Financial Analysis Lecture I

Academic Year 2011-12 Trimester II

Basic Study Plan

(A) Textbooks 1. Palepu, Healy & Bernard Business Analysis & Valuation using financial statements, Third Edition India Edition 2006 2. Charles H Gibson Analysis of Financial Statements: India Edition 2009 (B) Financial Analysis of companies and other tasks, in groups, as per the next slide

The Companies/Issues for Financial Analysis

Basic background material, mostly up-to-date, e.g. B/S as of 31/03/11 is being made available to you today. You will obtain the other material from the corporate/other websites
Group 1: Ambuja Cements: Company Analysis Group 2: DR Reddy s: Company Analysis Group 3: HCL Technologies (June 10 B/S): Company Analysis Group 4: ITC: Company Analysis Group 5: Jyoti Structures Issue of NCDs with warrants (convertible into equity shares) Group 6: Mphasis: Company Analysis Group 7: MTNL (Mar 10 B/S): Company Analysis Group 8: Network 18 Media & Investments: Company Analysis Group 9: ONGC: Company Analysis Group 10: Siemens Offer to acquire shares by Siemens AG

The Next Class

One or two persons from each group to present (not more than 3 slides can be used) the group s view about the company, the industry, the task on hand and how the group will go about performing the task, and the aspects that will receive the focus of attention of the group About the company, you may talk about the activity(ies) that it is engaged in, its market position, the nature of the industry that it operates in, etc.

Key components of Company Analysis which you will do

Promoters/Group Business Strategy Analysis Accounting Analysis Financial Analysis Prospective Analysis & Valuation

Promoters
The various companies in the group related, diverse Historical background the story so far Corporate governance track record reputation Management of the companies professionally managed, family owned, etc View of the future the game plan for growth

Business Strategy Analysis

The purpose of business strategy analysis is: 1. to identify key profit drivers and business risks, and 2. to assess the company s profit potential at a qualitative level. Business strategy analysis involves analyzing: 1. a firm s industry, and 2. its strategy to create a sustainable competitive advantage.

Accounting Analysis
The purpose of accounting analysis is to evaluate the degree to which a firm s accounting captures the underlying business reality. By identifying places where there is accounting flexibility, and by evaluating the appropriateness of the firm s accounting policies and estimates, analysts can assess the degree of distortion in a firm s accounting numbers. Another important step in accounting analysis is to undo any accounting distortions by recasting a firm s accounting numbers to create unbiased accounting data.

Financial Analysis
The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to assess its sustainability. Second, 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. Ratio analysis focuses on evaluating a firm s product market performance and financial policies. Cash flow analysis focuses on a firm s liquidity and financial flexibility.

Prospective Analysis
Prospective analysis, which focuses on forecasting a firm s future, is the final step in business analysis. Two commonly used techniques in prospective analysis are: 1. financial statement forecasting, and 2. valuation.

Prospective Analysis . Contd.

While the value of a firm is a function of its future cash flow performance, it is also possible to assess a firm s value based on the firm s current book value of equity, and its future return on equity (ROE) and growth. Strategy analysis, accounting analysis, and financial analysis, the first three steps in the framework discussed here, provide an excellent foundation for estimating a firm s intrinsic value.

Influence of the accounting system on the quality of the financial statements

A key aspect of financial statement analysis, involves understanding the influence of the accounting system on the quality of the financial statement data being used in the analysis. One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. The use of accrual accounting lies at the center of many important complexities in corporate financial reporting. Because accrual accounting deals with expectations of future cash consequences of current events, it is subjective and relies on a variety of assumptions.

Influence of the accounting system contd. Accounting Standards & Auditing

A number of accounting conventions have evolved to ensure that managers use their accounting flexibility to summarize their knowledge of the firm s business activities, and not to disguise reality for self-serving purposes. For example, the measurability and conservatism conventions are accounting responses to concerns about distortions from managers potentially optimistic bias. Both these conventions attempt to limit managers optimistic bias by imposing their own pessimistic bias. Auditing, broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable.

Influence of the accounting system contd. Managers Reporting Strategy

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 businesses. A superior disclosure strategy will enable managers to communicate the underlying business reality to outside investors. One important constraint on a firm s disclosure strategy is the competitive dynamics in product markets. Disclosure of proprietary information about business strategies and their expected economic consequences may hurt the firm s competitive position. Subject to this constraint, managers can use financial statements to provide information useful to investors in assessing their firm s true economic performance.

The Context
The exact nature of the analysis depends on the context. The contexts that you might examine include: 1. securities analysis, 2. credit evaluation, 3. mergers and acquisitions, 4. evaluation of debt and dividend policies, and 5. assessing corporate communication strategies. The four analytical steps discussed today are useful in each of these contexts.