CHAPTER 3

BUSINESS ANALYSIS

LEARNING OBJECTIVES
1. Why business analysis is crucial to security valuation.
2. How to prepare an external analysis of the firm.
3. How to prepare an internal analysis of the firm.
4. Where to get information for business analysis.

TRUE/FALSE QUESTIONS
1. A careful, detailed financial statement analysis will be worthless without a strong understanding of what
will drive the business in the future.
(easy, L.O. 1, Introduction, true)

2. Financial statement analysis will highlight issues we need to study further in the business analysis stage.
(moderate, L.O. 1, Introduction, true)

3. The nature of the particular target business will determine which elements of the internal analysis are most
important to us.
(moderate, L.O. 2, Section 1, false)

4. The more intense the competition, the lower the expected industry return, and the lower the value of a given
firm in the industry.
(moderate, L.O. 2, Section 1, true)

5. Research indicates that industry growth rates do not affect the intensity of competition.
(easy, L.O. 2, Section 1, false)

6. Substitute products can remove profits from an industry.

(easy, L.O. 2, Section 1, true)

7. Understanding each competitors strengths will help us project the future for the target company.
(easy, L.O. 2, Section 1, true)

8. The choice of distributor, broker, or internal sales force is similar from industry to industry.
(moderate, L.O. 2, Section 1, false)

9. The final step in external analysis is to understand the customer or buyer group as an economic factor
affecting industry profitability.
(moderate, L.O. 2, Section 1, false)

10. Substitute products are a factor that prevents new firms from venturing into the market.
(difficult, L.O. 2, Section 1, false)

11. One aspect of positioning is to identify the target customer group.

(easy, L.O. 3, Section 2, true)

12. Differentiation includes the combined efforts of purchasing, manufacturing, research and development, and
distribution.
(moderate, L.O.3, Section 2, false)

13. A key aspect of human resources is understanding the strengths and weaknesses of employee skills and

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 experience.
(moderate, L.O. 3, Section 2, true)

14. Core competencies are the special skills and abilities that allow a firm to be successful.
(easy, L.O. 3, Section 2, true)

15. One way for an analyst to identify a firms core competencies is to analyze its annual report.
(moderate, L.O. 4, Section 2, true)

MULTIPLE CHOICE QUESTIONS

16. Which of the following items is not considered a part of the internal analysis of a business?
a. investment priorities
b. customer analysis
c. supply chain
d. product life cycle
(moderate, L.O. 1, Introduction, b)

17. The goal of business analysis is to learn everything about a business that somehow might impact the future
cash flow of the firm. The result of a valuation analysis depends entirely on:
a. the assumptions used in the valuation model
b. the assumptions made about the business itself
c. the assumptions made for projected sales
d. the facts gathered from relevant past and current public information about the business
(moderate, L.O. 1, Introduction, a)

18. Which of the following items is considered a part of the external analysis of a business?
a. human resources
b. pricing and differentiation
c. investment priorities
d. economic structure
(moderate, L.O. 1, Introduction, d)

19. The more intense the competition, the __________ the expected industry return and the __________ the
value of a given firm in the industry.
a. greater; greater
b. lower; lower
c. lower; greater
d. greater; lower
(moderate, L.O. 2, Section 1, b)

20. Competitive rivalry is likely to cause price competition among businesses. Which item below is not a factor
that increases competitive rivalry?
a. massive product differentiation
b. high fixed costs
c. excess industrial capacity
d. more competitors
(moderate, L.O. 2, Section 1, a)

21. A force that influences amount of new competition in an industry by preventing a firm from venturing into
the market is(are):
a. existing competitive rivalry
b. buyers
c. barriers to entry
d. suppliers
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 (easy, L.O. 2, Section 1, c)

22. An example of a powerful barrier to entry within a market is:

a. limited product differentiation
b. the ease with which resources may be obtained
c. more competitors in the market
d. a patent on a drug
(moderate, L.O. 2, Section 1, d)

23. There are very few products that do not have substitutes. Substitutes can remove profits from an industry.
Which example below is not representative of a product that may have substitutes?
a. coffee
b. a patented medication
c. tea
d. an over-the-counter pain reliever
(easy, L.O. 2, Section 1, b)

24. What example below would not be a criterion that makes buyers a force that can drive industry
competition?
a. the buyers can act in concert
b. the buyers represent a small proportion of the industrys sales
c. there are many suppliers for the product
d. the product purchased by the buyers is not very differentiated
(difficult, L.O. 2, Section 1, b)

25. The force that is part of the five force framework that has the bargaining power to raise prices or reduce
quality if there are only a few of them is known as:
a. competitors
b. buyers
c. suppliers
d. potential entrants
(moderate, L.O. 2, Section 1, c)

26. The analysis that addresses the specific strategies of key competitors on a microeconomic level is called
the:
a. existing competitive rivalry assessment
b. individual competitor assessment
c. potential entrant analysis
d. substitute product identification survey
(moderate, L.O. 2, Section 1, b)

27. In customer analysis, we find two levels of customers that must be understood. When we have correctly
identified the firm that sells products to a customer, who then resells the product to the consumer, we have
successfully:
a. distinguished between the firms immediate customer and the ultimate consumer
b. identified the existing competitive rivalry between manufacturers
c. distinguished between the firms immediate competitors and its ultimate customers
d. All of the above answers are correct.
(difficult, L.O. 2, Section 1, a)

28. Select the statement that is true from the choices given below.
a. The first step in external analysis is to understand the governmental and regulatory environment of the
firm.
b. Regulation generally has only a minor impact on profitability.
c. Consulting firms encounter many regulatory concerns and problems.
d. The extent and type of regulation vary a great deal from one industry to the next.
(difficult, L.O. 2, Section 1, d)
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29. The U.S. government has a wealth of information available for external business analysis purposes. The
government agency that publishes the Survey of Current Business is:
a. Securities and Exchange Commission
b. the Federal Reserve Bank
c. U.S. Department of Commerce
d. U.S. Census Bureau
(moderate, L.O. 4, Section 1, c)

30. The analyst may find articles about future expectations in certain industries, market share information, and
stories about individual firms in:
a. trade journals
b. the Internal Revenue Service Publication 334
c. ACNielsen Homescan Consumer Facts Reports
d. the decennial U.S. Census
(easy, L.O. 4, Section 1, a)

31. Which of the following factors below is used in internal analysis?

a. customer analysis
b. finance/accounting
c. individual competitor assessment
d. economic structure
(moderate, L.O. 3, Section 2, b)

32. The text of what a firm hopes to accomplish is called its:

a. products and services
b. investment priorities
c. mission statement
d. marketing and selling strategies
(difficult, L.O. 3, Section 2, c)

33. The stage of the product life cycle in which sales remain fairly constant is:
a. introduction
b. growth
c. maturity
d. decline
(easy, L.O. 3, Section 2, c)

34. Categorizing a product based on the perceived quality, service, or function is known as product:
a. pricing
b. differentiation
c. positioning
d. life cycle
(moderate, L.O. 3, Section 2, b)

35. Leadership ability and style are also important to the firm. To identify and analyze this aspect of the human
resources factor, an analyst would find relevant information in:
a. a customer analysis
b. a government and regulatory analysis
c. the firms financial statements
d. the firms annual report
(moderate, L.O. 4, Section 2, d)

36. What is a key element to understanding a companys supply chain?

a. understanding the purchasing part of the supply chain
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 b. understanding the manufacturing part of the supply chain
c. recognizing which parts of the supply chain are more important than others
d. understanding the research and development part of the supply chain
(moderate, L.O. 3, Section 2, c)

ESSAYS
37. Discuss the Five Forces Framework of Michael Porter.

Suggested solution:

Porters model identifies five distinct forces that drive industry competition on a macroeconomic level. The
five forces are:
Existing competitive rivalries
Potential entrants to the market
Suppliers
Substitute products
Buyers

Existing competitive rivalries can drive profitability down and put enormous pressure on the market. Some
of the factors that contribute to such rivalries include a growing number of competitors in the market, low
industrial growth, limited product differentiation, high fixed costs, and excess industrial capacity.

Potential entrants to the market will also weaken profitability. The analyst is concerned with estimating the
number of potential new competitors into a market. There are barriers to entry for potential competitors
that must also be analyzed. Some of the barriers include economies of scale, product differentiation, high
capital needs, the access to distribution channels, etc.

Substitute products can remove profits from industry as well. Consider the price of coffee. If the prices go
too high, consumers will seek substitute products that are available at a lower price, such as tea or soft
drinks. The analyst should consider both actual and potential substitute products in any target firm
analysis.

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 Buyers can exert pressure to drive down industry profits if they are in a strong bargaining position. If
customers represent a large proportion of the industrys sales or can act in concert, they can begin to
negotiate price and thus reduce industry profitability and cash flow.

Suppliers can raise prices or reduce quality when they are small in number and few substitutes for a
product exist. If suppliers have many customers and the particular industry under analysis does not
generate a significant portion of the suppliers sales, the suppliers will have more pricing flexibility, which
will impact and affect industry profitability and cash flow.
(moderate, L.O. 2, Section 1)

38. Explain the product life cycle.

Suggested solution:

Products generally go through a four-stage process: introduction, growth, maturity, and decline. This model
can be helpful in analyzing many businesses that produce goods. The analyst should note that costs
associated with these stages vary as well. In the introduction stage, costs will be high. Costs may drop
somewhat as the product moves from the introduction to the growth stage. In the maturity stage, costs may
be low as the firm is focused on cost reduction strategies. During the decline stage, costs may be cut
altogether as the product is phased out of production.
(moderate, L.O. 3, Section 2)

39. Discuss where to get information for business analysis.

Suggested solution:

Business analysis can be broken into two distinct parts: external and internal. Likewise, the sources for
information used in business analysis can be either external to the target firm or internal to it. External
sources would include historical relevant information about the firm, and current information available
from various public sources. Internal information would include information gathered from within the firm
itself, via interviews or examination of internal documents.

Sources for external information can come from the private sector or from the government. Private sector
information would include reliable business publications, studies conducted by research and consulting
groups, industry and trade publications, consultation with industry experts, and sources such as Internet
postings and Web sites. Information from the government sector would include analyses from the U.S.
Census Bureau, the Federal Reserve Bank, the U.S. Department of Commerce, and the Securities and
Exchange Commission. Information may also be found from state government resources as well, such as
the Department of Industrial Relations, various other regulatory agencies, or the office of the Secretary of
State.

Sources for internal information would come from the firm itself. Annual reports, marketing and promotion
announcements, press releases, and interviews with employees and management may provide the analyst
with fruitful information.

The analyst must also place some degree of reliability on the source itself. Respected business publications
such as Forbes or The Wall Street Journal generally are creditable and reliable. Interviews with certain
employees of a firm may or may not prove to be as credible, while information obtained from Internet
postings and Web sites may be used with caution as to their reliability.
(moderate, L.O. 4, Sections 1 & 2)

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