“Valuation of Business” (valuation of companies) is a series of articles launched by MoneyBol to apprise our readers about different aspects of valuation of business.

The first article in Business Valuation series was Analysis of Environment and Industry

Now in the second article we are presenting different aspects of Financial Analysis of the company to arrive at the intrinsic value of the company.

Financial analysis

Financial statements of a company provide immense information about the financial standing of a company. They must never be taken at their face value; rather a careful scrutiny is required to unearth the hidden facts.

Financial analysis aims at reclassification and summarization of information through the establishment of ratios and trends.

Horizontal Analysis-

Also known as comparative analysis, this is conducted by setting consecutive balance sheet, income statement or statement of cash flow side-by-side and reviewing changes in individual categories on a year-to-year or multiyear basis. The most important item revealed by comparative financial statement analysis is trend.
A comparison of statements over several years reveals direction, speed and extent of a trend(s).

The horizontal financial statements analysis is done by restating the amount of each item or group of items as a percentage the figures of a predetermined base year.

Vertical Analysis-

In this analysis, each entry for each of the three major categories of accounts (assets, liabilities and equities) in a balance sheet is represented as a proportion of the total account. The main advantage of this form of analysis is that the balance sheets of businesses of all sizes can easily be compared. It also makes it easy to see relative annual changes in one business.

Ratio Analysis-

Ratio Analysis enables the valuer to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry.

To do this a firm’s ratios are compared with the average of similar businesses. The ratios are also compared with the firm’s own ratios for several successive years, watching especially for any unfavorable trends that may be starting.

Ratio analysis may provide the all-important early warning indications that can allow one to solve business problems before they assume a larger magnitude.

Normalization of financial statements

Normalization is required to present a true and fair picture of the firm’s economic financial position. The financial statements must be made to comply with GAAP. The following adjustments need to be made:

Comparability Adjustments- Only occasionally do any two different closely held companies use the same set of accounting practices to keep their books and prepare their financial statements. The analyst must adjust for them by eliminating such differences.

Non-Operating Adjustments- More often than not, the financial statements of a firm present a picture that is very different from economic reality. Any assets or liabilities which are not related to the production of earnings must be eliminated from the balance sheet.

Non-Recurring Adjustments- The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of fixed assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management’s expectations of future performance.

Fair Value Adjustments- In most cases, closely held businesses have actual values that are different from what is recorded in their financial statements. Balance sheet adjustments are made to present the current market value position of an enterprise, with both assets and liabilities shown at their respective current market values. Discretionary adjustments also need to be made with respect to compensation paid to all employees including owner, benefits and perquisites given, rent paid, etc. to industry standards.

Keep visiting our website for further articles which would take up company specific ananlysis for valuation.

Author name: Preeti Patawari, MBA- Intl Business (IMT)

Related posts:

  1. Valuation of Business: Analysis of environment and Industry
  2. Accounting and Business are Interrelated in IFRS
  3. Fair Value Accounting in IFRS