Financial statement analysis

Contents Cover Endorsement Series Title Page Copyright Dedication Preface to Fourth Edition Acknowledgments Part One: Reading between the Lines Chapter 1: The Adversarial Nature of Financial Reporting THE PURPOSE OF FINANCIAL REPORTING THE FLAWS IN THE REASONING SMALL PROFITS AND BIG BATHS MAXIMIZING GROWTH EXPECTATIONS DOWNPLAYING CONTINGENCIES THE IMPORTANCE OF BEING SKEPTICAL CONCLUSION Part Two: The Basic Financial Statements Chapter 2: The Balance Sheet THE VALUE PROBLEM COMPARABILITY PROBLEMS IN THE VALUATION OF FINANCIAL ASSETS INSTANTANEOUS WIPEOUT OF VALUE HOW GOOD IS GOODWILL? LOSING VALUE THE OLD-FASHIONED WAY TRUE EQUITY IS ELUSIVE PROS AND CONS OF A MARKET-BASED EQUITY FIGURE THE COMMON FORM BALANCE SHEET CONCLUSION Chapter 3: The Income Statement MAKING THE NUMBERS TALK HOW REAL ARE THE NUMBERS? CONCLUSION Chapter 4: The Statement of Cash Flows THE CASH FLOW STATEMENT AND THE LEVERAGED BUYOUT ANALYTICAL APPLICATIONS CASH FLOW AND THE COMPANY LIFE CYCLE THE CONCEPT OF FINANCIAL FLEXIBILITY IN DEFENSE OF SLACK CONCLUSION Part Three: A Closer Look at Profits Chapter 5: What Is Profit? BONA FIDE PROFITS VERSUS ACCOUNTING PROFITS WHAT IS REVENUE? WHICH COSTS COUNT? HOW FAR CAN THE CONCEPT BE STRETCHED? CONCLUSION Chapter 6: Revenue Recognition CHANNEL-STUFFING IN THE DRUG BUSINESS A SECOND TAKE ON EARNINGS ASTRAY ON LAYAWAY RECOGNIZING MEMBERSHIP FEES A POTPOURRI OF LIBERAL REVENUE RECOGNITION TECHNIQUES FATTENING EARNINGS WITH EMPTY CALORIES TARDY DISCLOSURE AT HALLIBURTON MANAGING EARNINGS WITH RAINY DAY RESERVES FUDGING THE NUMBERS: A SYSTEMATIC PROBLEM CONCLUSION Chapter 7: Expense Recognition NORTEL'S DEFERRED PROFIT PLAN GRASPING FOR EARNINGS AT GENERAL MOTORS TIME-SHIFTING AT FREDDIE MAC CONCLUSION Chapter 8: The Applications and Limitations of EBITDA EBIT, EBITDA, AND TOTAL ENTERPRISE VALUE THE ROLE OF EBITDA IN CREDIT ANALYSIS ABUSING EBITDA A MORE COMPREHENSIVE CASH FLOW MEASURE WORKING CAPITAL ADDS PUNCH TO CASH FLOW ANALYSIS CONCLUSION Chapter 9: The Reliability of Disclosure and Audits AN ARTFUL DEAL DEATH DUTIES SYSTEMATIC PROBLEMS IN AUDITING CONCLUSION Chapter 10: Mergers-and-Acquisitions Accounting MAXIMIZING POSTACQUISITION REPORTED EARNINGS MANAGING ACQUISITION DATES AND AVOIDING RESTATEMENTS CONCLUSION Chapter 11: Is Fraud Detectable? TELLTALE SIGNS OF MANIPULATION FRAUDSTERS KNOW FEW LIMITS ENRON: A MEDIA SENSATION HEALTHSOUTH'S EXCRUCIATING ORDEAL MILK AND OTHER LIQUID ASSETS CONCLUSION Part Four: Forecasts and Security Analysis Chapter 12: Forecasting Financial Statements A TYPICAL ONE-YEAR PROJECTION SENSITIVITY ANALYSIS WITH PROJECTED FINANCIAL STATEMENTS PROJECTING FINANCIAL FLEXIBILITY PRO FORMA FINANCIAL STATEMENTS PRO FORMA STATEMENTS FOR ACQUISITIONS MULTIYEAR PROJECTIONS CONCLUSION Chapter 13: Credit Analysis BALANCE SHEET RATIOS INCOME STATEMENT RATIOS STATEMENT OF CASH FLOWS RATIOS COMBINATION RATIOS RELATING RATIOS TO CREDIT RISK CONCLUSION Chapter 14: Equity Analysis THE DIVIDEND DISCOUNT MODEL THE PRICE-EARNINGS RATIO WHY P/E MULTIPLES VARY THE DU PONT FORMULA VALUATION THROUGH RESTRUCTURING POTENTIAL CONCLUSION Appendix: Explanation of Pro Forma Adjustments for Hertz Global Holdings, Inc./DTG Notes CHAPTER The Adversarial Nature of Financial Reporting CHAPTER The Balance Sheet CHAPTER The Income Statement CHAPTER The Statement of Cash Flows CHAPTER What Is Profit? CHAPTER Revenue Recognition CHAPTER Expense Recognition CHAPTER The Applications and Limitations of EBITDA CHAPTER The Reliability of Disclosure and Audits CHAPTER 10 Mergers-and-Acquisitions Accounting CHAPTER 11 Is Fraud Detectable? CHAPTER 12 Forecasting Financial Statements CHAPTER 13 Credit Analysis CHAPTER 14 Equity Analysis Glossary Bibliography About the Authors Index Additional Praise for Financial Statement Analysis, Fourth Edition “This is an illuminating and insightful tour of financial statements, how they can be used to inform, how they can be used to mislead, and how they can be used to analyze the financial health of a company.” –Jay O Light, Dean Emeritus, Harvard Business School “Financial Statement Analysis should be required reading for anyone who puts a dime to work in the securities markets or recommends that others the same.” –Jack L Rivkin, Director, Neuberger Berman Mutual Funds and Idealab “Fridson and Alvarez provide a valuable practical guide for understanding, interpreting, and critically assessing financial reports put out by firms Their discussion of profits–‘quality of earnings’–is particularly insightful given the recent spate of reporting problems encountered by firms I highly recommend their book to anyone interested in getting behind the numbers as a means of predicting future profits and stock prices.” –Paul Brown, Associate Dean, Executive MBA Programs, Leonard N Stern School of Business, New York University “Let this book assist in financial awareness and transparency and higher standards of reporting, and accountability to all stakeholders.” –Patricia A Small, Treasurer Emeritus, University of California; Partner, KCM Investment Advisors “This book is a polished gem covering the analysis of financial statements It is thorough, skeptical, and extremely practical in its review.” –Daniel J Fuss, Vice Chairman, Loomis, Sayles & Company, LP Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com earnings or, dividend discount model free cash flow life cycle and measure of, comprehensive total-debt-to-cash-flow ratio Cash flows ratios, statement of: capital expenditures to depreciation cash flow to capital expenditures depreciation as percentage of cash flow free cash flow and generally Cash-on cash-profit Cash vs income disparity Cedar Fair LP Channel-stuffing: doomed scheme, background of drop in earnings excessive inventory, detecting Chanos, James Chartered Financial Analysts Institute Chief executive officer (CEO) Cisco Systems, Inc Class action suits Coca-Cola Company: balance sheet ratios income statement profit margins of COGS See Cost of goods sold (COGS) Combination ratios: rate-of-return measures total-debt-to-cash-flow ratio turnover ratio Common form balance sheet Company life cycle, cash flow and Comparability: generally accepted accounting principles (GAAP) and problems, financial asset valuation Comparative ratio analysis: generally homogeneous industry peer group peer groups, generally rating peer groups and Competition, entry of Consolidation Constraints, market share Consumer Federation of America Contingencies, downplaying Contribution Corporate restructuring See Restructuring potential Corporations Cost(s): counting fixed vs variable Cost of capital Cost of goods sold (COGS): pretax costs and projected income statement and total costs and Credit analysis: balance sheet ratios cash flows ratios, statement of combination ratios credit risk, relating ratios to EBITDA, role in generally income statement ratios Credit approval process Credit quality: improving key indicator of Credit risk, EBITDA coverage and Credit risk, relating ratios to: bond ratings and comparative ratio analysis generally Criminal misrepresentation See Fraud, detectability of David W Tice Associates Death duties Debt: management's attitude toward return on equity and total, constitution of total-debt-to-cash-flow ratio Debt restriction disclosures Declining growth, rationalizations: diversification, mature markets and growth back on track, new products and year-over-year comparisons distorted Defaulting on debt Default risk models Deferred profit plan: accounting discrepancies background on from bad to worse lessons learned Deferred taxes, capital and Denari, Stephen Depreciation schedules Derivatives Dex One Corporation Dilution Disclosure/audits: artful deal death duties generally systematic problems, auditing and Discount rate Discretionary uses of cash Diversification Dividend discount model: dividends and future appreciation earning or cash flow future dividends/present stock price growing company, valuing Dividends Dooner, John J Double-entry bookkeeping Dow Jones Industrial Average Downgrading of debt Drug business See Channel-stuffing Dunn, Frank Du Pont formula, equity analysis and Dynegy Earnings: manipulation or cash flow, dividend discount model rainy day reserves and second take on Earnings multiple See Price-earnings ratio (P/E ratio) Earnings per share (EPS) Earnings-smoother EBITDA: EBIT, total enterprise value and peer-group multiple based on predictability of, near term restructuring and EBITDA, applications/limitations: abusing EBITDA cash flow, more comprehensive measure credit analysis and EBIT, total enterprise value and generally working capital and Economic conditions, volatility and Economies of scale Economies of scope Elkind, Peter Energy, economic conditions and Enforcement Division Enron: media sensation: analysts, fraud detection and company background lessons learned magazines/books and misleading of investors EPS See Earnings per share (EPS) Equity: elusive nature of market based figure, pros/cons Equity analysis: dividend discount model Du Pont formula generally P/E multiples, variability of price-earnings ratio restructuring potential, valuation through Ernst & Young Expense recognition: deferred profit plan at Nortel earnings, General Motors generally time-shifting at Freddie Mac Extraordinary/nonrecurring items Fair Value Accounting FASB See Financial Accounting Standards Board (FASB) Fastow, Andrew Federal Home Loan Mortgage Corporation See Freddie Mac, time-shifting at Fiduciary duty Financial Accounting Standards Board (FASB): corporate world, confrontations and deliberations of extraordinary events and profits, share prices and SFAS 95, “Statement of Cash Flows,” Financial assets, comparability and Financial derivatives “Financial engineering,” Financial flexibility: concept of income statements and Financial leverage Financial modeling tools Financial reporting, purpose of: generally Interpublic Group of Companies Lernout & Hauspie Speech Products (L&H) MicroStrategy Financial Statement Alert Fixed charge coverage Fixed costs: net profit margin and vs variable costs Fixed-rate debt Floating-rate debt Fluor Corporation Forbes Forecasting financial statements: financial flexibility, projecting generally multiyear projections one-year projection, typical pro forma financial statements pro forma statements for acquisitions sensitivity analysis, projected financial statements For-profit companies Fortune Fraud, detectability of: Enron - media sensation fraudsters know few limits generally HealthSouth's ordeal milk and other liquid assets telltale signs, manipulation and Freddie Mac, time-shifting at Free cash flow: calculation of excess cash flow and at Tyco Fresh start accounting Fudging the numbers Fundamental analysis GAAP See Generally accepted accounting principles (GAAP) GDP See Gross domestic product (GDP) Generally accepted accounting principles (GAAP): acquisitions and comparability and costs, counting deviations from Du Pont formula and lease structuring and manipulation and revenue-inflating tricks and traditional assets and General Motors (GM) GM See General Motors (GM) Goldberg, Arthur Goodwill: balance sheet and past acquisitions and write-offs Gramm, Phil Grant, James Gross domestic product (GDP) Growing company, valuing Growth: internal vs external organic rate of, sustainability and Growth, limits to continued: base, increasing entry of competition market share constraints saturation Growth expectations, maximizing: declining growth, rationalizations generally limits to continued growth Halliburton, tardy disclosure at: accounting issues background on lessons learned resolution HealthSouth Henderson, Barry Higher-than-trendline growth Historical cost Illiquidity Income statement See also Projected income statement costs, fixed vs variable economies of scale and extraordinary/nonrecurring items generally growth, external vs internal making the numbers talk not all sales final price-earnings multiples and revenues, skepticism about stock market proceeds into revenue Income statement ratios: capitalized interest for Coca-Cola Company fixed charge coverage generally interest income lease expense profit margins and Income taxes: deferred provision for Income vs cash disparity The Independent Initial public offering Interest, capitalized Interest expense Interest income Interpublic Group of Companies Inventory: buildup, involuntary turnover Investor relations officers JDS Uniphase Kendall Square Research Kimberly-Clark Corporation Kozlowski, Dennis Krispy Kreme: heat goes up lessons learned long slide begins resolution same-store sales Larcker, David F Lay, Kenneth Layaway LBO See Leveraged buyout (LBO) Lease expense Legal contingencies Lernout & Hauspie Speech Products (L&H) Lev, Baruch Leverage, financial Leveraged buyout (LBO) Leveraged recapitalizations Levitt, Arthur Liquidity Long-term debt, repayment Lucas, Timothy S Macroeconomic events Macroeconomic variables Maher, Robert P Manoukian, Stan Manville Corporation Market-based equity figure Market capitalizations: Internet start-ups and market-based equity figure and Market share constraints Mature markets, diversification and McKinsey & Co McLean, Bethany Megascandals Membership fees Mergers-and-acquisitions (M&A) accounting: generally postacquisition reported earnings, maximizing restatements, acquisition dates and Tyco International Meyer, Albert Microeconomic variables MicroStrategy Misrepresentation See Fraud, detectability of Moody's ratings Multivariate analysis Multiyear projections National Association of Securities Dealers Navigant Consulting Negative equity Net present values New Economy New products New York Times New York Times Company Nominal dollar Nonrecurring/extraordinary items Norris, Floyd Nortel Networks See Deferred profit plan Notes payable, increase in Off-balance-sheet liabilities Old Economy One-year projection, typical: balance sheet cash flows (see Projected statement of cash flows) earnings forecast generally income statement (see Projected income statement) Operating cash flow (OCF) Operating income Operating leverage Organic growth P&G See Procter & Gamble (P&G) Panera Bread Co Peet's Coffee & Tea income statement P/E multiples: best financial statement and income statement and P/E multiples, variation in: earnings, normalizing generally growth rate, sustainable P/E ratio See Price-earnings ratio (P/E ratio) Percentage-of-completion method Portfolios Postacquisition reported earnings, maximizing Preferred stock Present value Price-earnings multiples See P/E multiples Price-earnings ratio (P/E ratio) Procter & Gamble (P&G) Product Control Group Profit margin improvement, restructuring and Profit margins, commonly used Profit-maximizing accounting firms Profit plan See Deferred profit plan Profit(s) bona fide vs accounting costs, counting of generally revenue and stretching the concept Pro forma balance sheets, goodwill and Pro forma financial statements Pro forma statements for acquisitions Projected balance sheet Projected income statement:, See also Income statement cost of goods sold depreciation earnings forecast and income taxes, provision for interest expense interest income operating income research and development (R&D) sales selling, general, administrative expense Projected statement of cash flows See also Cash flows; Statement of cash flows additions to property, plant, equipment deferred income taxes dividends notes payable, increase in repayment of current maturities of long-term debt working capital changes Property, plant, and equipment R&D See Research and development (R&D) Rainy day reserve Ratio trend analysis Raychem Raymond, David Reported earnings Research and development (R&D) Restatements Restructuring potential: asset sales EBITDA and generally profit margin improvement Revenue Revenue recognition: channel-stuffing, drug business earnings, second take on fattening earnings with empty calories fudging the numbers generally layaway liberal techniques membership fees percentage-of-completion method rainy day reserves and tardy disclosure at Halliburton Risk-based audits Rock Center for Corporate Governance Rocker, David Roper, Barbara Roth, Michael I Sale-leaseback Saturation Sauer, Richard Saylor, Michael Schilit, Howard SEC See Securities and Exchange Commission (SEC) Securities and Exchange Commission (SEC): accounting rules of audit committees and auditing-consulting conflict certification requirements federal budget and Financial Accounting Standards Board (FASB) and fudging the numbers and restatements and Selling, general, and administrative expenses (SG&A) Sensitivity analysis, projected financial statements September 11, 2001, terrorist attacks SG&A See Selling, general, and administrative expenses (SG&A) Shakeout Skepticism, importance of Skilling, Jeffrey Slack, defense of Smartest Guys in the Room, The (McLeand and Elkind) Sorkin, Andrew Ross Standard & Poor's ratings Starbucks: balance sheet of income statement and Statement of cash flows See also Cash flows; Projected statement of cash flows analytical applications company life cycle, cash flow and financial flexibility concept generally leveraged buyout and slack, defense of Statement of Financial Accounting Standards (SFAS) Statutory tax rate Stock market proceeds, transforming into revenue Story, investors and Straight-line basis, depreciation Sustainability Swartz, Mark Synergy Takeover, hostile Tax rate, statutory Technical default Tech Wreck Tesla Motors Time-shifting Total debt, constitution of Total-debt-to-cash-flow ratio Total enterprise values: EBIT, EBITDA and net income and Trump Hotels & Casino Resorts Turner, Lynn Turnover ratio Tyco International Underperforming companies, equity value estimation Value: instantaneous wipeout of losing, old-fashioned way problems of Value problem, balance sheet ant Variable vs fixed costs Walker, Richard Wall Street Journal Wal-Mart Stores, Inc Western Union Working capital: balance sheet and cash flow analysis and projected statement of cash flows and WorldCom W.R Grace Write-offs W T Gran Year-after-year comparisons, distortion of Year-over-year increase Zakolyukina, Anastasia A Zeckhauser, Richard Zero-coupon financing Zeta model Z-Score model ... Security Analysis Chapter 12: Forecasting Financial Statements A TYPICAL ONE-YEAR PROJECTION SENSITIVITY ANALYSIS WITH PROJECTED FINANCIAL STATEMENTS PROJECTING FINANCIAL FLEXIBILITY PRO FORMA FINANCIAL. .. 12 Forecasting Financial Statements CHAPTER 13 Credit Analysis CHAPTER 14 Equity Analysis Glossary Bibliography About the Authors Index Additional Praise for Financial Statement Analysis, Fourth... PRO FORMA FINANCIAL STATEMENTS PRO FORMA STATEMENTS FOR ACQUISITIONS MULTIYEAR PROJECTIONS CONCLUSION Chapter 13: Credit Analysis BALANCE SHEET RATIOS INCOME STATEMENT RATIOS STATEMENT OF CASH