Palepu35098 0170135098 02.01 Chapter01

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Business Analysis and Valuation - Using Financial
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Statements
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Title: Business analysis and valuation : using financial statements / Sue
Fourth edition of Business Analysis & Valuation: Using
Wright ... [et al.].
Financial Statements, published by South-Western, a

division of Cengage Learning in 2008
Edition: 1st ed.

ISBN: 9780170135092 (pbk.)
Notes: Includes index.
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Subjects: Business enterprises--Valuation--AsiaPacific. Financial

statements--Australasia.
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CHAPTER 1
A FRAMEWORK
FOR BUSINESS
A N A LY S I S
A N D VA L U AT I O N
USING FINANCIAL
S TAT E M E N T S
This chapter outlines a comprehensive framework for financial

statement analysis. Because financial statements provide the most
investors and other stakeholders rely on financial reports to assess
acquire this organisation? How can we finance the acquisition?
using financial statements, as shown in the following examples:
s financial
these financial reports
communicate the current status and significant risks of the
A loan officer may need to ask: What is the credit risk involved in
s financing and dividend policies?
financial

CHAPTER 1
A F R A M E W O R K F O R B U S I N E S S A N A LY S I S A N D V A L U A T I O N U S I N G F I N A N C I A L S T A T E M E N T S
o understand the contribution that financial statement analysis

the role of financial reporting
that shape financial statements. Therefore we present first a brief
to uncover inside information from analysing financial statement
from financial statements and provide valuable forecasts.
THE ROLE OF FINANCIAL

R E P O R T I N G I N C A P I TA L
MARKETS
A critical challenge for any economy is the allocation of savings to investment opportunities. Economies
that do this well can exploit new business ideas to spur innovation and create jobs and wealth at a rapid
pace. Incontrast, economies that manage this process poorly dissipate their wealth and fail to support
business opportunities.
Figure 1.1 provides a schematic representation of how capital markets typically work. Savings in
any economy are widely distributed among households. There are usually many new entrepreneurs and
existing companies that would like to attract these savings to fund their business ideas. While both savers
and entrepreneurs would like to do business with each other, matching savings to business investment
opportunities is complicated for at least two reasons. First, entrepreneurs typically have better information
than savers on the value of business investment opportunities. Second, communication by entrepreneurs to
investors is not completely credible because investors know entrepreneurs have an incentive to inflate the
value of their ideas.
These information and incentive problems lead to what economists call the lemons problem, which
can potentially break down the functioning of the capital market.1 Itworks like this. Consider a situation
Savings
Financial
Intermediaries
Information
Intermediaries
Business
Ideas
Figure 1.1
iChapters User
4
PART 1 FRAMEWORK
where half the business ideas are good and the other half are bad. Ifinvestors cannot distinguish between
the two types of business ideas, entrepreneurs with bad ideas will try to claim that their ideas are as
valuable as the good ideas. Recognising this possibility, investors value both good and bad ideas at an
average level. Unfortunately, this penalises good ideas, and entrepreneurs with good ideas find the terms
on which they can get financing to be unattractive. Asthese entrepreneurs leave the capital market, the
proportion of bad ideas in the market increases. Over time, bad ideas crowd out good ideas and investors
lose confidence in this market.
The emergence of intermediaries can prevent such a market breakdown. An intermediary is like a car
mechanic who provides an independent certification of a used cars quality to help a buyer and seller agree
on a price. There are two types of intermediaries in the capital markets. Financial intermediaries, such as
venture capital organisations, banks, superannuation funds, managed funds and insurance companies,
focus on aggregating funds from individual investors and analysing different investment alternatives
to make investment decisions. Information intermediaries, such as auditors, financial analysts, creditrating agencies and the financial press, focus on providing information to investors (and to financial
intermediaries who represent them) on the quality of various business investment opportunities. Both
types of intermediaries add value by helping investors distinguish between good investment opportunities
and bad ones.
Financial reporting plays a critical role in the functioning of both the information intermediaries and
the financial intermediaries. Information intermediaries add value either by enhancing the credibility of
financial reports (as auditors do) or by analysing the information in the financial statements (as analysts
and the rating agencies do). Financial intermediaries rely on the information in the financial statements
to analyse investment opportunities, and supplement this information with other sources of information.
Inthe following section, we discuss key aspects of the financial reporting system design that enable it to
effectively play this vital role in the functioning of the capital markets.
FROM BUSINESS ACTIVITIES

T O F I N A N C I A L S TAT E M E N T S
Corporate managers are responsible for acquiring physical and financial resources from the organisations
environment and using them to create value for the organisations investors. Value is created when the
organisation earns a return on its investment in excess of the cost of capital. Managers formulate business
strategies to achieve this goal, and they implement them through business activities. Anorganisations
business activities are influenced by its economic environment and its own business strategy. The economic
environment includes the organisations industry, its input and output markets, and the regulations under
which it operates. The organisations business strategy determines how it positions itself in its environment
to achieve a competitive advantage.
As shown in Figure 1.2, an organisations financial statements summarise the economic consequences
of its business activities. The organisations business activities in any time period are too numerous to
be reported individually to outsiders. Further, some of the activities undertaken by the organisation are
proprietary in nature, and disclosing these activities in detail could be detrimental to the organisations
competitive position. The organisations accounting system provides a mechanism through which business
activities are selected, measured and aggregated into financial statement data.
Intermediaries using financial statement data to do business analysis have to be aware that financial
reports are influenced both by the organisations business activities and by its accounting system. Akey
aspect of financial statement analysis, therefore, involves understanding the influence of the accounting

CHAPTER 1
system on the quality of the financial statement data being used in the analysis. The institutional features of
accounting systems discussed below determine the extent of that influence.
Accounting System Feature 1: Accrual Accounting

One of the fundamental features of corporate financial reports is that they are prepared using accrual rather
than cash accounting. Unlike cash accounting, accrual accounting distinguishes between the recording of
costs and benefits associated with economic activities and the actual payment and receipt of cash. Profit
is the primary periodic performance index under accrual accounting. Tocompute profit, the effects of
economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and
payments. Expected cash receipts from the delivery of products or services are recognised as revenues, and
expected cash outflows associated with these revenues are recognised as expenses.
The need for accrual accounting arises from investors demand for financial reports on a periodic basis.
Because organisations undertake economic transactions continually, the arbitrary closing of accounting
books at the end of a reporting period leads to a fundamental measurement problem. Since cash accounting
does not report the full economic consequence of the transactions undertaken in a given period, accrual
accounting is designed to provide more complete information about an organisations periodic performance.
Business Environment
Business Strategy
Labour markets
Capital markets
Product markets:
Suppliers
Customers
Competitors
Business regulations
Scope of business:
Degree of diversification
Type of diversification
Competitive positioning:
Cost leadership
Differentiation
Key success factors and
risks
Business Activities
Operating activities
Investment activities
Financing activities
Accounting Strategy
Accounting Environment
Capital market structure

Contracting and
governance
Accounting conventions
and regulations
Tax and financial
accounting linkages
Third-party auditing
Legal system for
accounting disputes
Accounting System
Measure and report

economic
consequences of
business activities.
Choice of accounting
policies
Choice of accounting
estimates
Choice of reporting format
Choice of supplementary
disclosures
Financial Statements
Managers superior
information on
business activities
Estimation errors
Distortions from
managers accounting
choices
Figure 1.2

6
PART 1 FRAMEWORK
Accounting System Feature 2: Accounting

Standards and Auditing
The use of accrual accounting lies at the centre of many important complexities in corporate financial
reporting. Because accrual accounting deals with expectations of future cash consequences of current
events, itis subjective and relies on a variety of assumptions. Who should be charged with the primary
responsibility of making these assumptions? Anorganisations managers are entrusted with the task of
making the appropriate estimates and assumptions to prepare the financial statements because they have
intimate knowledge of their organisations business.
The accounting discretion granted to managers is potentially valuable because it allows them to reflect
inside information in reported financial statements. However, since investors view profits as a measure of
managers performance, managers have incentives to use their accounting discretion to distort reported
profits by making biased assumptions. Further, the use of accounting numbers in contracts between the
organisation and outsiders provides another motivation for management manipulation of accounting
numbers. Income management distorts financial accounting data, making them less valuable to external
users of financial statements. Therefore, the delegation of financial reporting decisions to corporate
managers has both costs and benefits.
A number of accounting conventions have evolved to ensure that managers use their accounting
flexibility to summarise their knowledge of the organisations business activities, and not to disguise reality
for self-serving purposes. For example, the measurability and conservatism conventions are accounting
responses to concerns about distortions from managers potentially optimistic bias. Both these conventions
attempt to limit managers optimistic bias by imposing their own pessimistic bias.
Accounting standards also limit potential distortions that managers can introduce into reported numbers.
Uniform accounting standards attempt to reduce their ability to record similar economic transactions in
dissimilar ways, either over time or across organisations. Inthe past, accounting standards have been set by
national standard-setting bodies, such as the Australian Accounting Standards Board (AASB) in Australia
and the Financial Reporting Standards Board (FRSB) in New Zealand. Recently more than 70 countries
worldwide, including Australia and New Zealand, have adopted International Financial Reporting
Standards (IFRS) promulgated by the International Accounting Standards Board (IASB).
Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility
for managers to reflect genuine business differences in their organisations financial statements. Rigid
accounting standards work best for economic transactions whose accounting treatment is not predicated
on managers proprietary information. However, when there is significant business judgement involved
in assessing a transactions economic consequences, rigid standards that prevent managers from using
their superior business knowledge would be dysfunctional. Further, ifaccounting standards are too rigid,
they may induce managers to expend economic resources to restructure business transactions to achieve a
desired accounting result.
Auditing, broadly defined as a verification of the integrity of the reported financial statements by
someone other than the preparer, ensures that managers use accounting rules and conventions consistently
over time, and that their accounting estimates are reasonable. Therefore auditing improves the quality of
accounting data.
Third-party auditing may also reduce the quality of financial reporting because it constrains the kinds
of accounting rules and conventions that evolve over time. For example, the IASB considers the views
of auditors in the standard-setting process. Auditors are likely to argue against accounting standards
producing numbers that are difficult to audit, even if the proposed rules produce relevant information for
investors.

CHAPTER 1
The legal environment in which accounting disputes between managers, auditors and investors are
adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and
resulting penalties has the beneficial effect of improving the accuracy of disclosure. However, the potential
for a significant legal liability may also discourage managers and auditors from supporting accounting
proposals that require risky forecasts, such as forward-looking disclosures.
Accounting System Feature 3: Managers

Reporting Strategy
Because the mechanisms that limit managers ability to distort accounting data add noise, itis not optimal
to use accounting regulation to eliminate managerial flexibility completely. Therefore real-world accounting
systems leave considerable room for managers to influence financial statement data. Anorganisations
reporting strategy that is, the manner in which managers use their accounting discretion has an
important influence on the organisations financial statements.
Corporate managers can choose accounting and disclosure policies that make it more or less difficult for
external users of financial reports to understand the true economic picture of their businesses. Accounting
rules often provide a broad set of alternatives from which managers can choose. Further, managers
are entrusted with making a range of estimates in implementing these accounting policies. Accounting
regulations usually prescribe minimum disclosure requirements, but they do not restrict managers from
voluntarily providing additional disclosures.
A superior disclosure strategy will enable managers to communicate the underlying business reality
to outside investors. One important constraint on an organisations disclosure strategy is the competitive
dynamics in product markets. Disclosure of proprietary information about business strategies and their
expected economic consequences may hurt the organisations competitive position. Subject to this
constraint, managers can use financial statements to provide information useful to investors in assessing
their organisations true economic performance. Reporting on corporate environmental and social effects
under the heading of sustainability isone example of a voluntary disclosure that has emerged in the past
decade.
Managers can also use financial reporting strategies to manipulate investors perceptions. Using the
discretion granted to them, managers can make it difficult for investors to identify poor performance on a
timely basis. For example, managers can choose accounting policies and estimates to provide an optimistic
assessment of the organisations true performance. They can also make it costly for investors to understand
the true performance by controlling the extent of information that is disclosed voluntarily.
The extent to which financial statements are informative about the underlying business reality varies
across organisations and across time for a given organisation. This variation in accounting quality provides
both an important opportunity and a challenge in doing business analysis. The process through which
analysts can separate noise from information in financial statements, and gain valuable business insights
from financial statement analysis, is discussed next.
F R O M F I N A N C I A L S TAT E M E N T S
T O B U S I N E S S A N A LY S I S
Because managers insider knowledge is a source both of value and of distortion in accounting data, it is
difficult for outside users of financial statements to separate true information from distortion and noise.
Not being able to undo accounting distortions completely, investors discount an organisations reported

8
PART 1 FRAMEWORK
accounting performance. Indoing so, they make a probabilistic assessment of the extent to which an
organisations reported numbers reflect economic reality. Asa result, investors can have only an imprecise
assessment of an individual organisations performance. Financial and information intermediaries can
add value by improving investors understanding of an organisations current performance and its future
prospects.
Effective financial statement analysis is valuable because it attempts to get at managers inside
information from public financial statement data. Because intermediaries do not have direct or complete
access to this information, they rely on their knowledge of the organisations industry and its competitive
strategies to interpret financial statements. Successful intermediaries have at least as good an understanding
of the industry economics as do the organisations managers as well as a reasonably good understanding
of the organisations competitive strategy. Although outside analysts have an information disadvantage
relative to the organisations managers, they are more objective in evaluating the economic consequences
of the organisations investment and operating decisions. Figure 1.3 provides a schematic overview of how
business intermediaries use financial statements to accomplish four key steps: (1)business strategy analysis,
(2)accounting analysis, (3)financial analysis and (4)prospective analysis. Together these four steps form a
structured business analysis methodology.
Financial Statements
Business Application Context
Managers superior information

on business activities
Noise from estimation errors
Distortion from managers
accounting choices
Credit analysis
Securities analysis
Mergers and acquisitions analysis
Debt/dividend analysis
Corporate communication
strategy analysis
General business analysis
Other Public Data
Industry and firm data

Outside financial statements
ANALYSIS TOOLS
Business Strategy
Analysis
Generate performance
expectations through
industry analysis and
competitive strategy
analysis.
Figure 1.3
Accounting Analysis
Financial Analysis
Prospective Analysis
Evaluate accounting
quality by assessing
accounting policies and
estimates.
Evaluate performance
using ratios and cash
flow analysis.
Make forecasts and

value business.

CHAPTER 1
Analysis Step 1: Business Strategy Analysis

The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess
the organisations profit potential at a qualitative level. Business strategy analysis involves analysing an
organisations industry and its strategy to create a sustainable competitive advantage. This qualitative
analysis is an essential first step in a Structured Business Analysis because it enables the analyst to frame
the subsequent accounting and financial analysis better. For example, identifying the key success factors
and key business risks allows the identification of key accounting policies. Assessment of an organisations
competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business
analysis enables the analyst to make sound assumptions in forecasting an organisations future performance.
Analysis Step 2: Accounting Analysis

The purpose of accounting analysis is to evaluate the degree to which an organisations accounting
captures the underlying business reality. Byidentifying places where there is accounting flexibility, and by
evaluating the appropriateness of the organisations accounting policies and estimates, analysts can assess
the degree of distortion in an organisations accounting numbers. Another important step in accounting
analysis is to undo any accounting distortions by recasting an organisations accounting numbers to
create unbiased accounting data. Sound accounting analysis improves the reliability of conclusions from
financial analysis, the next step in a Structured Business Analysis.
Analysis Step 3: Financial Analysis

The goal of financial analysis is to use financial data to evaluate the current and past performance of an
organisation and to assess its sustainability. There are two important skills related to financial analysis.
First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use
financial data to explore business issues. Ratio analysis and cash flow analysis are the two most commonly
used financial tools. Ratio analysis focuses on evaluating an organisations product market performance and
financial policies; cash flow analysis focuses on an organisations liquidity and financial flexibility.
Analysis Step 4: Prospective Analysis

Prospective analysis, which focuses on forecasting an organisations future, is the final step in a Structured
Business Analysis. Two commonly used techniques in prospective analysis are financial statement forecasting
and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis
and financial analysis so that predictions can be made about an organisations future.
While the value of an organisation is a function of its future cash flow performance, itis also possible
to assess an organisations value based on its current book value of equity, and its future return on equity
(ROE) and growth. Strategy analysis, accounting analysis and financial analysis, the first three steps in the
framework discussed here, provide an excellent foundation for estimating an organisations intrinsic value.
Strategy analysis, in addition to enabling sound accounting and financial analysis, also helps in assessing
potential changes in an organisations competitive advantage and their implications for the organisations
future ROE and growth. Accounting analysis provides an unbiased estimate of an organisations current book
value and ROE. Financial analysis facilitates an in-depth understanding of what drives the organisations
current ROE.
The predictions from a sound Structured Business Analysis are useful to a variety of parties and can
be applied in various contexts. The exact nature of the analysis will depend on the context. The contexts
that we will examine include securities analysis, credit evaluation, mergers and acquisitions, evaluation of

10
PART 1 FRAMEWORK
debt and dividend policies, and assessing corporate communication strategies. The four analytical steps
described above are useful in each of these contexts. Appropriate use of these tools, however, requires a
familiarity with the economic theories and institutional factors relevant to the context.
There are several ways in which financial statement analysis can add value, even when capital markets
are reasonably efficient. First, there are many applications of financial statement analysis whose focus is
outside the capital market context credit analysis, competitive benchmarking, analysis of mergers and
acquisitions, to name a few. Second, markets become efficient precisely because some market participants
rely on analytical tools such as the ones we discuss in this book to analyse information and make informed
investment decisions.
SUMMARY
and valuation using financial statements is not very useful,

unless you are interested in becoming a financial analyst.
accounting data in financial
4
(strategy analysis, accounting analysis, financial analysis, and
a financial analyst, explain why each
the office:
financial
key steps: business strategy analysis, accounting analysis, financial
DISCUSSION QUESTIONS
1 Qian, who has just completed his first finance course, is

and valuation using financial statements because he believes
that financial analysis adds little value, given the efficiency of
capital markets. Explain to Qian when financial analysis can
add value, even if capital markets are efficient.
2 Accounting statements rarely report financial performance
before making this decision, and where might you find that
ENDNOTE
1
Quarterly Journal of Economics
financial reporting.

11
TH E R O L E O F CAPI TAL MARKET INTERMEDIARIES IN THE DOT-CO M

C R A S H O F 2000
T he Rise a n d F a ll o f th e In ter n et
Consu lta n ts
firms, financial analysts, and money management companies were
CASE STUDY
C H A P T E R 1 C A S E S T U D Y T H E R O L E O F C A P I TA L M A R K E T I N T E R M E D I A R I E S I N T H E D O T- C O M C R A S H O F 2 0 0 0
Exhibit 3
Exhibit 1
Cont ex t : T he Technology Bull Market
enhance productivity and efficiency through the computerization and
to many of the other blue-chip technology firms such as Intel and Dell
Exhibit 4
Exhibit 2
CASE STUDY
12
PART 1 FRAMEWORK
, film,
boundless, and they were global in scale. The benefits of the Internet
The Wall Street Journal
ones (exemplified by companies in traditional manufacturing, retail,
because of the benefits of network effects. In addition, a large customer

base was needed to cover the high fixed costs often associated with
raditional companies, finding their
was one of the first of many Internet companies to go public without
which would presumably translate at a later point into profitability
Exhibit 5
Scient Corporat ion
included several leading firms such as Sequioa Capital and Benchmark

Exhibit 3
industrial era, so the firms that prey on the passion and feed

13
Exhibit 7
Exhibit 8
Exhibit 6
. Analysts wrote glowingly about the firm
firms floundered in the single digits, they received increasing attention
CASE STUDY
Now they are discovering that the relationships firmly established
stocks are now high-tech whipping boys. Even financial analysts, who
. . . . Many of these firms were built on the back
will be difficult to maintain top-tier talent in the current market

and company specific environment.
Performance of t he N asdaq
CASE STUDY
14
PART 1 FRAMEWORK
firms.
once high-flying
coms, operating at losses and starved for cash, filed for bankruptcy or
Exhibit 9
at any point in time. Accountants audit the financial statements of

firms.
the confidence to make decisions based on these financial documents.
T h e Rol e of I n te rme d ia rie s

i n a Well-Func tio n in g Ma rke t
confidence
system. Without this confidence, they would not plough their money back
they want to invest, and companies need capital to finance and grow
What Happened During t he Dot -Com Bubble?

BusinessWeek
s top financial firms
efficiently
Fortune
all Street firms had led investors and companies astray
management firms, and even the media (see Exhibit 10
contributor to the sharp drop in consumer confidence that took place
fully aligned in accordance with their fiduciary responsibility
that could have been more efficiently allocated within the economy
people who worked at failed Internet firms could have spent their time
benefited
could be argued that there were benefits as well, and that the large

15
Ventur e C api tal i s ts
CASE STUDY
T he In te rme d ia rie s
a company that has no track record, profitability
In v e s t m e n t B a n k U n d e r wr it e r s
The partners in a VC firm typically had a substantial percentage of
Investment banks provided advisory financial services, helped the
Several blue-chip firms were involved in the capitalExhibit 3

Just Who Brought Those Duds to
Market?
New York Times

firms
profits for at least three quarters.

pointing fingers at the venture capitalists that had invested in many
of the failed dot-coms. They blamed them for being unduly influenced
S e ll-S i d e A n a lys t s
a venture capital firm that invested in one of the Internet consulting
expectations of high stock market valuations, VC firms invested in

very influential
CASE STUDY
16
PART 1 FRAMEWORK
value of cash flow or earnings, it is equal to what someone is
illiquid stocks and steep growth curves that are difficult to
banking revenue they help the firm to generate through their research.

for being too heavily influenced by the possibility of banking deals
Forbes
Financial Times
got significant fees from the trading revenue they generated and the
, he did note that the potential deal flow could

flying
firms, stated:
of the Internet consulting firms, looking back before the correction
bubble. According to financial information company First Call, more

financials for
B u y-S id e A n a lys t s a n d P o r t f o l io M a n a g e r s

17
Th e R ol e of In for m ati on
T he Account ing Profession
Independent accountants audited the financial statements of public
reasonably satisfied, they provided an unqualified opinion statement
s public filings. If auditors were
not fully satisfied, this is noted as well. Investors usually took heed of
CASE STUDY
was dominated by five major accounting firms, collectively referred to
During the aftermath of the dot-com crash, these firms came

Why then, did so may buy-side firms buy and hold on to the
Internet consulting firms during the market bubble? Did they really
the precarious financial position of some of the companies. The Wall

Street Journal
financing, rather than money generated by their own operations, to

stay afloat. Y
reasonable price. At first the general impression in the firm was
Internet firms would blow
irrational and unjustifiable whether it was an auditor
at the firm began to recommend companies simply because
financial research organization,
CASE STUDY
18
PART 1 FRAMEWORK
that the accounting rules caused Internet firms to appear unprofitable
FAS B A R e gul a t or
firms were allowed to capitalize their major investments such as
of financial accounting and

users of financial information.
financial reporting of public companies in the United States.
The accounting practices of some new economy firms posed
Specific examples included the treatment of barter revenues in
R etai l In vestor s
Inc.) Given that the valuations of many Internet firms were driven by
how quickly they grew revenues, there was a lot of incentive to inflate
many dot-com firms really began . . . when it quietly issued new

o rein in what it saw as an alarming trend in inflated revenue
practices to restate financial results by the end of their next fiscal
financial results. . . .
charged by traditional brokerage firms. These companies were dot-
The financial press also became increasingly visible during this

Barrons
had always been very influential in the financial community

19
Th e B l am e G am e
Many of the retail investors did not know much about finance or
fault it was that the whole bubble occurred in the first place. As
heavily influenced by some of the intermediaries previously described,

especially the financial press, and the sell-side analysts that publicly
CASE STUDY
Wall Street Journal
and venture capitalists have stepped up their finger
T he Co mp a n ie s Th e mse lves
The Internet stock market bubble was certainly not the first one to
Obviously there were many benefits to having a high stock
be a part of the firm, partly because the stock was doing so well.
system? If so, could it be fixed so that this sort of thing did not happen
When asked about his thoughts on his firm
QUESTI ONS
consulting firms were facing renewed competition from companies
like IBM, the Big Five accounting firms and the strategy consulting
firms. Overall, though the rise and
1.
2.
3.
4.
CASE STUDY
20
PART 1 FRAMEWORK
EXHIBIT 1
Timeline of the Internet consultants Founding and IPO
1984
1990
1991
LNTE
founded
1992
1993
1994
USIT
founded
1995
1996
1997
RAZF
IIXL
founded
VIAN
founded
SCNT
XPDR
founded
1999
Jan
Feb Mar Apr May Jun

RAZF SCNT VIAN
IPO IPO IIXL
IPOs
1998
1999
2000
2000
Jul
Aug Sep Oct Nov Dec Jan
Feb Mar
USIT
IPO
LNTE
IPO
XPDR
IPO
Source:
EXHIBIT 2
Internet consultants stock price highs and lows
Company
IPO Pricea
Peak
%Price
Change
IPO to
Peak
Date of
Peak
Price at End
of Feb 2001
% Change
from Peak
a.
b.
Source:
CASE STUDY
Continued
float)
float)
float)
float)
21
Auditorsa Analyst Coverage

Investment Bank
Underwriters
Venture Capital Stage
Investors
Company
Intermediaries in the capital-raising process of the Internet consultants
EXHIBIT 3
Selected
Institutional
Holders
Venture
Funding
($M)
IPO
Amount
Raised
($M)b
IPO Underwriting % Institutional

Fee ($M)
Ownershipc
float)
float)
float)
IPO Underwriting % Institutional

Fee ($M)
Ownershipc
PART 1 FRAMEWORK
Safeguard Scientific,
a.
b.
c.
Source:
Company
Venture Capital Stage

Investors
Investment Bank
Underwriters
Auditorsa Analyst Coverage
Selected
Institutional
Holders
Venture
Funding
($M)
IPO
Amount
Raised
($M)b
CASE STUDY
22

CASE STUDY
EXHIBIT 4
Market capitalization of major technology companies, January 2000
Company
Market Capitalization
($ billions)a
23
Stock Price
(January 3, 2000)
a.
Sources:
EXHIBIT 5
Market valuations given to loss-making dot-coms
Company
Net Income (99/00)a

($ millions)
Market Capitalization
($ billions)b
Stock Price
(January 3, 2000)
a.
b.
Sources:
CASE STUDY
24
PART 1 FRAMEWORK
EXHIBIT 6
Scient Consolidated financial statements
Income Statement
(in thousands except per-share amounts)
November 7, 1997 (inception)
through
March 31, 1998
Year Ended March 31,

1999
2000

25
Balance Sheet
(in thousands except per-share amounts)
March 31,
1999
Assets
2000
CASE STUDY
Liabilities and Stockholders Equity
Accrued compensation and benefits
Accumulated deficit
Sources:
http://www.freedgar.com
CASE STUDY
26
PART 1 FRAMEWORK
EXHIBIT 7
Analyst downgrades of the Internet consultants
Company
Number of Analysts that Downgraded during

August 30September 8, 2000
Analyst downgrades of Scient Corporation, August 30September 8, 2000

Institution
Previous
Recommendation
New Recommendation Date of Downgrade
Source:
EXHIBIT 8
Selected institutional holders of Scient Corporation, 19992000
Quarter Ended:
Institution
June 1999
September
1999
December
1999
March 2000
June 2000
September
2000
December
2000
Source:
EXHIBIT 9
Dot-coms that filed for bankruptcy or closed operations (Selected List)
August 2000
November 2000
January 2000
27
CASE STUDY
September 2000
Affinia.com
October 2000
December 2000
HotOffice.com
Sources:
Wall Street Journal

Infoworld
CASE STUDY
28
PART 1 FRAMEWORK
EXHIBIT 10
Capital flows from investors to companies
Private
Equity
Have
Capital
Investors
Venture
Capitalists &
Other PE
Entities
Money
Managers
Investment
Banks
Public
Markets
Brokers
Supporting
Intermediaries: Financial Planners
The Media
Regulators:
Companies
Need
Capital
Profit
Repatriation
Portfolio
Managers
Sell-side
Analysts
Buy-side
Analysts
Investment
Bankers
Accountants
Auditors
Sales Force
Lawyers
Traders
SEC, FASB, etc.
Source:
Endnot es
17
18
2
3
4
5

19
Fortune
20
Financial Times
21
22 Several financial journals published analyst rankings. The most prominent
23
24
25
26
27
28
10
29
30
31
influential in the analyst and investment community

Money
The CPA Journal
unusual or aggressive accounting practices to camouflage such problems.
BusinessWeek
11
firms reaped billions from the Net boom while investors got burned,
12 Fortune
13
firms reaped billions from the Net boom while investors got burned,
BusinessWeek
14
Venture Capital
Journal
15
capital firm itself usually serves as the general partner
16
32
Strategic Finance
33
34
35
36
37
s hidden profits, Fortune
Forbes

38

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Business Analysis and Valuation - Using Financial

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Fourth edition of Business Analysis & Valuation: Using

Wright ... [et al.].

Financial Statements, published by South-Western, a

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Subjects: Business enterprises--Valuation--AsiaPacific. Financial

Licensed to: iChapters User

This chapter outlines a comprehensive framework for financial

s financing and dividend policies?

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o understand the contribution that financial statement analysis

THE ROLE OF FINANCIAL

FROM BUSINESS ACTIVITIES

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Accounting System Feature 1: Accrual Accounting

Capital market structure

Measure and report

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Accounting System Feature 2: Accounting

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Accounting System Feature 3: Managers

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Business Application Context

Managers superior information

Other Public Data

Industry and firm data

Make forecasts and

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Analysis Step 1: Business Strategy Analysis

Analysis Step 2: Accounting Analysis

Analysis Step 3: Financial Analysis

Analysis Step 4: Prospective Analysis