When can financial analysis can add
value, even if capital markets are efficient?
The efficient market hypothesis states that all information is fully reflected in the stock price.
There must be mispricing in the markets that can be corrected it is during this time of non-correction through the use of financial analysis that creates value for investors
Strategies can be used to exploit publicly available data that is often ignored during the price setting process such as determining the value of a company targeted for acquisition, estimate the share price of a company undertaking an IPO, and predict how sustainable a company is.
Four steps for business analysis are discussed in this chapter (strategy analysis, accounting analysis, financial analysis and prospective analysis). As a financial analyst, explain why each of these steps is a critical part of your job and how they relate to one another.
- Strategy Analysis identifies how an organisation creates it’s competitive advantage and whether or not that translates into sustainability and successful performance in the future.
- Accounting analysis removes distortions by recasting financial statements in order to improve reliability.
- Financial analysis is used to evaluate the financial performance of a firm through the use of cash flows and ratio analysis.
- Prospective analysis combines strategy, accounting analysis, financial analysis in order to make predictions about the future.
Accounting statements rarely report financial performance without error. List three types of errors that can arise in financial reporting.
- Errors introduced by rigidity in accounting rules: Errors are introduced because they restrict management’s ability of accounting choice, limiting what can be revealed through accounting choice.
- Random forecasting errors occur because management cannot predict future consequences that occur from current transactions.
- Managers accounting choices: managers may introduce errors into financial reporting due incentives associated financial performance.
Would financial statement analysis still be necessary if managers reported truthfully and fully on the firm’s performance? Why or why not?
Financial statement analysis includes more than viewing historical financial performance of the firm but describes the strengths and weaknesses of the firm that can be projected into the future in order to provide a valuation of the business.
Explain voluntary disclosure of information in financial reports as a solution to the ‘lemons problem’ described in the chapter. Is it a full solution or a partial solution? Why?
Voluntary disclosure refers to managers who report noncompulsory information that is verified by reporters, the information refers to ideas from the managers that appear to be superior to others managers. These include market research on product demand, the morale of staff. However Voluntary disclosure is only a partial solution because it can be imitated by managers as well as they are not audited thus making it difficult for verification of reliability.
What are the advantages and disadvantages of accounting standards for financial statement analysis?
Advantages:
- Consistent information in a consistent format that enables the comparison of separate financial statements in the present time as well as comparison over a duration of time.
- Reduction of reporting flexibility in order to reduce distortion of the reporting of data.
Disadvantages:
- The reduction in flexibility prevents managers reporting differences in genuine business issues because of the amount of information required to assess a decision.
- Encourage the use of resources in order to achieve a desired accounting result.
Research demonstrates that managers usually report truthfully, rather than seeking to distort the firm’s performance and financial position. Explain why accounting analysis is still an important step in financial statement analysis.
. Accounting analysis allows analysts to uncover financial statements whose managers have not genuinely disclosed reliable information.
. Accounting analysis assists in the discovery of further information that may have not been completely disclosed by the reporting manager.
. Accounting analysis demonstrates the reporting style of managers including the accounting policies used and the estimates that the manager has made
Your brother, who works in a bank, has recommended to you that you purchase shares in an organisation, on the basis of the following information, which he has heard discussed around the office:
Total assets have increased by 33%.
Revenue has increased by 12%.
Profit after tax has decreased by 4%.
The dividend per share is 23¢.
The current share price is $8.50, whereas 12 months ago it was $7.50.
Would you invest in this organisation? What information encourages you to do so, and what reasons might you have for hesitating? What additional information would you like before making this decision, and where might you find that information?
The information that encourages you to invest in the increase in revenue and total assets which is supported by the increase in the current share price.
The information that discourages you to invest is the decrease in profit and the low dividend yield.
Addition questions:
- How were the assets financed?
- Why have expenses increased if revenue has increased but profit has fallen?
- What was the previous dividend provision?
- How does the organisation compare in performance to competitors?
- Is the information provided reliable?
Discuss the effective functioning of capital markets in Australia during and immediately after the Global Financial Crisis (GFC). How was the raising of finance affected by the GFC and what was the role of governance guidelines in supporting it?
It was difficult to raise capital, those were seeking to raise finance were more likely to issue equity, there was a preference to raise capital from private sources of finance which meant that companies were less publicly exposed to a possible failure of raising funds.
Discuss the intended roles of the institutions and intermediaries discussed in the case, such as central banks (e.g., the U.S. Federal Reserve), stock exchanges (e.g., ASX), individual banks and governments. Are their incentives aligned properly with their intended role? Whose incentives are most misaligned? At what stage of the economic cycle are the misalignments more pronounced?
Central Banks: Protect national deposits and national systemic stability which is achieved through monetary policy and capital markets.
Stock Exchanges: Keep capital markets functioning smoothly and assist companies to raise finance.
Individual Banks: They are responsible to their shareholders and depositors through their focus on profitability and market share.
Governments: Ensure that the national activity and distribution of wealth provides a benefit to the population as a whole, this is achieved through the implementation of fiscal policies, social programs. However, their aim is not for the long-term but rather the election duration.
- Who if anyone was primarily responsible for the GFC?
There were multiple factors that contributed to the GFC including the housing bubble collapse in the U.S as well as poor quality housing loans that were made that ultimately contributed to the housing bubble collapse. Also, globalisation was also a contributing factor which cause governments and national institutions to relax policies and competition for growth and finance.
- What are the costs of such an event? As a future business professional, what lessons do you draw from it?
The cost of the GFC are the loss of enourous wealth from both an individual level as well as an institutional level, there also the loss of innovation and national economic growth.
The lessons to be learned from the GFC is that the future does not always guarantee growth or a smooth path but rather a highly volatile one.
