Chapter 2
Chapter 2
Strategy Analysis
Discussion Questions
1. Judith, an accounting major, states, “Strategy analysis seems to be an unnecessary detour in doing financial statement analysis. Why can’t we just get straight to the accounting issues?” Explain to Judith why she might be wrong.
Strategy analysis enables the analyst to understand the underlying economics of the firm and the industry in which the firm competes. There are a number of benefits to developing this knowledge before performing any financial statement analysis.
1. Strategy understanding provides a context for evaluating a firm’s choice of accounting policies and hence the information reflected in its financial statements. For example, accounting policies (such as revenue recognition and cost capitalization) can differ across firms either because of differences in business economics or because of differences in management’s financial reporting incentives. Only by understanding differences in firms’ business strategies is it possible to assess how much to rely on a firm’s accounting information.
2. Strategy analysis highlights the firm’s profit drivers and major areas of risk. An analyst can then use this information to evaluate current firm performance and to assess the firm’s likelihood of maintaining or changing this performance based on its business strategy.
3. Strategy analysis also makes it possible to understand a firm’s financial policies and whether they make sense. As discussed later in the book, the firm’s business economics is an important driver of its capital structure and dividend policy decisions.
In summary, understanding a firm’s business, the factors that are critical to the success of that business, and its key risks is critical to effective financial statement analysis.
2. What are the critical drivers of industry profitability?
Rivalry Among Existing Firms. The