Financial Statement Analysis and

Business Valuation

Step 1
Qualitative Analysis

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 5 steps to analyzing a company

• (1) Qualitative analysis

• Understand the firm’s business model
• (2) Reading financial statements
• Examine the balance sheet and income statement. Is
there any particular item that stands out?
• (3) Financial statement analysis
• What drives profitability?
• What is the firm’s capital structure?
• Can the firm cover its liabilities and interest
payments?

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 5 steps to analyzing a company

• (4) Forecast future financial statements

• Financial statement analysis establishes where the
firm is now
• Forecasting asks how it will be different in the
future
• (5) Conduct valuation
• Convert forecasts in the future financial statements
to a valuation.
• Is the company’s stock price over-valued, under-
valued or correctly priced?
• If the company does not have publicly traded stock,
how much would you pay in order to acquire the
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company? How much is it worth?
 Step 1. Qualitative analysis

• Understand the firm’s business model

What is the production process?
What is the selling process?
When does the cash come in?
How much competition does it face?
What do these imply about fixed assets, working
capital, inventories, profit margins?
How does it make money?
Is it in a growing phase or in a mature phase?
Does it need capital? How does it raise capital?
Borrowing or equity?
Compare with competitors.
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 Step 1. Qualitative analysis

• How do the answers to the questions in the

previous slide translate into figures in the
financial statements?
What is the production process?
•Example: What differences do we expect to see in
the financial statements of two companies in the
same industry, one producing everything in-house,
and the other outsourcing production?

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 Step 1. Qualitative analysis

• How do the answers to the questions in the

previous slide translate into figures in the
financial statements?
What is the selling process?
•Example: What differences do we expect to see in
the financial statements of two retailers, one brick-
and-mortars retailer, and the other selling online?

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 Step 1. Qualitative analysis

• How do the answers to the questions in the

previous slide translate into figures in the
financial statements?
When does the cash come in?
•Example: Compare a company that sells directly to
the final consumer with a company that sells its
products to other companies (e.g. a manufacturer of
spare parts for cars)

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 Step 1. Qualitative analysis

• How do the answers to the questions in the

previous slide translate into figures in the
financial statements?
When does the cash come in?
•How about
–An aircraft manufacturer?
–A defense contractor?
–A real estate developer?

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 Step 1. Qualitative analysis

• How do the answers to the questions in the

previous slide translate into figures in the
financial statements?
Is it in a growing phase or in a mature phase?

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 Step 1. Qualitative analysis

• Stock analysts usually focus on one industry,

where they can understand the economics,
different business models etc.

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 Step 1. Qualitative analysis

• Throughout the course, we will use the example of

Prada S.p.A. (1913:HK) to demonstrate the analysis.
 http://www.hkex.com.hk/eng/invest/company/profile_page_e.asp?WidCoID
=01913&WidCoAbbName=&Month=&langcode=e
• Prada is an Italian luxury brand, founded in 1913 in
Milan.
• The company was not publicly listed until 24 June
2011, when it listed in the Hong Kong Stock Exchange.
• Prada S.p.A. is the publicly listed holding company of
Prada Group.
 http://www.pradagroup.com/en/home

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Step 2. Reading financial statements

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 Step 2. Reading financial statements

• Examine the balance sheet and income

statement
Is there any particular item that stands out?
What is the growth in sales and assets?
Are the numbers in line with your
expectations from Step 1 or is there any
obvious discrepancy?
Do not compute any ratios yet

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 Refreshing our memory:
The balance sheet and the income statement

31 Dec 2010 31 Dec 2011 31 Dec 2012

Balance Balance Balance

Sheet Sheet Sheet

Income Income
Statement Statement

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 Balance Sheet

• The balance sheet gives the value of the owners’

(shareholders’) investment in the firm at a given
point in time
• Alternatively, it’s a list of the firm’s assets and
how they are financed at a given point in time

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 Balance Sheet

• Since all assets must have been financed

somehow, someone provided the funds to
acquire every asset listed on the balance sheet,
through a loan that has to be repaid,
as capital contributed by the owners,
through accumulated profits,
by selling another asset,
• then as an identity
Assets = Liabilities + Stockholders’ Equity
• Assets are listed in order of liquidity
Ease of conversion to cash
Without significant loss of value
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 The Balance Sheet

Total Value of Assets Total Value of Liabilities

and Shareholders’ Equity

Net
Working Current liabilities
Capital
Current Assets

Long-term debt
Fixed assets

1. Tangible fixed
assets
2. Intangible fixed Shareholders’ equity
assets

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 Market Vs. Book Value

• The balance sheet provides the book value of

the assets, liabilities and equity.

• Market value is the price at which the assets,

liabilities or equity can actually be bought or
sold.

• Market value and book value are often very

different.

• Market value is what we will try to estimate in

this course.
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 Income Statement

• The income statement shows the changes in value of

the owners’ investment (i.e. shareholders’ equity)
from one balance sheet to the next

• You generally report revenues first and then deduct

any expenses for the period

• Matching principle – show revenue when it accrues

and match the expenses required to generate the
revenue (i.e. NOT when they are received or paid)

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 Question!!!!!

• Is it possible for a company to show large

profits in its income statement and go
bankrupt at the same time?
• Assume that the numbers in the financial
statements are real (i.e. no fraud)

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 Manipulating financial statements

• During 2001-2002, a series of accounting

scandals involving prominent U.S. companies
presented numerous examples on how
financial statements can be manipulated.
Bausch & Lomb
Worldcom
Enron
• When these scandals broke out, they were also
instrumental in precipitating the demise of
Arthur Andersen, one of the top five auditing
firms worldwide at the time.
Arthur Andersen had been the auditors of both
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Worldcom and Enron.
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 Manipulating financial statements

• Bausch & Lomb

The company manipulated financial statements by
recording large values of sales just before the end
of the financial year (or quarter).
Despite the fact that the customers did not pay
cash and probably wouldn’t pay at all, recording
large sales in the income statement led to higher
reported profits for the year/quarter in question.

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 Manipulating financial statements

• Worldcom
Instead of subtracting some expenses from
revenues in the income statement (and showing
lower profits), it treated these expenditures as
purchase of capital goods (i.e. fixed assets).
Therefore, the company did not have to subtract
the whole value of the expenses all at once, but
could subtract it over a large number of financial
years as depreciation.
By subtracting a lower amount of annual expenses,
the company reported higher profits on a yearly
basis.
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 Manipulating financial statements

• Enron
Manipulated debt levels (long-term liabilities).
Created special purpose entity (SPE) partnerships in
secretive locations, and placed part of its debt with
them. Some of these entities were not consolidated on
its balance sheet, and their debt did not appear as owed
by Enron, although in fact, as a partner, Enron was
essentially guaranteeing this debt.
Received loans from banks, which it did not report as
loans on the balance sheet. Instead, it reported them as
energy trades “pre-paid” by the banks. Therefore, not
only did the loans not appear on the firm’s balance
sheet but the cash received also appeared as part of its
revenues, thus reducing debt and increasing profits. 26
 Working capital

• The firm’s ultimate objective is to generate

cash for its shareholders.

• To do so, it must make two types of

investments.
First, it must invest in fixed assets.
Second, it must invest in its operating cycle.

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 Working capital

• The firm’s operating cycle starts with the

procurement of raw materials,
which are then used in the production process,
and the finished product is sold in order to
generate cash for the firm.

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 Working capital

• In order to support this operating cycle the

firm must make some investment (over and
above the investment it has already made in
fixed assets).

• What is the nature of this investment in the

operating cycle?
• Let’s assume that the firm is about to begin
operations for the very first time, and that the
fixed assets are already in place.

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 Working capital

• First, the firm must purchase a stock of raw

materials that will be later used in production.

• Second, it starts production by drawing down

the raw materials inventory. Finished goods
become part of the finished goods inventory
and goods that are not yet complete become
part of the work-in-progress inventory.

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 Working capital

• Third, after the build-up of a significant

finished goods inventory, the firm can start
shipping products to its clients or distributors
and making sales.

• Notice that not all sales are settled in cash.

Most customers will be invoiced and they may
have the option to settle bills later.
As long as the customers haven’t settled their bills,
the sales generate accounts receivable.

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 Working capital

• Fourth, once the first customers start settling

their bills, the firm converts the accounts
receivable into cash.

• It is only at this point that it receives the cash.

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 Working capital

• Fifth, in the same way that its customers will

settle their bills later, the firm may also take its
time to pay its suppliers of raw materials.

• As long as it hasn’t paid its obligations, its

expenses will generate accounts payable.

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 Working capital

• This process means that there could be a long

delay of at least several days or even months
from the time the firm purchases the first raw
materials until it receives the first cash.

• During all this time, the firm must be able to

operate without receiving cash.

• It must have funds in-hand to meet these

obligations.

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 Working capital

• These funds represent the investment in the

firm’s operating cycle or its working capital
requirement (WCR).

WCR = [Accounts receivable + Inventories +

Prepaid expenses] – [Accounts payable + Accrued
expenses]

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 665,929
1,654,093
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 665,929
1,654,093
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Paid-in
Common
Capital

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Retained
Earnings

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(12,956)
6,791

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(12,956)
6,791

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Net Interest Expense

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Non-Operating
Income (Loss)

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