Components of Business Analysis
Business Environment and Strategy Analysis
Analysis of the business environment seeks to identify and assess a company’s economic and industry circumstances. This includes analysis of its product, labor, and capital markets within its economic and regulatory setting. Analysis of business strategy seeks to identify and assess a company’s competitive strengths and weaknesses along with its opportunities and threats.
Business environment and strategy analysis consists of two parts-industry analysis and strategy analysis. Industry analysis is the usual first step since the prospects and structure of its industry laigely drive a company’s profitability. Industry analysis is often done using the framework proposed by Porter (1980, 1985) or value chain analysis. Strategy analysis is the evaluation of both a company’s business decisions and its success at establishing a competitive advantage. This includes assessing a company’s expected strategic responses to its business environment and the impact of these responses on its future success and growth. Strategy analysis requires scrutiny of a company’s competitive strategy for its product mix and cost structure.
Accounting Analysis
Accounting analysis is a process of evaluating the extent to which a company’s accounting reflects economic reality. This is done by studying a company’s transactions and events, assessing the effects of its accounting policies on financial statements, and adjusting the statements to both better reflect the underlying economics and make them more amenable to analysis. Financial statements are the primary source of information for financial analysis. This means the quality of financial analysis depends on the reliability of financial statements that in turn depends on the quality of accounting analysis. Accounting analysis is especially important for comparative analysis.
Accounting analysis includes evaluation of a company’s earnings quality or, more broadly, its accounting quality. Evaluation of earnings quality requires analysis of factors such as a company’s business, its accounting policies, the quantity and quality of information disclosed, the performance and reputation of management, and the opportunities and incentives for earnings management. Accounting analysis also includes evaluation of earnings persistence, sometimes called sustainable earning power.
Financial Analysis
Financial analysis is the use of financial statements to analyze a company”s financial position and performance, and to assess future financial performance. Several questions can help focus financial analysis. One set of questions is future oriented. For example, does a company have the resources to succeed and grow? Does it have resources to invest in new projects? What are its sources of profitability? What is the company’s future earning power? A second set involves questions that assess a company’s track record and its ability to deliver on expected financial performance. For example, how strong is the company’s financial position? How profitable is the company? Did earnings meet analyst forecasts? This includes an analysis of why a company might have fallen short of (or exceeded) expectations.
Financial analysis consists of three broad areas-profitability analysis, risk analysis, and analysis of sources and uses of funds. Profitability analysis is the evaluation of a company’s return on investment. It focuses on a company’s sources and levels of profits and involves identifying and measuring the impact of various profitability drivers. Risk analysis is the evaluation of a company’s ability to meet its commitments. Risk analysis involves assessing the solvency and liquidity of a company along with its earnings variability. Analysis of cash flows is the evaluation of how a company is obtaining and deploying its funds. This analysis provides insights into a company’s future financing implications.
Prospective Analysis
Prospective analysis is the forecasting of future payoffs-typically earnings, cash flows, or both. This analysis draws on accounting analysis, financial analysis, and business environment and strategy analysis. The output of prospective analysis is a set of expected future payoffs used to estimate company value.
Valuation
Valuation is a main objective of many types of business analysis. Valuation refers to the process of converting forecasts of future payoffs into an estimate of company value. To determine company value, an analyst must select a valuation model and must also estimate the company’s cost of capital. While most valuation models require forecasts of future payoffs, there are certain ad hoc approaches that use current financial information.
Financial Statement Analysis and Business Analysis
Financial statement analysis is a collection of analytical processes that are part of business analysis. These separate processes share a common bond in that they all use financial statement information, to varying degrees, for analysis purposes. While financial statements do contain information on a company’s business plans, analysis of a company’s business environment and strategy is sometimes viewed outside of conventional financial statement analysis. Also, prospective analysis pushes the frontier of conventional financial statement analysis. Yet most agree that an important part of financial statement analysis is analyzing a company’s business environment and strategy. Most also agree that valuation, which requires forecasts, is part of financial statement analysis. Therefore, financial statement analysis should be, and is, viewed as an important and integral part of business analysis and all of its component analyses. At the same time, it is important to understand the scope of financial statement analysis. Specifically, this book focuses on financial statement analysis and not on aspects of business analysis apart from those involving analysis of financial statements.
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