawHill, p.15)
• Beyond the position of the firm within its environment, the analyst must also have a good understanding of the overall
business model or strategic outlook of the firm and how it fits with market or non-market forces
o Stephen Penman gives a checklist of how one can ‘master the details’ of a business model
MASTERING THE DETAILS CHECKLIST
• Know the firm’s products
o Types of products
o Consumer demand
o Price elasticity of demand
o Product substitutes and differentiation
o Brand strength
o Patent protection
• Know the technology required to bring the products to market
4
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller biancakeating. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $40.48. You're not tied to anything after your purchase.
