Why and when

B- Why and when conduct financial analysis

Financial analysis is conducted to assess the value of a firm for the purpose of buying or selling its shares, lending, acquiring the company, leasing equipment, entering into or terminating some contract. Value is defined as the sum of future benefits of the decision maker derived from earnings, proceeds from the sale, interest from the loan or some other flow of cash. Value, like beauty, is very much in the eyes of the beholder. For each decision maker, future benefits are different. Hence, there isn't a single measure of value. The assessment of value differs according to the purpose an analyst has for conducting the analysis. In the ocean, a fish has a different value depending on whether it is looked upon as a potential mating partner or a meal. Chapter 3 distinguishes different approaches to value measurement depending on decision maker's concerns. The decision maker could be an outside investor, a long term lender, a short term lender, a government agency, a client, a supplier, a contractor, an executive or an employee of the company. None of these individuals perceive the value of a firm in the same light and with the same preoccupations.

Let's verify this with examples of two different viewpoints. Take for instance, a banker and an equity investor. The banker may justifiably prefer that the current assets represent a multiple of current liabilities. The well known current ratio adds to the creditworthiness of the firm if it is in excess of the often mentioned value of two: the higher the better. But to an equity investor, current liabilities and accounts payable to suppliers, in particular, are the cheapest source of funds available; if the firm does not use them, its profitability and, in the eyes of investors, its value are diminished. What is the reason for the difference? The bank sees value in quick repayment of short term liabilities; the equity investor sees value in slow repayment of short term liabilities.

Much more will be said about the impact different magnitudes of given ratios have on a firm's perceived value. Yet, all analysts go through a somewhat similar sequence of steps. While the nature of benefits and value differ according to type of financial asset, the parameters of their evaluation are similar. Whether the benefits expected are dividends, interest payments or some other cash flow, such benefits are always in the future, and since the future is uncertain, all analytical process must deal with ever present risk, difficulty of measurement, timing and translation over time.

Another dimension of value determination is that it is never conducted on one single firm or asset in isolation. Financial analysis is always comparative. The banker considering granting a loan has other potential borrowers: he/she must approve the loan only if the applicant is a better client than other applicants. No wise investor locks all wealth in a single stock: a portfolio of varied securities is periodically rebalanced, selling some shares and buying others, depending on corporate performance and portfolio strategy (provided, however, that transactions costs do not exceed the potential gain from the portfolio rebalancing). Thus, financial analysts must gather comparative data and must be continuously on the alert for the most attractive alternative.

What emerges from this initial discussion is that the concept of value is universal (i.e. value is today's sum of future benefits), but not its measurement (i.e. the benefits are different in terms of nature, size, timing, uncertainty and method of projection). Moreover, value measurements are also affected by attitudes, needs and abilities of analysts and/or decision makers. Take the example of the banker once again and consider another banker looking at the same potential borrower. Each of the bankers judges the client in the context of their bank's portfolio strategy. One bank may have a need to earn a higher rate of interest, while the other bank may need to lend only on very short term even if the interest collected is lower.

In spite of these differences in value assessment, there is, for many reasons, much similarity in the analytical process regardless of purpose. First, because many different types of future benefits are affected by the same elements. Except for a decision to sell the assets of an acquired firm, most analysts look at firms as a going concerns. Hence, most analysis includes an assessment of a firm's ability to grow and prosper in the future.

-- Speed of analysis is important : Ball and Brown.--

The second reason relates to the financial analyst him/herself. Financial analysis requires considerable work (as it will be apparent throughout the chapters, and as it can be expected since comparison with many other firms is necessary). It requires special skills. Making erroneous assessments leads to decisions in which losses will push the decision maker out of the market. Avoiding wrong conclusions extends analytical work experience, skills and industry specialization of financial analysts. Decision makers tend not to be always capable to carry out financial analysis themselves because everyone who makes a decision is influenced by personal emotions. One can verify that in the case of real estate: while the seller of a house has an affectionate attachment to the house, the potential buyer has a fear of unknown problems in the structure, the roof or the basement. A neutral agent, especially an independent appraiser, is useful in reducing misperceptions on both sides. Likewise, financial analysts must rely on objective methods and avoid subjective or affective interference. Furthermore, because of the training necessary to become a financial analyst, a certification is desirable (as discussed in the previous section).

Let's return for a moment to the idea that financial analysis is not a goal in itself. Financial analysts are concerned with money, not the art of evaluation (even if financial analysis is indeed considered sometimes an art, more than a science). The notion of art for art sake has no place in the world of finance. Again, the reason for all forms of financial analysis is to determine if the asset under study is worth holding/buying or selling/getting rid of. This decision is not made in isolation, but in conjunction with all the other assets currently held or available for purchase. The decision follows the well known universal dominance principles. Among comparable assets with same level of risk, investors should prefer the one with the highest return; and, among comparable assets with same level of return, investors should prefer the one with the lowest risk.

Thus, financial analysis is conducted to determine value in order to decide to buy/hold or sell the asset. As new information affects the determination of value, so will the decision to buy/hold-or-sell will continuously need to be reassessed. In other words, an analysis is never completed and value is a dynamic rather than a static concept. Consider the purchaser of a new BMW 320i, who valued the use of the BMW more than the $40,000 it cost. Will he stop comparing the BMW to the Volvos, Hondas and Peugeots? No. Still, he/she may not return the BMW and buy some other car even if he/she discovers that that other car has become a better buy. Transaction costs (taxes, information cost and time devoted to the transaction) prevent the switch as long as they exceed the additional features of that other car. In fiance, transaction costs have been going down for a long time, and are often trivial compared to potential losses on poorly performing financial assets, and that justifies more periodic financial analyses to identify opportunities.

See review questions Q-1B.1 to Q-1B.6

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