Financial Statement Analysis for A&C – Lecture 1
Chapter 1
Capital markets: play an important role in channelling financial resources from savers to business
enterprises that need capital
The role of financial reporting in capital markets
à critical challenge in any economy is the allocation of savings to investment opportunities
à economies that do this well can exploit new business ideas to spur innovation and create
jobs and wealth at a rapid pace, and vice versa
3 reasons make the matching between savings and business investment opportunities
difficult:
1. Information asymmetry between savers and entrepreneurs
- Entrepreneurs typically have better information than savers on the value of business
investment opportunities
2. Potentially conflicting interests – credibility problems
- Communication by entrepreneurs to savers is not completely credible, as
entrepreneurs have an incentive to inflate the value of their ideas
3. Expertise asymmetry
- Savers generally lack the financial sophistication needed to analyse and differentiate
between the various business opportunities
à result: lemons problem à can potentially break down the functioning of the capital market
• Due to the limited possibility to distinguish the ‘bad’ from the ‘good’, both ideas are valued at
average level, drifting the ‘good’ away
à proportion of ‘bad’ increases
à investors lose confidence in the market
à the emergence of intermediaries can prevent such a market breakdown
à 2 types of intermediaries in capital markets:
1. Financial intermediaries
- Focus on aggregating funds from individual investors and analysing different
investment alternatives to make investment decisions
- Rely on information in financial statements to analyse investment opportunities
- Venture capital firms, banks, collective investment funds, pension funds, insurance
companies
2. Information intermediaries
- Focus on providing or assuring information to investors on the quality of various
business investment opportunities
- Add value by enhancing credibility of financial reports (auditors) or by analysing the
information in the financial statements
- Auditors, financial analysts, credit-rating agencies, financial press
à both help investors distinguish ‘good’ from ‘bad’ investment opportunities
• In countries where individual investors traditionally have had strong legal rights, information
intermediaries are most important
• In countries where individual investors traditionally have had weak legal rights to discipline
entrepreneurs, financial intermediaries are most important
- >2010: many European countries have been moving toward a model of strong legal
protection of investors’ rights
From business activities to financial statements
Financial statements: summarize the economic consequences of its business activities
• The firm’s accounting system provides a mechanism through which business activities are
selected, measured, and aggregated into financial statement data
,Periodically, firms typically produce 5 financial reports
(1) Income statement (2) Balance sheet (3) Cash flow statement (4) Statement of other
comprehensive income (5) Statement of changes in equity
• These statements are in turn accompanied by notes that provide additional details and
management’s narrative discussion
Influences of the accounting system on information quality
à financial reports are influenced both by the firm’s business activities and by its accounting system
à various features of accounting systems are specifically important:
Feature 1: Accrual accounting
= distinguished between the recording of costs or benefits associated with economic activities and the
actual payment or cash receipt
• To compute profit or loss, the effects of economic transactions are recorded on the
basis of expected, not necessarily actual
- Timing differences between the moment of recording costs or benefits and
experiencing cash inflows or outflows, result in the recognition of assets and liabilities
on the balance sheet
Fundamental relationship balance sheet
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑒𝑞𝑢𝑖𝑡𝑦
Fundamental relationship income statement
𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑟 𝑙𝑜𝑠𝑠 = 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Matching: consistent application of the principles that define assets and liabilities implies that
associated elements of income and expenses appear in the income statement in the same period
Feature 2: Accounting conventions and standards
As accrual accounting deals with expectations of future cash consequences of current events, it is
subjective and relies on various assumptions
• Several accounting conventions ensure that managers use their accounting flexibility to
summarize their knowledge of the firm’s business activities
- And especially to preventing the disguise of reality for self-serving purposes
• Accounting standards and rules limit management’s ability to misuse accounting judgements
by regulating how firms record particular types of transactions
• Disclosure principles in turn complement accounting standards
- They guide the amount and kinds of information disclosed and require a firm to
provide qualitative information related to assumptions, policies, and uncertainties that
underlie the quantitative data presented
à standards from the International Financial Reporting Standards (IFRS) create:
• Uniform accounting language
• Improves comparability of financial statements
• Increase the credibility of financial statements by limiting a firm’s ability to distort them
à disadvantage is that flexibility for managers is reduced
• If accounting standards are too rigid, they may induce managers to expand economic
resources to restructure business transactions to achieve desired accounting result or forego
transactions that may be difficult to report on
Feature 3: Managers’ reporting strategy
Firm’s reporting strategy: how managers use their accounting discretion
à highly influence the firm’s financial statements
- Corporate managers can choose accounting and disclosure policies that make it
more or less difficult for external users of financial reports to understand the true
economic picture of their business
o Disclosure of proprietary information about business strategies and their
expected economic consequences may hut the firm’s competitive position
, o Therefore, manager can also use financial reporting strategies to manipulate
investor’s perceptions etc.
Feature 4: Auditing, legal liability, and public enforcement
I: Auditing
= ensures that managers use accounting rules and conventions consistently over time and that their
accounting estimates are reasonable
• Auditors follow the rules of the Generally Accepted Auditing Standards (GAAS)
II: Legal liability
• The threat of lawsuits and resulting penalties have the beneficial effect of improving the
accuracy of disclosure
• Legal liability regimes however vary in strictness across countries, both within and outside
Europe
III: Public enforcement
As a final guarantee on reporting quality, public enforcement bodies have been established
that:
• Either proactively or on a complaint basis initiate reviews of companies’ compliance with
accounting standards and take actions to correct noncompliance
• In the US there is for example the SEC (Securities and Exchange Commission)
- Do note: public enforcement bodies cannot ensure full compliance of all listed
companies
à most is done on a sampling basis
Alternative mechanism to communicate with investors
Due to the limitations of accounting standards, auditing, and enforcement, and the reporting credibility
problems faced by management, firms also often communicative effectively in other ways:
1. Analyst meetings
- Regular meeting with financial analysts that follow the firm
- Management will field questions about the firm’s current financial performance and
discuss future business plans
- In addition, often a director of investor relations is appointed to provide further
contact with analysts seeking for more information
o Especially, firms in industries where financial statement data fails to capture
key business fundamentals on a timely basis use these meetings
o Smaller and less heavily traded firms in particular benefit from initiating
investor conference calls
o Again, rules are in place that prevent unfair disclosure
2. Voluntary disclosure
- Accounting rules usually prescribe min. disclosure requirements, but they do not
restrict managers from voluntarily providing additional information
- Do note that those voluntary disclosures are not audited
- Constraint on expanded disclosure: competitive dynamics in product markets
o Disclosure of proprietary information on strategies and their expected
economic consequences may hurt the firm’s competitive position
• Managers thus face a trade-off between providing information useful
to investors in assessing the firm’s economic performance and
withholding information to maximize the firm’s product market
advantage
- Constraint: management’s legal liability
o Dissatisfied shareholders can potentially use forecasts and voluntary
disclosures to bring civil actions against management for providing
misleading information
• Sounds paradoxical; however, where the manager’s disclosures
good-faith estimates of future events which did not materialize or
where they used to manipulate the market?
, 3. Non-financial reporting (increasing importance)
- Not all resources and obligations can be easily and immediately expressed in
monetary terms and classified as ‘economic’
- Non-financial disclosures are commonly referred to as environmental, social, and
governance (ESG) disclosures
- Some examples of non-financial disclosures:
o Quantitative measures of carbon dioxide emissions, energy use, and water
consumption
o Actions taken to improve labour conditions and monitor labour code
o Compliance with codes or participation in training programs that aim to
reduce the use of chemicals and water
- What is relevant to report depends strongly on the industry and environment in
which a firm operates
à result: it’s almost impossible to regulate non-financial reporting using one-
size-fits-all rules
From financial statements to business analysis
Effective financial statement analysis is valuable because it attempts to get at managers’ inside
information from public financial statement data
• Intermediaries do not have direct or complete access to managers’ inside information, thus
they rely on their knowledge of the firm’s industry and its competitive strategies to interpret
financial statements
Business intermediaries use financial statements in a way they can accomplish 4 key steps:
1. Business strategy analysis
- Purpose: identify key profit drivers and business risks and assess the company’s
profit potential at a qualitative level
- Involves: analysing a firm’s industry and its strategy to create a sustainable
competitive advantage
- Enables the analyst to:
o Evaluate whether current profitability is sustainable
o Make sound assumptions in forecasting a firm’s future performance
2. Accounting analysis
- Purpose: evaluate the degree to which a firm’s accounting captures the underlying
business reality
- Enables the analyst to:
o Assess the degree of distortion in a firm’s accounting numbers
o Improve the reliability of conclusion from financial analysis
3. Financial analysis
- Purpose: use financial data to evaluate a firm’s current and past performance and
assess its sustainability
- 2 important skills related to financial analysis:
1) Analysis should be systematic and efficient
2) The analysis should allow the analyst to use financial data to explore
business issues
- Ratio analysis and cash flow analysis are the two most commonly used financial tools
4. Prospective analysis
- Purpose: focuses on forecasting a firm’s future
- Common techniques: forecasting and valuation
- The firm’s intrinsic value is a function of its future cash flow performance
o But, it’s also possible to assess a firm’s value based on its current book value
of equity and its future ROE and growth
Chapter 1
Capital markets: play an important role in channelling financial resources from savers to business
enterprises that need capital
The role of financial reporting in capital markets
à critical challenge in any economy is the allocation of savings to investment opportunities
à economies that do this well can exploit new business ideas to spur innovation and create
jobs and wealth at a rapid pace, and vice versa
3 reasons make the matching between savings and business investment opportunities
difficult:
1. Information asymmetry between savers and entrepreneurs
- Entrepreneurs typically have better information than savers on the value of business
investment opportunities
2. Potentially conflicting interests – credibility problems
- Communication by entrepreneurs to savers is not completely credible, as
entrepreneurs have an incentive to inflate the value of their ideas
3. Expertise asymmetry
- Savers generally lack the financial sophistication needed to analyse and differentiate
between the various business opportunities
à result: lemons problem à can potentially break down the functioning of the capital market
• Due to the limited possibility to distinguish the ‘bad’ from the ‘good’, both ideas are valued at
average level, drifting the ‘good’ away
à proportion of ‘bad’ increases
à investors lose confidence in the market
à the emergence of intermediaries can prevent such a market breakdown
à 2 types of intermediaries in capital markets:
1. Financial intermediaries
- Focus on aggregating funds from individual investors and analysing different
investment alternatives to make investment decisions
- Rely on information in financial statements to analyse investment opportunities
- Venture capital firms, banks, collective investment funds, pension funds, insurance
companies
2. Information intermediaries
- Focus on providing or assuring information to investors on the quality of various
business investment opportunities
- Add value by enhancing credibility of financial reports (auditors) or by analysing the
information in the financial statements
- Auditors, financial analysts, credit-rating agencies, financial press
à both help investors distinguish ‘good’ from ‘bad’ investment opportunities
• In countries where individual investors traditionally have had strong legal rights, information
intermediaries are most important
• In countries where individual investors traditionally have had weak legal rights to discipline
entrepreneurs, financial intermediaries are most important
- >2010: many European countries have been moving toward a model of strong legal
protection of investors’ rights
From business activities to financial statements
Financial statements: summarize the economic consequences of its business activities
• The firm’s accounting system provides a mechanism through which business activities are
selected, measured, and aggregated into financial statement data
,Periodically, firms typically produce 5 financial reports
(1) Income statement (2) Balance sheet (3) Cash flow statement (4) Statement of other
comprehensive income (5) Statement of changes in equity
• These statements are in turn accompanied by notes that provide additional details and
management’s narrative discussion
Influences of the accounting system on information quality
à financial reports are influenced both by the firm’s business activities and by its accounting system
à various features of accounting systems are specifically important:
Feature 1: Accrual accounting
= distinguished between the recording of costs or benefits associated with economic activities and the
actual payment or cash receipt
• To compute profit or loss, the effects of economic transactions are recorded on the
basis of expected, not necessarily actual
- Timing differences between the moment of recording costs or benefits and
experiencing cash inflows or outflows, result in the recognition of assets and liabilities
on the balance sheet
Fundamental relationship balance sheet
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑒𝑞𝑢𝑖𝑡𝑦
Fundamental relationship income statement
𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑟 𝑙𝑜𝑠𝑠 = 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Matching: consistent application of the principles that define assets and liabilities implies that
associated elements of income and expenses appear in the income statement in the same period
Feature 2: Accounting conventions and standards
As accrual accounting deals with expectations of future cash consequences of current events, it is
subjective and relies on various assumptions
• Several accounting conventions ensure that managers use their accounting flexibility to
summarize their knowledge of the firm’s business activities
- And especially to preventing the disguise of reality for self-serving purposes
• Accounting standards and rules limit management’s ability to misuse accounting judgements
by regulating how firms record particular types of transactions
• Disclosure principles in turn complement accounting standards
- They guide the amount and kinds of information disclosed and require a firm to
provide qualitative information related to assumptions, policies, and uncertainties that
underlie the quantitative data presented
à standards from the International Financial Reporting Standards (IFRS) create:
• Uniform accounting language
• Improves comparability of financial statements
• Increase the credibility of financial statements by limiting a firm’s ability to distort them
à disadvantage is that flexibility for managers is reduced
• If accounting standards are too rigid, they may induce managers to expand economic
resources to restructure business transactions to achieve desired accounting result or forego
transactions that may be difficult to report on
Feature 3: Managers’ reporting strategy
Firm’s reporting strategy: how managers use their accounting discretion
à highly influence the firm’s financial statements
- Corporate managers can choose accounting and disclosure policies that make it
more or less difficult for external users of financial reports to understand the true
economic picture of their business
o Disclosure of proprietary information about business strategies and their
expected economic consequences may hut the firm’s competitive position
, o Therefore, manager can also use financial reporting strategies to manipulate
investor’s perceptions etc.
Feature 4: Auditing, legal liability, and public enforcement
I: Auditing
= ensures that managers use accounting rules and conventions consistently over time and that their
accounting estimates are reasonable
• Auditors follow the rules of the Generally Accepted Auditing Standards (GAAS)
II: Legal liability
• The threat of lawsuits and resulting penalties have the beneficial effect of improving the
accuracy of disclosure
• Legal liability regimes however vary in strictness across countries, both within and outside
Europe
III: Public enforcement
As a final guarantee on reporting quality, public enforcement bodies have been established
that:
• Either proactively or on a complaint basis initiate reviews of companies’ compliance with
accounting standards and take actions to correct noncompliance
• In the US there is for example the SEC (Securities and Exchange Commission)
- Do note: public enforcement bodies cannot ensure full compliance of all listed
companies
à most is done on a sampling basis
Alternative mechanism to communicate with investors
Due to the limitations of accounting standards, auditing, and enforcement, and the reporting credibility
problems faced by management, firms also often communicative effectively in other ways:
1. Analyst meetings
- Regular meeting with financial analysts that follow the firm
- Management will field questions about the firm’s current financial performance and
discuss future business plans
- In addition, often a director of investor relations is appointed to provide further
contact with analysts seeking for more information
o Especially, firms in industries where financial statement data fails to capture
key business fundamentals on a timely basis use these meetings
o Smaller and less heavily traded firms in particular benefit from initiating
investor conference calls
o Again, rules are in place that prevent unfair disclosure
2. Voluntary disclosure
- Accounting rules usually prescribe min. disclosure requirements, but they do not
restrict managers from voluntarily providing additional information
- Do note that those voluntary disclosures are not audited
- Constraint on expanded disclosure: competitive dynamics in product markets
o Disclosure of proprietary information on strategies and their expected
economic consequences may hurt the firm’s competitive position
• Managers thus face a trade-off between providing information useful
to investors in assessing the firm’s economic performance and
withholding information to maximize the firm’s product market
advantage
- Constraint: management’s legal liability
o Dissatisfied shareholders can potentially use forecasts and voluntary
disclosures to bring civil actions against management for providing
misleading information
• Sounds paradoxical; however, where the manager’s disclosures
good-faith estimates of future events which did not materialize or
where they used to manipulate the market?
, 3. Non-financial reporting (increasing importance)
- Not all resources and obligations can be easily and immediately expressed in
monetary terms and classified as ‘economic’
- Non-financial disclosures are commonly referred to as environmental, social, and
governance (ESG) disclosures
- Some examples of non-financial disclosures:
o Quantitative measures of carbon dioxide emissions, energy use, and water
consumption
o Actions taken to improve labour conditions and monitor labour code
o Compliance with codes or participation in training programs that aim to
reduce the use of chemicals and water
- What is relevant to report depends strongly on the industry and environment in
which a firm operates
à result: it’s almost impossible to regulate non-financial reporting using one-
size-fits-all rules
From financial statements to business analysis
Effective financial statement analysis is valuable because it attempts to get at managers’ inside
information from public financial statement data
• Intermediaries do not have direct or complete access to managers’ inside information, thus
they rely on their knowledge of the firm’s industry and its competitive strategies to interpret
financial statements
Business intermediaries use financial statements in a way they can accomplish 4 key steps:
1. Business strategy analysis
- Purpose: identify key profit drivers and business risks and assess the company’s
profit potential at a qualitative level
- Involves: analysing a firm’s industry and its strategy to create a sustainable
competitive advantage
- Enables the analyst to:
o Evaluate whether current profitability is sustainable
o Make sound assumptions in forecasting a firm’s future performance
2. Accounting analysis
- Purpose: evaluate the degree to which a firm’s accounting captures the underlying
business reality
- Enables the analyst to:
o Assess the degree of distortion in a firm’s accounting numbers
o Improve the reliability of conclusion from financial analysis
3. Financial analysis
- Purpose: use financial data to evaluate a firm’s current and past performance and
assess its sustainability
- 2 important skills related to financial analysis:
1) Analysis should be systematic and efficient
2) The analysis should allow the analyst to use financial data to explore
business issues
- Ratio analysis and cash flow analysis are the two most commonly used financial tools
4. Prospective analysis
- Purpose: focuses on forecasting a firm’s future
- Common techniques: forecasting and valuation
- The firm’s intrinsic value is a function of its future cash flow performance
o But, it’s also possible to assess a firm’s value based on its current book value
of equity and its future ROE and growth
