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10 Financial Statement Analysis

future profitability and risk are estimated, the analyst uses a valuation model to convert
these estimates into a measure of intrinsic value. Intrinsic value is used in many con-
texts, including equity investment and stock selection, initial public offerings, private
placements of equity, mergers and acquisitions, and the purchase/sale of companies
without traded securities.

Other Uses of Business Analysis
Business analysis and financial statement analysis are important in a number of other
contexts.
Managers. Analysis of financial statements can provide managers with clues to
strategic changes in operating, investing, and financing activities. Managers also
analyze the businesses and financial statements of competing companies to
evaluate a competitor’s profitability and risk. Such analysis allows for interfirm
comparisons, both to evaluate relative strengths and weaknesses and to benchmark
performance.
Mergers, acquisitions, and divestitures. Business analysis is performed when-
MERGER BOOM ever a company restructures its operations, through mergers, acquisitions, divesti-
Nearly $4 trillion worth tures, and spin-offs. Investment bankers need to identify potential targets and
of mergers occurred during determine their values, and security analysts need to determine whether and how
the dot-com era— much additional value is created by the merger for both the acquiring and the target
more than in the entire
preceding 30 years. companies.
Financial management. Managers must evaluate the impact of financing
decisions and dividend policy on company value. Business analysis helps assess the
NEW DEALS impact of financing decisions on both future profitability and risk.
Experts say the defining Directors. As elected representatives of the shareholders, directors are respon-
deals for the next decade
will be the alliance, the sible for protecting the shareholders’ interests by vigilantly overseeing the com-
joint venture, and the pany’s activities. Both business analysis and financial statement analysis aid
partnership. Such deals directors in fulfilling their oversight responsibilities.
will be more common Regulators. The Internal Revenue Service applies tools of financial statement
in industries with analysis to audit tax returns and check the reasonableness of reported amounts.
rapid change.
Labor unions. Techniques of financial statement analysis are useful to labor
unions in collective bargaining negotiations.
PROFIT TAKERS Customers. Analysis techniques are used to determine the profitability (or staying
Microsoft’s profitability power) of suppliers along with estimating the suppliers’ profits from their mutual
levels encouraged recent transactions.
antitrust actions against it.

Components of Business Analysis
Business analysis encompasses several interrelated processes. Exhibit 1.4 identifies these
processes in the context of estimating company value—one of the many important ap-
plications of business analysis. Company value, or intrinsic value, is estimated using a
valuation model. Inputs to the valuation model include estimates of future payoffs
(prospective cash flows or earnings) and the cost of capital. The process of forecasting
future payoffs is called prospective analysis. To accurately forecast future payoffs, it is im-
portant to evaluate both the company’s business prospects and its financial statements.
Evaluation of business prospects is a major goal of business environment and strategy
analysis. A company’s financial status is assessed from its financial statements using