📊Financial Information Analysis Unit 15 – Financial Analysis & Corporate Strategy

Key Concepts and Terminology

• Financial analysis involves examining financial statements and data to assess a company's financial health, performance, and future prospects
• Financial statements include the balance sheet, income statement, and cash flow statement which provide a snapshot of a company's financial position at a given point in time
• Liquidity refers to a company's ability to meet its short-term obligations and is measured by metrics such as the current ratio and quick ratio
• Solvency assesses a company's ability to meet its long-term financial obligations and is evaluated using metrics like the debt-to-equity ratio
• Profitability measures a company's ability to generate profits relative to its revenue or assets and is assessed using ratios like gross margin, operating margin, and return on equity (ROE)
• Efficiency ratios such as inventory turnover and accounts receivable turnover measure how effectively a company manages its assets and resources
• Corporate strategy encompasses the long-term goals, objectives, and plans a company develops to achieve a competitive advantage and create value for stakeholders

Financial Statement Analysis Techniques

• Horizontal analysis compares financial statement items over time, typically using a base year as a reference point to identify trends and changes in performance
• Vertical analysis expresses each financial statement item as a percentage of a base figure (total assets for the balance sheet, total revenue for the income statement) to analyze the composition and relative importance of each component
• Common-size analysis standardizes financial statements by expressing each item as a percentage of a common base, allowing for easier comparison between companies of different sizes
• Trend analysis examines the direction and rate of change in financial statement items over time to identify patterns and potential issues
• Comparative analysis compares a company's financial performance to that of its peers, industry benchmarks, or its own historical performance to gauge relative strength and weaknesses
• Ratio analysis uses financial ratios to assess various aspects of a company's financial health, such as liquidity, solvency, profitability, and efficiency

Ratio Analysis and Performance Metrics

• Liquidity ratios, such as the current ratio (current assets / current liabilities) and quick ratio (quick assets / current liabilities), measure a company's ability to meet its short-term obligations
• Solvency ratios, like the debt-to-equity ratio (total debt / total equity) and interest coverage ratio (EBIT / interest expense), assess a company's ability to meet its long-term financial obligations
• Profitability ratios, including gross margin (gross profit / revenue), operating margin (operating income / revenue), and return on equity (net income / shareholders' equity), measure a company's ability to generate profits relative to its revenue or assets
• Efficiency ratios, such as inventory turnover (cost of goods sold / average inventory) and accounts receivable turnover (net credit sales / average accounts receivable), evaluate how effectively a company manages its assets and resources
• Return on assets (ROA) measures a company's profitability relative to its total assets, calculated as net income / total assets
• Return on invested capital (ROIC) assesses the efficiency of a company's capital allocation, calculated as (net operating profit after tax) / (debt + equity)
• Economic value added (EVA) measures a company's true economic profit by subtracting the cost of capital from its operating profit

Corporate Strategy Fundamentals

• Corporate strategy defines a company's long-term goals, objectives, and plans to achieve a competitive advantage and create value for stakeholders
• Strategic planning involves analyzing the internal and external environment, setting objectives, and developing action plans to achieve those objectives
• SWOT analysis identifies a company's strengths, weaknesses, opportunities, and threats to inform strategic decision-making
• Competitive advantage refers to a company's ability to outperform its rivals by offering unique value to customers through differentiation or cost leadership
• Diversification strategies involve entering new markets or industries to reduce risk and capitalize on growth opportunities (related or unrelated diversification)
• Vertical integration occurs when a company expands its operations to include earlier or later stages of the supply chain (backward or forward integration)
• Mergers and acquisitions (M&A) are strategic transactions in which companies combine or acquire other firms to achieve growth, synergies, or market power

Valuation Methods and Models

• Discounted cash flow (DCF) valuation estimates a company's intrinsic value by discounting its expected future cash flows to the present value using a required rate of return
• The capital asset pricing model (CAPM) calculates the expected return of an asset based on its systematic risk (beta) and the market risk premium, using the formula: $E(R_i) = R_f + \beta_i(E(R_m) - R_f)$
• Relative valuation methods, such as the price-to-earnings (P/E) ratio and enterprise value-to-EBITDA (EV/EBITDA) ratio, compare a company's valuation to that of its peers or industry benchmarks
• The dividend discount model (DDM) values a company based on the present value of its expected future dividend payments, assuming a constant growth rate (Gordon growth model)
• Scenario analysis involves modeling different possible outcomes (base case, best case, worst case) to assess the potential range of a company's value
• Sensitivity analysis examines how changes in key assumptions (growth rates, discount rates) impact a company's valuation to identify the most critical variables

Risk Assessment and Management

• Business risk refers to the inherent uncertainty in a company's operations and industry, which can impact its financial performance and cash flows
• Financial risk arises from a company's use of debt financing, which increases the volatility of its earnings and the potential for financial distress
• Operational risk encompasses the potential for losses resulting from inadequate or failed internal processes, people, and systems, or from external events
• Market risk is the risk of losses due to adverse changes in market factors such as interest rates, exchange rates, and commodity prices
• Credit risk is the risk that a borrower or counterparty will default on its obligations, leading to financial losses for the lender or creditor
• Liquidity risk refers to the risk that a company will be unable to meet its short-term financial obligations due to insufficient liquid assets or access to funding
• Enterprise risk management (ERM) is a holistic approach to identifying, assessing, and managing risks across an organization to support strategic decision-making and value creation

Industry and Competitive Analysis

• Industry analysis examines the structure, dynamics, and attractiveness of an industry using frameworks such as Porter's Five Forces (threat of new entrants, bargaining power of suppliers, bargaining power of buyers, threat of substitutes, and intensity of rivalry)
• Competitive analysis assesses a company's position relative to its rivals based on factors such as market share, product differentiation, cost structure, and strategic positioning
• The industry life cycle model describes the stages of an industry's evolution (introduction, growth, maturity, decline) and the implications for competitive dynamics and strategic choices
• Benchmarking involves comparing a company's performance to industry averages, best practices, or key competitors to identify areas for improvement
• Value chain analysis examines the activities a company performs to create and deliver value to customers, identifying sources of competitive advantage and potential efficiencies
• PEST analysis assesses the macro-environmental factors (political, economic, social, and technological) that impact an industry and its participants

Financial Decision-Making and Value Creation

• Capital budgeting involves evaluating and selecting long-term investment projects based on their expected cash flows and risk-adjusted returns, using methods such as net present value (NPV) and internal rate of return (IRR)
• The weighted average cost of capital (WACC) represents a company's overall cost of financing, taking into account the proportions and costs of debt and equity, and is used as a discount rate for evaluating investments
• Dividend policy refers to a company's decisions regarding the distribution of earnings to shareholders, balancing the need for reinvestment with the desire to provide shareholder returns
• Capital structure optimization involves determining the mix of debt and equity financing that maximizes a company's value while minimizing its cost of capital
• Working capital management focuses on optimizing the levels of current assets (inventory, accounts receivable) and current liabilities (accounts payable) to ensure sufficient liquidity and operational efficiency
• Value-based management (VBM) aligns a company's strategic and operational decisions with the ultimate goal of maximizing shareholder value, using metrics such as economic value added (EVA) and return on invested capital (ROIC)
• Corporate governance encompasses the systems, processes, and practices that ensure the effective oversight and alignment of interests between a company's management, board of directors, and shareholders