Financial Statement Analysis A Practitioner's Guide third edition - Martin Fridson Fernado Alvarez

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Financial Statement Analysis
John Wiley & Sons Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, 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 fi- nancial instrument analysis, as well as much more. For a list of available titles, please visit our Web site at www. WileyFinance.com.
F inancial Statement analysis A Practitioner’s Guide Third Edition MARTIN FRIDSON FERNANDO ALVAREZ John Wiley & Sons, Inc.
Copyright © 2002 by Martin Fridson and Fernando Alvarez. All rights reserved. Published by John Wiley & Sons, Inc. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ@WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. This title is also available in print as ISBN 0-471-40915-4. Some content that appears in the print version of this book may not be available in this electronic edition. For more information about Wiley products, visit our web site at www.Wiley.com
In memory of my father, Harry Yale Fridson, who introduced me to accounting, economics, and logic, as well as the fourth discipline essential to the creation of this book—hard work! M. F. For Shari, Virginia, and Armando. F. A.
A DDITIONAL PRAISE FOR FINANCIAL STATEMENT ANALYSIS, THIRD EDITION “With a solid understanding of accepted accounting standards, one must peel through the fog generated by audited accounting numbers to get a clear picture of any company’s financial health. Certainly, Fridson and Alvarez show us how to do just that. What I like best about the book is the authors’ ability to provide examples of real-life debacles dis- cussed in the business press that could have been foreseen using the techniques explained in the book and having a healthy dose of skepticism. Their approach to analyzing finan- cial statements should be commended.” —Ivan Brick Professor and Chair, Finance and Economics Department, Rutgers Business School “This book should be required reading for the seasoned investor and novice alike. Frid- son and Alvarez show, in a very readable format, that diligent analysis still can make a difference. Finally a book that covers not just the basics, but all the subtleties and every- thing that management doesn’t want you to know.” —Robert S. Franklin, CFA Portfolio Manager, Neuberger Berman, LLC “Read it, digest it, and review it frequently. Fridson and Alvarez take you through finan- cial statement analysis with many salient examples that expose hidden agendas and help with assessing the true value of securities.” —Ron Habakus Director of High Yield Investments, Brown Brothers Harriman “Fridson and Alvarez clearly show why the most successful financial analysts approach their jobs with healthy doses of cynicism. Well written, insightful, and with numerable real life war stories, this book is required reading for all high yield bond analysts at AIG.” —Gordon Massie Managing Director, High Yield Bonds American International Group Global Investment Advisors “Fridson and Alvarez give financial analysts, accountants, investors, auditors and all other finance professionals something to chew over. They succeed in illustrating the use of financial statement analysis with many astonishing real life examples. This book starts where others stop. Clearly, a must read that brings the reader beyond the pure number crunching!” —Marc J.K. De Ceuster Professor at the University of Antwerp (Belgium) and Director of Risk Management at Deloitte & Touche “Alvarez and Fridson have a real gift for expressing the concepts of finance in down-to- earth, understandable ways. The situations they choose, and the skillful way they lay out each example, make all the subtle relationships come to. They are real artists with spreadsheets that are easy for the reader to follow, and easy to adapt to new situations. For instant financial empowerment, buy this book and let Alvarez and Fridson ramp up your financial modeling skills.” —John Edmunds Director of the Stephen D. Cutler Investment Management Center at Babson College
preface to third edition his third edition of Financial Statement Analysis, like its predecessors, T seeks to equip its readers for practical challenges of contemporary busi- ness. Once again, the intention is to acquaint readers who have already ac- quired basic accounting skills with the complications that arise in applying textbook-derived knowledge to the real world of extending credit and in- vesting in securities. Just as a swiftly changing environment necessitated ex- tensive revisions and additions in the second edition, new concerns and challenges for users of financial statements have accompanied the dawn of the twenty-first century. For one thing, corporations have shifted their executive compensation plans increasingly toward rewarding senior managers for “enhancing share- holder value.” This lofty-sounding concept has a dark side. Chief executive officers who are under growing pressure to boost their corporations’ share prices can no longer increase their bonuses by goosing reported earnings through financial reporting tricks that are transparent to the stock market. They must instead devise more insidious methods that gull investors into believing that the reported earnings gains are real. In response to this trend, we have expanded our survey of revenue recognition gimmicks designed to deceive the unwary. Another innovation that demands increased vigilance by financial ana- lysts is the conversion of stock market proceeds into revenues. In terms of accounting theory, this kind of transformation is the equivalent of alchemy. Companies generate revenue by selling goods or services, not by selling their own shares to the public. During the Internet stock boom of the late 1990s, however, clever opera- tors found a way around that constraint. Companies took the money they raised in initial public offerings, bought advertising on one another’s web- sites, and recorded the shuttling of dollars as sales. Customers were superflu- ous to the revenue recognition process. In another variation on the theme, franchisers sold stock, lent the proceeds to franchisees, then immediately had the cash returned under the rubric of fees. By going out for a short stroll and coming back, the proceeds of a financing mutated into revenues. vii
viii PREFACE TO THIRD EDITION The artificial nature of these revenues becomes apparent when readers combine an understanding of accounting principles with a corporate fi- nance perspective. We facilitate such integration of disciplines throughout Financial Statement Analysis, making excursions into economics and busi- ness management as well. In addition, we encourage analysts to consider the institutional context in which financial reporting occurs. Organiza- tional pressures result in divergences from elegant theories, both in the con- duct of financial statement analysis and in auditors’ interpretations of accounting principles. The issuers of financial statements also exert a strong influence over the creation of the financial principles, with powerful politi- cians sometimes carrying their water. A final area in which the new edition offers a sharpened focus involves success stories in the critical examination of financial statements. Wherever we can find the necessary documentation, we show not only how a corpo- rate debacle could have been foreseen through application of basis analyti- cal techniques, but how practicing analysts actually did detect the problem before it became widely recognized. Readers will be encouraged by these examples, we hope, to undertake genuine, goal-oriented analysis, instead of simply going through the motions of calculating standard financial ratios. Moreover, the case studies should persuade them to stick to their guns when they spot trouble, despite management’s predictable litany. (“Our financial statements are consistent with Generally Accepted Accounting Principles. They have been certified by one of the world’s premier auditing firms. We will not allow a band of greedy short-sellers to destroy the value created by our outstanding employees.”) Typically, as the vehemence of management’s protests increases, conditions deteriorate and accusations of aggressive ac- counting give way to revelations of fraudulent financial reporting. As for the plan of Financial Statement Analysis, readers should not feel compelled to tackle its chapters in the order we have assigned to them. To aid those who want to jump in somewhere in the middle of the book, the third edition provides increased cross-referencing and an expanded Glos- sary. Words that are defined in the Glossary are shown in bold faced type in the text. Although skipping around will be the most efficient approach for many analysts, a logical flow does underlie the sequencing of the material. In Part I (“Reading between the Lines”), we show that financial state- ments do not simply represent unbiased portraits or corporations’ financial performance and explain why. The section explores the complex motiva- tions of issuing firms and their managers. We also study the distortions pro- duced by the organizational context in which the analyst operates. Part II (“The Basic Financial Statements”) takes a hard look at the in- formation disclosed in the balance sheet, income statement, and statement
ix Preface to Third Edition of cash flows. Under close scrutiny, terms such as value and income begin to look muddier than they appear when considered in the abstract. Even cash flow, a concept commonly thought to convey redemptive clarification, is vulnerable to stratagems designed to manipulate the perceptions of in- vestors and creditors. In Part III (“A Closer Look at Profits”), we zero in on the lifeblood of the capitalist system. Our scrutiny of profits highlights the manifold ways in which earnings are exaggerated or even fabricated. By this point in the book, the reader should be amply imbued with the healthy skepticism nec- essary for a sound, structured approach to financial statement analysis. Application is the theme of Part IV (“Forecasts and Security Analysis”). For both credit and equity evaluation, forward-looking analysis is empha- sized over seductive but ultimately unsatisfying retrospection. Tips for max- imizing the accuracy of forecasts are included and real-life projections by professional securities analysts are dissected. We cast a critical eye on stan- dard financial ratios and valuation models, however widely accepted they may be. Financial markets continue to evolve, but certain phenomena appear again and again in new guises. In this vein, companies never lose their re- sourcefulness in finding new ways to skew perceptions of their performance. By studying their methods closely, analysts can potentially anticipate the vari- ations on old themes that will materialize in years to come. MARTIN FRIDSON FERNANDO ALVAREZ
acknowledgments Mukesh Agarwal Eric Matejevich John Bace John Mattis Mitchell Bartlett Pat McConnell Richard Bernstein Oleg Melentyev Richard Byrne Krishna Memani Richard Cagney Ann Marie Mullan George Chalhoub Kingman Penniman Sanford Cohen Richard Rolnick Margarita Declet Clare Schiedermayer Sylvan Feldstein Gary Schieneman David Fitton Bruce Schwartz Thomas Flynn III Devin Scott Daniel Fridson Elaine Sisman Igor Fuksman Charles Snow Ryan Gelrod Vladimir Stadnyk Kenneth Goldberg John Thieroff Susannah Gray Scott Thomas Evelyn Harris John Tinker David Hawkins Kivin Varghese Avi Katz Sharyl Van Winkle Rebecca Keim David Waill James Kenney Steven Waite Andrew Kroll Douglas Watson Les Levi Burton Weinstein Ross Levy Stephen Weiss Jennie Ma David Whitcomb Michael Marocco Mark Zand xi
contents PART I Reading between the Lines 1 CHAPTER 1 The Adversarial Nature of Financial Reporting 3 The Purpose of Financial Reporting 4 The Flaws in the Reasoning 8 Small Profits and Big Baths 11 Maximizing Growth Expectations 12 Downplaying Contingencies 18 The Importance of Being Skeptical 20 Conclusion 24 PART II The Basic Financial Statements 27 CHAPTER 2 The Balance Sheet 29 The Value Problem 30 Issues of Comparability 31 “Instantaneous” Wipeout of Value 33 How Good Is Goodwill? 34 Losing Value the Old-Fashioned Way 37 True Equity Is Elusive 39 Pros and Cons of a Market-Based Equity Figure 42 Undisclosed Hazards 45 The Common Form Balance Sheet 46 Conclusion 48 xiii
xiv CONTENTS CHAPTER 3 The Income Statement 49 Making the Numbers Talk 49 How Real Are the Numbers? 55 Conclusion 90 CHAPTER 4 The Statement of Cash Flows 91 The Cash Flow Statement and the LBO 93 Analytical Applications 98 Cash Flow and the Company Life Cycle 99 The Concept of Financial Flexibility 107 In Defense of Slack 110 Conclusions 112 PART III A Closer Look at Profits 115 CHAPTER 5 What is Profit? 117 Bona Fide Profits versus Accounting Profits 117 What Is Revenue? 118 Which Costs Count? 120 How Far Can the Concept Be Stretched? 122 Conclusion 123 CHAPTER 6 Revenue Recognition 125 Informix’s Troubles Begin 125 Calling the Signals 130 Astray on Layaway 136 Recognizing Membership Fees 137 A Potpourri of Liberal Revenue Recognition Techniques 140 Conclusion 152
xv Contents CHAPTER 7 Expense Recognition 153 AOL’s Search for Wiggle Room 153 IBM’s Innovative Expense Reduction 156 Simple Analysis Foils Elaborate Deception 157 Oxford’s Plans Go Astray 159 Conclusion 162 CHAPTER 8 The Applications and Limitations of EBITDA 163 EBIT, EBITDA, and Total Enterprise Value 164 The Role of EBITDA in Credit Analysis 168 Abusing EBITDA 172 A More Comprehensive Cash Flow Measure 174 Working Capital Adds Punch to Cash Flow Analysis 177 Conclusion 179 CHAPTER 9 The Reliability of Disclosures and Audits 181 An Artful Deal 182 Death Duties 185 Chainsaw Al 186 Stumbling Down the Audit Trail 190 Conclusion 191 CHAPTER 10 Mergers-and-Acquisitions Accounting 193 The Twilight of Pooling-of-Interests Accounting 194 Maximizing Postacquisition Reported Earnings 197 Managing Acquisition Dates and Avoiding Restatements 198 Conclusion 200 CHAPTER 11 Profits in Pensions 201 An Admonition from the SEC 206 Conclusion 207
xvi CONTENTS PART IV Forecasts and Security Analysis 209 CHAPTER 12 Forecasting Financial Statements 211 A Typical One-Year Projection 211 Sensitivity Analysis with Projected Financial Statements 224 How Accurate Are Projections in Practice? 230 Projecting Financial Flexibility 232 Pro Forma Financial Statements 234 Multiyear Projections 244 Conclusion 265 CHAPTER 13 Credit Analysis 267 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 CHAPTER 14 Equity Analysis 315 The Dividend Discount Model 316 The Price-Earnings Ratio 322 Why P/E Multiples Vary 325 The Du Pont Formula 333 Valuation through Restructuring Potential 336 Conclusion 343 Bibliography 345 Glossary 347 Notes 365 Index 377
PART one Reading between the Lines
1 CHAPTER The Adversarial Nature of Financial Reporting inancial statement analysis is an essential skill in a variety of occupations F including investment management, corporate finance, commercial lend- ing, 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 definitions. It may take little more effort or mental exertion than this to satisfy the formal requirements of many positions in the field of financial analysis. Operating in a purely mechanical manner, though, will not provide much of a profes- sional challenge. Neither will a rote completion of all of the “proper” stan- dard analytical steps ensure a useful, or even a nonharmful, result. Some individuals, however, will view such problems as only minor drawbacks. This book is aimed at the analyst who will adopt the second and more rewarding alternative, the relentless pursuit of accurate financial profiles of the entities being analyzed. Tenacity is essential because financial state- ments often conceal more than they reveal. To the analyst who pursues this proactive approach, producing a standard spreadsheet on a company is a means rather than an end. Investors derive but little satisfaction from the knowledge that an untimely stock purchase recommendation was sup- ported by the longest row of figures available in the software package. Gen- uinely valuable analysis begins after all the usual questions have been answered. Indeed, a superior analyst adds value by raising questions that are not even on the checklist. Some readers may not immediately concede the necessity of going be- yond an analytical structure that puts all companies on a uniform, objective scale. They may recoil at the notion of discarding the structure altogether when a sound assessment depends on factors other than comparisons of 3

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