Business Analysis and
Valuation
Instructor - Dr. Mohit Kumar
Nokia (2011)
What Went Wrong: Nokia's management and analysts failed to
foresee the rapid shift in consumer preferences towards
smartphones and the importance of software ecosystems. They
underestimated the threat posed by competitors like Apple and
Android.
Blockbuster (2010)
What Went Wrong: Business analysts and executives at
Blockbuster failed to recognize the disruptive potential of digital
streaming services like Netflix. They continued to invest in
physical rental stores instead of developing a robust digital
strategy.
Kodak (2012)
What Went Wrong: Kodak's business analysis underestimated
the speed and impact of the shift from film to digital
Who you are?
• Investor
• Management
• Regulator
• Auditor
• Consultant
Module 1:
Framework for
Business Analysis
and Valuation
• Introduction
• Role of financial reporting in capital
markets
• Business activities to financial statement
• Financial statement of business analysis
The Role of Financial Reporting in Capital Markets
Capital Markets
1. Financial
Entrepreneurs
Individual Institutions
• 2. Information Business
Doubt analyzer
• ideas
Lack of 3. Transaction
Objectives of Accounting
resources to find outAnalysis Facilitators
4. Regulators
issues
• Lack of information
Accounting Analysis - Goal
Challenges in Capital Markets
Imperfection from financial intermediaries.
The governance issues
Conflict of interest
Introduction
The Enron scandal was a major corporate fraud that led to the
bankruptcy of Enron Corporation, an energy, commodities, and services
company, in 2001. It also caused the dissolution of Arthur Andersen LLP,
one of the world's largest auditing firms. This scandal had widespread
repercussions and led to significant changes in accounting and corporate
governance practices.
Founding and Growth of Enron
•1985: Enron was founded by Kenneth Lay through the merger of
Houston Natural Gas Corporation and InterNorth, Inc.
•Transformation: Under Jeffrey Skilling, Enron shifted from operating
pipelines to trading energy derivative contracts, allowing producers to
stabilize prices.
•Aggressive Culture: Skilling created a competitive environment
focused on rapid trading and high profits. Andrew Fastow, the CFO,
developed complex financial instruments to support this strategy.
Downfall and Bankruptcy
•Increased Competition: Enron's profits began to decline due to increased competition in the
energy trading market.
•Dubious Accounting Practices: Executives used "mark-to-market accounting" to record
projected profits as current income, creating an illusion of higher profits. Troubled assets were
hidden in special purpose entities (SPEs), keeping them off Enron's balance sheet.
•Leadership Changes: In 2001, Skilling became CEO but resigned shortly after. Kenneth Lay
resumed the CEO role.
•Financial Troubles: Enron announced significant losses and shareholder equity reductions in
2001, leading to SEC investigations and document shredding by Arthur Andersen.
Impact and Aftermath
•Bankruptcy: Enron's stock plummeted, and the company filed for Chapter 11 bankruptcy in
December 2001.
•Legal Consequences: Many executives were convicted of fraud and conspiracy. Arthur
Andersen was indicted for obstruction of justice and lost its auditing license.
•Regulatory Changes: The Sarbanes-Oxley Act (2002) was enacted to improve financial
reporting accuracy and impose stricter penalties for corporate fraud. It also restricted auditing
From Business Activities to Financial Statements
Managerial Responsibilities and Value Creation
Objectives of Accounting Analysis
• Resource Acquisition: Corporate managers are tasked with acquiring both
physical and financial resources from the external environment.
• Value Creation: The goal is to create value for investors by earning returns
on investment
Accounting Analysis -that
Goalexceed the cost of capital.
• Business Strategies: Managers develop and implement business strategies
to achieve this goal through various business activities.
Accounting Analysis
Objectives of Accounting Analysis
Accounting Analysis - Goal
Accounting Analysis
• Role of Financial Statements: These documents summarize the economic outcomes of
a firm’s numerous and varied business activities over a specific period.
• Proprietary Activities: Some business activities are proprietary and cannot be disclosed
Objectives of Accounting Analysis
in detail without harming the firm’s competitive position.
• Accounting System: This system selects, measures, and aggregates business activities
into financial statement data.
Accounting
InfluenceAnalysis - Goal
of the Accounting System
• Intermediaries' Awareness: Those using financial statement data for business analysis
must understand how the firm's accounting system influences the quality of this data.
• Institutional Features: The inherent characteristics and rules of the accounting system
impact how business activities are reflected in financial statements.
The Institutional Features of Accounting Systems
Accounting System Feature 1: Accrual Accounting
• Accrual vs. Cash Accounting: Corporate financial reports are prepared using accrual
Objectives of Accounting
accounting, Analysis
which records costs and benefits of economic activities based on expectations,
not just actual cash flows. This contrasts with cash accounting, which only records cash
transactions.
• Net Income Measurement: Net income is computed by recognizing expected cash receipts
Accounting Analysis - Goal
as revenues and associated expected cash outflows as expenses.
• Periodic Reporting: Investors demand periodic financial reports, leading to the need for
accrual accounting to provide a more complete picture of a firm’s performance than cash
accounting can.
Accounting System Feature 2: Accounting Convention,
Standards and Auditing
Accrual accounting is subjective and relies on estimates and
Complexity of Accrual Accounting
assumptions.
Managerial discretion in accounting allows reflection of inside
information but also poses the risk of profit distortion due to
Accounting Discretion
biases and incentives.
Objectives of Accounting Analysis
Measurability and conservatism conventions help mitigate
Accounting Conventions optimistic biases by imposing a pessimistic bias
Generally Accepted Accounting Principles (GAAP) and similar
Uniform
Accounting Standards
Analysis - Goal standards reduce potential distortions
Rigid standards are useful for straightforward transactions but
can be dysfunctional for complex ones requiring business
Rigid vs. Flexible Standards
judgment
External auditing ensures consistency and reasonableness in
the use of accounting rules and estimates, improving data
Auditing
quality.
The threat of legal liability improves disclosure accuracy but
The Institutional Features…
Accounting System Feature 3: Managers’ Reporting Strategy
• Balance of Regulation and Flexibility: Complete elimination of managerial flexibility
through regulation is not optimal. Real-world systems allow managerial influence on
Objectives of Accounting Analysis
financial data.
• Reporting Strategy: Managers' accounting and disclosure choices significantly affect
financial statements, offering varying degrees of clarity regarding the firm’s economic
reality.
Accounting Analysis - Goal
• Disclosure Policies: Managers can select from a broad set of accounting alternatives
and are responsible for a range of estimates. Minimum disclosure requirements are
prescribed, but voluntary disclosures are not restricted.
• Superior Disclosure Strategy: Effective disclosure communicates the business reality,
while competitive dynamics may limit the extent of disclosure to protect the firm’s
position.
•
FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS
Objectives of Accounting Analysis
Accounting Analysis - Goal
[Link] Strategy Analysis 2. Accounting
Analysis
[Link]: Identify key profit drivers and business
[Link]: Evaluate how well a firm's accounting
risks, and assess the company's profit potential
captures underlying business reality.
qualitatively.
[Link] Flexibility: Identify areas of accounting
Objectives of and
[Link] Accounting Analysis
Competitive Strategy: Analyze the
flexibility and assess the appropriateness of
firm's industry and strategy to create a sustainable
accounting policies and estimates.
competitive advantage.
[Link] Correction: Recast accounting numbers to
[Link]: This qualitative analysis helps frame
eliminate distortions and create unbiased data.
subsequent accounting and financial analyses,
[Link]: Improved reliability of conclusions derived
guiding assumptions for future performance
from financial analysis.
forecasts.
[Link]: Understanding key success factors and
business risks, and evaluating the sustainability of
current profitability.
3. Financial Analysis 4. Prospective Analysis
•Objective: The final step in business analysis, prospective analysis,
[Link]: Evaluate a firm's current and past
focuses on forecasting a firm's future performance.
performance, and assess its sustainability.
•Techniques:
[Link] Required: Conduct systematic and efficient • Financial Statement Forecasting: Project future financial
Objectives
analysis,of Accounting
and Analysis
use financial data to explore business performance based on historical data and analysis.
issues. • Valuation: Estimate the firm's intrinsic value by synthesizing
[Link]: insights from business, accounting, and financial analyses.
[Link] Analysis: Evaluate product market Framework for Estimating Firm Value
performance and financial policies. •Future Cash Flow Performance: The primary determinant of a
[Link] Flow Analysis: Assess liquidity and firm's value is its future cash flows.
•Book Value of Equity and ROE: It is also possible to assess value
financial flexibility.
based on the firm's current book value of equity, future return on
[Link]: A comprehensive understanding of the
equity (ROE), and growth.
firm’s financial health. Foundation from Previous Analyses
•Strategy Analysis: Accounting Analysis: Financial Analysis: