Basic Statements Fridson Alvarez

Financial Statement Analysis

Reporting & Basic Statements: Balance Sheet & Income Statement

based on M. Fridson, F. Alvarez: Financial Statement Analysis (2011)

Piotr Winiewski, Ph.D.

[email protected]

Purpose of financial reporting?

Source: Psalm 118 (2011)

Cheap financing for corporates

Purpose of financial reporting

Source: Access Brokers (2011)

Why smooth earnings?

Source: MS Windows (2011)

Because

Volatility is perceived as a risk factor.

Source: Options Playbook (2011)

How is the smoothing done?

Source: Out of Comfort Zone (2011)

Thats how Lags and leads in recording accounting events. Incentives to business parties to speed up revenues, slow down expenses to prop up incomes

Source: 21 Ace (2011)

Why earnings revised up often?

Source: Traders Narrative (2011)

Cos

Good news spreads faster than bad news. Ever heard of people who brag?

Source: Martina Schonfeld (2011)

Why do big baths make sense?

Source: Interior Exterior Designs (2011)

Because

Empirically, investors have tended to react similarly to hyper-bloodbaths as to mega-bloodbaths. The blood is spilled (bad news share price slumps) and cest ca!

Source:The Fathomless Master (2011)

What is done during bloodbaths?

Source: The Angry Dome (2011)

During bloodbaths

Dramatic write-offs of obsolete assets, contingencies made to create space for longer-term stable income streams

Source: Cartell (2011)

Why wont auditors complain?

Source: Listentomywords (2011)

Pressure groups Accounting standards are worked out by the FASB during a bargaining process involving accountants, issuers (companies) and users (everyone else) of financial statements.

Source: Suite Life (2011)

Whats the agency problem?

Source: Buyer's Broker (2011)

Conflicts of interests

[..]between a companys shareholders and hired managers. Can arise from performance related incentive schemes and other disequilibria. Digression: private equity managers bonuses.

Source: CADRE (2011)

What if owners = managers?

Source: EOS (2011)

When owners = managers

Even worse for the analyst. Harder to find out what they are up to. Things swept under the carpet more consistently and without major traces

Source: You Talk Like a Banjo (2011)

Why managers fight to keep earnings growth on track?

Source: National Guard Counterdrug Program (2011)

Because Broken dreams are mercilessly avenged: the company ceases to be perceived as a rising star and is now valued on a stable cash flow pattern Digression: DCF valuation.

Source: The Zombies Layer (2011)

What are natural limits to growth?

Source: Random Musings of a Curious Mind (2011)

1 of 4 Saturation. People get fed up

Source: Dreamstime (2011)

2 of 4 Entry of competition. Copycats, knockoffs.

Source: Luxury Watches Reviews (2011). Note that this is a genuine Patek Philippe picture.

3 of 4 Macro limitations. One product cannot fully substitute others

Source: ?

4 of 4 Limits to growth in the market in which the company operates A company cannot control 200% of a market.

Source: World of Monopoly (2011)

Any excuses to slow-downs?

Source: Sustainable Living for Dummies (2011)

1 of 3 Objective, short-term distortions. Bad weather. Logistic problems due to rampant sales. Y2Ks. Prices of raw materials temporarily out of line

Source: ?

2 of 3 Diversification away from mature markets. Conglomerate discounts. Examples from various countries.

Source: Cartoon Stock (2011)

3 of 3

Revolutionary products/services. Unfortunately high mortality rate.

Source: Manny The Movie Guy (2011)

Legal hazards nightmares waiting to happen?

Source: MWG Blog (2011)

Yes! Why?

An unquantifiable risk factor. How can we account for something immeasurable?

Source: Hazelnut Films (2011)

Why no provisions made in advance?

Source: SPL UK (2011)

Reasons

1. Vested interest in non-disclosure.

2. Conflicts of interests vis-a-vis current shareholders.

3. Lack of expertise in crisis detection and management.

Source: Anirundh Sethi Report (2011)

How share issues are sold?

Source: Your Money Dictionary (2011)

Stories, pampering

1. Hyped up stories thrown at retail investors. Mind-boggling forecasts.

2. More sophisticated appetizers for institutional buyers. Catering to their greed. Nature of portfolio management

Source: Experience Days (2011)

Why is credit evaluation abnormal?

Source: Free Credit Report (2011)

Optimum business scale

Because it makes a fair amount of sense to be sustaining a certain amount of losses in order to maximize gains at aggregate (portfolio) level.

Source: Families.com (2011)

Why do managers want a quick buck?

Source: Dribbble (2011)

Conflicting horizons

Maybe they are about to leave quickly. Retirement. Job changes. Other motifs?

Source: Art.com (2011)

Is human capital on balance sheets?

Source: Bret L. Simmons (2011)

No, no one knows how to price it! One of the principal challenges of contemporary accounting and finance world-wide

Source: On Product Management (2011)

Examples of distorted balance sheets

Source: The Inspiration Room (2011)

OK, here they are

The overwhelming majority of intangible assents unaccounted for until acquisition/sale.

Liabilities not updated for market interest changes.

Assets/liabilities unique to a companys operations (irreplacable).

Source: Jangle Pop Boutique (2011)

Did ratings respond to .com boom?

Source: Silicon Angle (2011)

Surprisingly to some

Not substantially. The credit agencies tended to ignore most of the elusive intangibles, notably: goodwill. Thus, goodwill wipeouts went largely unnoticed

Digression: risk profiles: equity/debt investors

Source: The Risk Management Guide (2011)

What can goodwill be good for?

Source: Baja Greenawalt's Cozy Book Nook (2011)

E.g

Beefing up a companys balance sheet total. Artificial de-leveraging.

Source: MyLot (2011)

How to engineer goodwill easily?

Source: India Talkies (2011)

Stock-for-stock M&A Both parties to the process happy: book-values get an instant boost. With speculative pre-M&A stock-price growth: a real dream factory.

Source: ChristieTaylorOnline (2011)

Why is goodwill no good to lenders?

Source: Wearenogood (2011)

Reason

Goodwill is hard to monetize. One cannot sell it and lease it back (like real estate), thereby no cash implications.

Source: Ehow (2011)

Can stable EPS destroy value?

Source: Tulum Second Line Lot (2011)

Yes

If it consistently fails to catch up with the going rate of return in the industry, then resources perhaps ought to be realocated. Opportunity cost of capital. Digression: the crowding-out effect of high real interest rates.

Source: Intermediate English (2011)

What benchmarks to use?

Source: Archithings (2011)

When comparing

Whilst comparing a companys productivity/profitability/cash generation, we should look at its peer group same industry, ideally, similar size

Source: CSL Cartoonstock (2011)

What a leveraged recap can do?

Source: Cool Science Projects (2011)

Effects

Up stock market valuation. Reconcile vying shareholders groups see previous. Fend off hostile take-overs

Source: Biotech Investment Paradigm (2011)

Pros of Market Cap valuation

Source: Seeking Alpha (2011)

Here they are

Ease of calculation.

Timeliness.

Large number of analysts.

Source: Music Teachers Helper (2011)

Drawbacks of Market Cap?

Source: HubPages (2011)

Quite a few

No reliable proxy for unquoted companies.

Volatility.

Behavioral finance asymmetries to information.

Going-concern assumptions

Source: Darwin's Game Closet (2011)

What about derivatives under GAAP?

Source: Financial Pipeline (2011)

Now Either capitalized (shown as assets) or written to debt (show as liabilities) at fair value. Hedging set-offs possible.

Source: CSL Cartoonstock (2011)

Why is % balance sheet useful?

Source: Mississauga Real Estate (2011)

Reasons

Because it shows individual assets as %s of total assets and individual liabilities and equity components as %s of (total liabilities + shareholders equity). Easier to see trends on each item!

Source: All Spammed Up (2011)

Which industries are susceptible to interest rate volatility?

Source: ETF Trends (2011)

The financial sector

Why? Because it often lives off borrowed capital.

Source: The World Bank Group (2011)

Which sectors do not care so much?

Source: Auto Under $20K (2011)

Traditional Retailers, traditional industries

Source: MPR News (2011)

Should consultants be retained?

Source: TheNewLead (2011)

Sometimes yes In industries demanding highly specialized know-how and in high-profile transactions it might be justified to retain a sectoral consultant.

Source: Innowacyjny Sklep Internetowy (2011)

Why are some sales bogus?

Source: Deep Bajaj (2011)

Sales propping

Longer payment periods, laxer credit standards, discounts for early order placement

Source: Behavior Advisor (2011)

How to detect them?

Source: Deadline (2011)

Answers

Talk to the companys managers. Look into its industry. Compare what competitors are doing

Source: ?

How to see depreciation gimmickry?

Source: Cartoonstock (2011)

Simple Look where the competitors depreciation ratios stand. Uderreported depreciation might be a way to pump up profitability.

Source: OAI (2011)

What rhetoric is used?

Source: With Friendship (2011)

To

To approximate industry norms closer. Subjective. Ultimately checked by an auditor.

Source: Financing Tips (2011)

When are depreciation methods switched?

Source: Memphis Invest (2011)

When Profits are desperately needed. E.g. a company is using straight-line, demand ebbs, so supposedly to reflect real asset use the company begins to depreciate as per the activity based rule. Lower charges, but part of a more general problem.

Source: Bear Manor Media (2011)

How extraordinary are some items?

Source: Animalamigo (2011)

Depends Sometimes a smokescreen to hide recent problems and convince weakness was temporary

Source: Arts & Sciences College Forum (2011)

Position of extraordinaries?

Source: Saint Paul Public Schools (2011)

After-tax

Below the bottom line: income/loss!

Source: Cotton Incorporated (2011)

Rules for extraordinaries?

Source: Caribbean Stud Online (2011)

Guidelines

GAAP: unusual nature - anomaly. Infrequency.

Source: DeviantArt (2011)

Did 9/11 qualify?

Source: September 11 News (2011)

Surprisingly NO!

Not even for airlines, which suffered an external shock to their financial standing. Why? By then they had been struggling; inability to separate the 9/11 impact from other, prior woes

Source: ETF Trends (2011)

What do companies do to stretch the definition?

Source: Juiced Muscle (2011)

Examples

Non-GAAP, yet compelling expressions such as: non-recurring, unusual, restructuring

Source: Home Buying/Selling (2011)

Why restructure?

Source: Cartoonstock (2011)

CEO succession A companys new CEO wants to have a clean slate and a big bath attributed to his predecessor (so a turn-around can now be possible)

Source: Brookeswords (2011)

Are there tireless restructurers out there?

Source: The Free Dictionary (2011)

Yes Procter & Gambles example. Restructured for 7 consecutive years

Source: Nappy Headed Black Girl (2011)

What are pro forma results?

Source: Plannersweb (2011)

Spin-mastery Protected and promulgated under freedom-of-the-press laws, non-GAAP information, oftentimes a manipulation.

Source: Pardio Wars (2011)

Why examine SEC filings?

Source: Sitepoint (2011)

Because

Less susceptible to manipulation

Source: Greek Shares (2011)

What is a quick revenue booster?

Source: Asia Ru (2011)

M&A

Consolidation of take-overs.

Source: Grants for New Business (2011)

Which is better: internal/extenal growth?

Source: Spread Shirt (2011)

Internal/external growth Internal - hard-earned. Usually more profitable/cash favorable.

External OK if synergies, economies/opportunities of scale, vertical/horizontal integrations materialize (oftentimes mere wishful thinking).

Source: Dreamstime (2011)

Fixed vs. variable costs: easy distinction?

Source: Lucy Learns (2011)

No

Hard to find in corporate financials. If found, very useful. Enables break-even calculations pre-and post-M&A.

Variable-biased (in relation to sales) cost structures usually more flexible, i.e. secure.

Source: Dr. Pinna (2011)

How do P/Es get pumped up?

Source: Skateboard Australia (2011)

E.g

Series of acquisitions of low-multiple (e.g. unlisted) targets.

Source: Meredith's in Brasilia (2011)

Earnings manipulation: early warnings

Source: Dating After Forty Eight (2011)

According to M. D. Beneish

1. Receivables collection decelerating.

2. Eroding gross margins.

3. Falling depreciation rates.

4. Non-current, non-PPE assets value soaring.

5. Sales growth.

Source: I keeps it (2011)