FINANCIAL RISK (continued)

FINANCIAL RISK (continued)

This article provides an overview of the

important role of financial analysis in the valuation

process. This article also illustrates how financial

analysis provides insight into a company’s operations,

its risks and its opportunities.

Financial Analysis. A thorough financial

analysis is an important aspect of any valuation

assignment. Examining the financial condition and

performance of a company provides crucial insight into

its financial risks, the factors that impacted its historic

results, and what this portends about the future. It is

important to remember that the purchaser of a company

is always looking forward and makes an assessment

about the risks and rewards associated with owning

shares in the business. While a company’s history is not

guaranteed to repeat itself, the analysis of past results

assists in identifying forces internal and external to the

business that impact how well or poorly the company

performs. This analysis provides insight into the

inquiries that need to be made of the company’s

management to identify financial and other risks. This

analysis also assists in the development of meaningful

and supported valuation forecasts.

How Much History Is Enough? In order to

begin a financial analysis, the valuator needs a sufficient

number of years of historical financial statements to

provide an accurate picture of the business and to

identify positive or negative trends. Valuation firms,

banks, and other creditors often request the last five

years financial statements. However, this is an arbitrary

number and is sometimes insufficient to gain perspective

on broad and long-term financial trends.

For example, if the company is in a cyclical

industry, five years may not be long enough to see all

aspects of the cycle, including the peak and the trough.

A good example of a cyclical industry is homebuilding,

which tends to have periods of booms and busts tied to

the general economy, interest rates, and other

macroeconomic forces. Suppose the last five years

represented the “boom” part of the cycle. If only five

years of information is requested, the valuator might

erroneously conclude that the financial trends are always

onward and upward. Another problem is that abnormally

long economic expansions obscure the presence of

cycles.

The Types of Financial Statement Spreads

and Their Use. Looking at a company’s printed

financial statements, it is difficult to easily discern broad

trends over time or to put the results in perspective.

“Spreading” a company’s historic financial statements

brings this added level of insight in a simple,

...