Commonly Heard Rationalizations for Declining Growth
Our Year-over-Year Comparisons Were Distorted Recognizing the sensitivity of investors to any slowdown in growth, companies faced with earnings deceleration commonly resort to certain standard arguments to persuade investors that the true, underlying profit trend is still rising at its historical rate (see Exhibit 1.2). Freak weather conditions may be blamed for supposedly anomalous, below-trendline earnings. Alternatively, the company may EXHIBIT 1.2 Our Year-over-Year Comparisons Were...
Recognizing Membership Fees
Bally Total Fitness provided another case in which questions about revenue recognition contributed to an unfavorable stock market reaction to seemingly upbeat earnings news. On July 30, 1998, the health club chain reported diluted earnings per share of 0.08, up from a year-earlier loss of 0.59. According to the Wall Street Journal,19 the improved profits were unexpectedly encouraging. They suggested that the success of the company's newer, more upscale clubs was bolstering overall performance....
Ebit Ebitda And Total Enterprise Value
The fictitious case of Deep Hock and Breathing Room (Exhibit 8.1) illustrates the problems of relating net income to total enterprise value. Both companies compete within the thingmabob industry. Their net profits for the latest year are 28.6 million and 33.0 million, respectively. When Breathing Room announces an agreement to be acquired by a multinational thingmabob producer for 666 million, Deep Hock's founder and controlling shareholder, Philip Atlee, realizes that his company is a hot item...
Additional Reasons to Be Skeptical about Revenues
Unfortunately for analysts, companies do not always spell out in the Notes to Financial Statements the means by which they have artificially inflated their revenues. A company might lower the credit standards it applies to prospective customers without simultaneously raising the percentage of reserves it establishes for losses on receivables. The result would be a rise in both revenues and earnings, in the current period, with the corresponding increase in credit losses not becoming apparent...
Through a Lens Darkly
At a special December 13, 1993, meeting, according to a Business Week report,27 Bausch & Lomb (B& L) informed its 32 independent contact lens distributors of a new policy. Going forward, the company would make fewer direct shipments to eye doctors and do a larger portion of its business through the distributors. On the face of it, the distributors appeared to be big winners under B& L's revised strategy. Lens division head Harold O. Johnson then revealed a substantial quid pro quo. To...
Pro Forma Statements for Acquisitions
Just as pro forma statements provide a useful basis for forecasting a company's results following a major divestment, subject to certain caveats, they are helpful in the context of acquisitions when used judiciously. If anything, though, analysts must exercise greater care in extrapolating from an acquisition-related pro forma income statement. The effects of shedding a business are highly predictable compared with the uncertainties inherent in combining companies. Mergers of companies in the...
The Role Of Ebitda In Credit Analysis
The dialogue between Phil Atlee and his niece shows that similar companies with similar net income can have substantially different total enterprise values. Much in the same way, companies with similar interest coverage can have substantially different default risk. In credit analysis, as in valuing businesses, EBITDA can discriminate among companies that look similar when judged in terms of EBIT. Consider the fictitious examples of Rock Solid Corporation and Hollowman, Inc. (Exhibit 8.3)....
Undisclosed Hazards
Yet another complication in the quest for true equity involves disclosure. Despite the pitfalls previously discussed, analysts can feel comfortable in relying on market capitalization for certain applications, provided they believe that all material information affecting companies' equity values is available for investors to assess. In practice, though, companies' equity values can be significantly altered by items that are either undisclosed or disclosed only in a limited fashion. Early in...
Marketbased Equity Figure
Relying on market capitalization is the practical means by which financial analysts commonly estimate the economists' more theoretically rigorous definition of equity as the present value of expected future cash flows. Monumental difficulties confront anyone who instead attempts to arrive at the figure through conventional financial reporting systems. The problem is that traditional accounting favors items that can be objectively measured. Unfortunately, future earnings and cash flows are...
Bona Fide Profits Versus Accounting Profits
In defining bona fide profits, the simple formula, revenue minus costs, represents a useful starting point. When calculating this kind of profit, the analyst must take care to consider only genuine revenues and deduct all relevant costs. A nonexhaustive list of costs includes labor, materials, occupancy, services purchased, depreciation of equipment, and taxes. No matter how meticulously the analyst carries out these computations, however, no calculation of profit can be satisfactory unless it...
Cash Flow And The Company Life Cycle
Business enterprises typically go through phases of development that are in many respects analogous to a human being's stages of life. Just as children are susceptible to illnesses different from those that afflict the elderly, the risks of investing in young companies are different from the risks inherent in mature companies. Accordingly, it is helpful to understand which portion of the life cycle a company is in and which financial pitfalls it is therefore most likely to face. Exhibit 4.4...
True Equity Is Elusive
What financial analysts are actually seeking, but are unable to find in the financial statements, is equity as economists define it. In scholarly studies, the term equity generally refers not to accounting book value, but to the present value of future cash flows accruing to the firm's owners. Consider a firm that is deriving huge earnings from a trademark that has no accounting value because it was developed internally rather than acquired. The present value of the profits derived from the...
Issues Of Comparability
Although some would regard the prohibition of adjusting debt figures to the market as artificial, they might at least find it tolerable if it applied in every instance. Consider what happens, however, in an acquisition. Statement of Financial Accounting Standards SFAS 141 Business Combinations makes it mandatory to revalue the acquired company's debt to current market if its value differs significantly from face value as a consequence of a shift in interest rates since the debt was issued. Here...
Redefining Pro Forma Earnings
As highlighted by the P amp G and Coca-Cola examples, companies encourage investors to focus on favorably constructed profit measures. The term core net earnings has enjoyed a vogue in recent years. Like above-the-line nonrecurring events, such numbers have no official status under GAAP. Companies' press releases, however, are not subject to GAAP. As time has gone on, corporations have devoted increasing energy to diverting analysts' attention to unofficial numbers that present their results in...
An Income versus Cash Disparity
The financial statements of a computer manufacturer likewise telegraphed future problems in the area of revenue recognition. Shortly before Kendall Square Research's October 1993 revision of its previously reported earnings, a research service known as Financial Statement Alert warned that the company was recognizing revenues too early. Kendall Square reported 45.4 million in revenue in the first six quarters after it went public in March 1992. Loren Kellogg, copublisher of Financial Statement...
Astray On Layaway
On August 9, 2000, Wal-Mart Stores reported a 28 year-over-year increase in net income for its fiscal second quarter ending July 31. At 0.36, earnings per share diluted were up by 29 . Sales rose by a healthy 20 , climbing 5 at Wal-Mart units open for more than one year. In light of these results, which one analyst characterized as a very good quarter, the discount chain's share price might have been expected to rise. At the very least, investors would have expected the stock to hold steady,...
Small Profits And Big Baths
Certainly, financial statement analysts do not have to fight the battle single-handedly. The Securities and Exchange Commission and the Financial Accounting Standards Board prohibit corporations from going too far in prettifying their profits to pump up their share prices. These regulators refrain from indicating exactly how far is too far, however. Inevitably, corporations hold diverse opinions on matters such as the extent to which they must divulge bad news that might harm their stock market...
Extraordinary and Nonrecurring Items
To most individuals who examine a company's income statement, the document is less important for what it tells about the past than for what it implies about future years.2 Last year's earnings, for example, have no direct impact on a company's stock price, which represents a discounting of a future stream of earnings see Chapter 14 . An equity investor is therefore interested in a company's income statement from the preceding year primarily as a basis for forecasting future earnings. Similarly,...
The Concept Of Financial Flexibility
Besides reflecting a company's stage of development, and therefore the categories of risk it is most likely to face, the cash flow statement provides essential information about a firm's financial flexibility. By studying the statement, an analyst can make informed judgments on such questions as How safe likely to continue being paid is the company's dividend Could the company fund its needs internally if external sources of capital suddenly become scarce or prohibitively expensive Would the...
Is Fraud Detectable
As a final point on the reality underlying the numbers, readers should note that although the tactics detailed in the preceding discussion may not win awards for candor in financial reporting, neither will most of them land corporate managers in the penitentiary. Analysts must be mindful that there are many ways for companies to pull the wool over investors' eyes without fear of legal retribution. Sometimes, however, corporate executives step over the line into illegality. Outright...
The Purpose Of Financial Reporting
Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of financial reporting. Their conceptual error connotes no lack of intelligence, however. Rather, it mirrors the standard accounting textbook's idealistic but irrelevant notion of the purpose of financial reporting. Even Howard Schilit see the MicroStrategy discussion, later in this chapter , an acerbic critic of financial reporting as it is actually...
No Straight Talk from Lernout Hauspie
On November 16, 2000, the auditor for Lernout amp Hauspie Speech Products L amp H withdrew its clean opinion of the company's 1998 and 1999 fi-nancials. The action followed a November 9 announcement by the Belgian producer of speech-recognition and translation software that an internal investigation had uncovered accounting errors and irregularities that would require restatement of results for those two years and the first half of 2000. Two weeks later, the company filed for bankruptcy. Prior...
Go to the Source
Although analysts must exercise judgment when considering pro forma earnings, there is one rule they should follow without fail. They must make sure to examine the actual SEC filings, instead of trying to save time by relying solely on company communications. The consequences of failing to check the filings are illustrated by an incident involving telecommunications services provider I.D.T. On October 14, 1999, I.D.T. issued a press release highlighting record revenues in its fiscal fourth...
Mercury Plunges
In January 1997, Mercury Finance's controller was reported to have disappeared3 after the company reduced its 1996 earnings to 56.7 million from an originally reported 120.7 million. The used-car loan company's co-founder and chief executive officer, John Brincat, contended that the irregularities necessitating the restatements were apparently the result of unauthorized entries being made to the accounting records of the company by the principal accounting officer, the missing James A. Doyle.4...
The Adversarial Nature of Financial Reporting
Financial statement analysis is an essential skill in a variety of occupations including investment management, corporate finance, commercial lending, and the extension of credit. For individuals engaged in such activities, or who analyze financial data in connection with their personal investment decisions, there are two distinct approaches to the task. The first is to follow a prescribed routine, filling in boxes with standard financial ratios, calculated according to precise and inflexible...
Downplaying Contingencies
A second way to mold disclosure to suit the issuer's interests is by downplaying extremely significant contingent liabilities. Thanks to the advent of class action suits, the entire net worth of even a multi-billion-dollar corporation may be at risk in litigation involving environmental hazards or product liability. Understandably, an issuer of financial statements would prefer that securities analysts focus their attention elsewhere. At one time, analysts tended to shunt aside claims that...
Preface to third edition
This third edition of Financial Statement Analysis, like its predecessors, seeks to equip its readers for practical challenges of contemporary business. Once again, the intention is to acquaint readers who have already acquired basic accounting skills with the complications that arise in applying textbook-derived knowledge to the real world of extending credit and investing in securities. Just as a swiftly changing environment necessitated extensive revisions and additions in the second...
Forecasting Financial Statements
Sensitivity Analysis with Projected Financial Statements 224 How Accurate Are Projections in Practice 230 Projecting Financial Flexibility 232 Balance Sheet Ratios 268 Income Statement Ratios 280 Statement of Cash Flows Ratios 285 Combination Ratios 287 Relating Ratios to Credit Risk 294 Conclusion 313 Valuation through Restructuring Potential 336
