Business analysis framework and stages of framework | Commerce Study Notes

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Business analysis framework and stages of framework

What is Business Analysis Framework 

Framework for business analysis and valuation using financial statement data.3 The framework’s four stages of analysis (discussed in more detail in the following pages) are: 
  1. Business strategy analysis, 
  2. Accounting analysis, 
  3. Financial analysis (ratio analysis and cash flow analysis), and 
  4. Prospective analysis (forecasting and valuation). 
The relative importance of each stage depends on the purpose of the analysis. The business analysis framework can be applied to many decision contexts including securities analysis, credit analysis, and merger and acquisition analysis.

Business Strategy Analysis 

Business strategy analysis is an important first step in financial statement analysis. It provides a qualitative understanding of a company and its competitors in relation to its economic environment. 

Understanding of a company and its competitors in relation to 
its economic environment. This ensures that quantitative analysis is performed using a holistic perspective. By identifying key profit drivers and business risks, business strategy analysis helps the analyst make realistic forecasts.

The use of additional information sources, such as the World Wide Web, trade groups, competitors, customers, reporters, lobbyists, regulators, and the trade press is becoming more common.

As noted previously, key profit drivers and types of business risk vary among countries. Understanding them can be daunting. Business and legal environments and corporate objectives vary around the world. Many risks (such as regulatory risk, foreign exchange risk, and credit risk, among others) need to be evaluated and brought together coherently. In some countries, sources of information are limited and may not be accurate.

Information Availability

Business strategy analysis is especially difficult in some countries due to lack of reliable information about macroeconomic developments. some countries due to lack of reliable information about macroeconomic developments.

 Governments in developed countries are sometimes accused of publishing faulty or misleading economic statistics. The situation is much worse in many emerging economies 

Obtaining industry information is also difficult in many countries and the quantity and quality of company information varies greatly. The availability of company-specific information has been strikingly low in many developing 

Recently, many large companies that list and raise capital in overseas markets have been expanding their
disclosures and have voluntarily switched to globally recognized accounting principles such as International Financial Reporting Standards.

Accounting Analysis  

The purpose of accounting analysis is to assess the extent to which a firm’s reported
results reflect economic reality. The analyst needs to evaluate the firm’s accounting policies and estimates, and assess the nature and extent of a firm’s accounting flexibility.
Corporate managers are allowed to make many accounting-related judgments
because they know the most about their firm’s operations and financial condition.
Flexibility in financial reporting is important because it allows managers to use accounting
measurements that best reflect the company’s particular operating circumstances.

Process of Accounting Analysis 

  1. Identify key accounting policies
  2. Assess accounting flexibility
  3. Evaluate accounting strategy
  4. Evaluate the quality of disclosure
  5. Identify potential red flags (e.g., unusually large asset write-offs,unexplained transactions that boost profits, or an increasing gap between a company’s reported income and its cash flow from operations)
  6.  Adjust for accounting distortions


The goal of financial analysis is to evaluate a firm’s current and past performance, and
to judge whether its performance can be sustained. Ratio analysis and cash flow analysis are important tools in financial analysis
Ratio analysis involves comparison of ratios between the firm and other firms in the same industry, comparison of a firm’s ratios across years or other fiscal periods, and/or comparison of ratios to some absolute
Cash flow analysis focuses on the cash flow statement, which provides information about a firm’s cash inflows and outflows, classified among operating, investing, and financing activities, and disclosures about periodic noncash investing and financing activities.
Ratio Analysis

I. Liquidity

1. Current ratio Current assets Current liabilities
2. Quick or acid-test ratio Cash, marketable securities, and receivables Current liabilities
3. Current cash debt ratio Net cash provided by operating activities
Average current liabilities

II. Efficiency

4. Receivables turnover Net sales Average trade receivables (net)
5. Inventory turnover Cost of goods sold Average inventory
6. Asset turnover Net sales Average total assets

III. Profitability

7. Profit margin on sales Net income Net sales
8. Rate of return on assets EBIT1 Average total assets
9. Rate of return on common stock equity Net income minus preferred dividends Average common stockholders’ equity
10. Earnings per share Net income minus preferred dividends Weighted common shares outstanding
11. Payout ratio Cash dividents Net income

IV. Coverage

12. Debt to total assets ratio Debt Total assets or equities
13. Times interest earned Income before interest charges and taxes Interest charges
14. Cash debt coverage ratio Net cash provided by operating activities Average total liabilities
15. Book value per share Common stockholders’ equity Outstanding common shares

Cash FLow 

cash flow analysis provides insights into a company’s cash flows
and management.
Cash flow–related measures are especially useful in international analysis because they
are less affected by accounting principle differences than are earnings-based measures.
 When cash flow statements are not presented, it is often difficult to compute cash flows
from operations and other cash flow measures by adjusting accrual-based earnings.
Many companies simply do not disclose the information needed to make the adjustments. As one example, German balance sheets often contain surprisingly large reserveaccounts that reflect many different types of accrual. Few (if any) details are presented that might allow the financial statement user to assess the implications for operating,
investment, and financing cash flows.


Prospective analysis involves two steps: forecasting and valuation. In forecasting, analysts make explicit forecasts of a firm’s prospects based on its business strategy, accounting, and financial analysis.
It addresses questions such as, How will a company’s change in business strategy affect future sales volume and profits? Has the company recently adopted new accounting policies that will make current earnings appear stronger, perhaps at the cost of lower earnings next year? Will financial relationships evidenced in an analyst’s ratio analysis continue?

For example, valuation is the basis of equity analysts’ investment recommendations. In analyzing a
possible merger, the potential acquirer will estimate the value of the target firm.

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