Analysis of Financial Statements

Transcription

1 Analysis of Financial Statements Investment Management Lakehead University

2 Analysis of Financial Statements Public companies have to produce three financial statements: The income statement The balance sheet The statement of cash flows 2

3 Alternative Measures of Cash Flow What is cash flow? Traditional Cash Flow: Net income + depreciation + change in deferred taxes For Andrés Wine, traditional cash flow was 6, , = $11,894 in

4 Alternative Measures of Cash Flow Note that before taking into account the changes in non-cash working capital items, there is another cash flow measure. This cash flow takes into account other non-cash items on the income statement. For Andrés Wine, this cash flow was $11,815 in

5 Alternative Measures of Cash Flow Cash Flow from Operations (CFO): Cash flow measure that takes into account all non-cash items on the income statement as well as the changes in non-cash working capital items ($14,409 for Andrés Wine in 2003) 5

6 Alternative Measures of Cash Flow Free Cash Flow: Modifies CFO to recognize some investing and financing activities of the firm Free Cash Flow = CFO CAPEX + Disp. of P&E To be more conservative, dividends could also be subtracted. 6

7 Alternative Measures of Cash Flow For Andrés Wine in 2003, this gives Free Cash Flow = 14,409 6, = $8,522. If we subtract dividends, we obtain Free Cash Flow = 14,409 6, ,971 = $5,551. 7

8 Financial Shenanigans Howard Schilit (2002), Financial Shenanigans How to Detect Accounting Gimmicks & Fraud in Financial Reports, McGraw-Hill Center for Financial Research & Analysis (CFRA) Financial Shenanigans are actions that intentionally distort a company s reported financial performance and financial condition. 8

9 Financial Shenanigans Seven financial shenanigans: 1. Recording revenue too soon or of questionable quality 2. Recording bogus revenue 3. Boosting income with one-time gains 4. Shifting current expenses to a later or earlier period 5. Failing to record or improperly reducing liabilities 6. Shifting current revenue to a later period 7. Shifting future expenses to the current period as a special charge 9

10 Searching for Shenanigans Accounting Policies Conservative Aggressive Revenue recognition Depreciation method Inventory method After sale, when risk has passed to the buyer Accelerated over shorter period LIFO (assuming prices are rising) At sale, when risk remains Straight-line over longer period FIFO (assuming prices are rising) Estimate of warranty High estimate Low estimate Estimate of bad debt High estimate Low estimate 10

11 Searching for Shenanigans Read the footnotes very carefully. The footnotes is where they hide the bad stuff they didn t want to disclose but had to... (Columnist Kenneth Fisher) Watch for changes in accounting principles for no apparent reason Favour companies with conservative accounting policies 11

12 Searching for Shenanigans Companies most likely to use shenanigans: Companies operating in a weak control environment. Management facing extreme competitive pressure. Management known or suspected of having questionable character. 12

13 Recording Revenue Too Soon Guiding Principle: Revenue should be recorded when the earnings process is complete and when the payment is assured. Sometimes, firms record revenue when future services remain to be provided, record revenue before shipment or before the customer s unconditional acceptance, record revenue even though the customer is not obligated to pay. 13

14 Recording Revenue Too Soon (Example) Software maker Transaction Systems Architect (TSAI) was experiencing slowing sales in It had always used conservative accounting. TSAI suddenly changed its accounting in The company had so far recorded revenue only when customer were billed over the five-year licence agreement. During the December quarter, TSAI began recording almost the entire five-year revenue immediately. 14

15 Recording Revenue Too Soon (Example) 3 Months 3 Months 6 Months 6 Months Ending 3/99 Ending 3/99 Ending 3/99 Ending 3/99 Reported CFRA-Adjusted Reported CFRA-Adjusted License revenue Growth (1 year) 26% (10%) 23% 0% Total revenue Growth (1 year) 21% 1% 23% 10% 15

16 Recording Revenue Too Soon (Example) Warning Signs Lagging CFO: CFO is not easily manipulated. When net income grow at a faster rate than CFO, there might be a problem. Long-Term Receivables vs Revenue: Long-term receivables are the receivables that are due more than one year after the sales date. If they grow faster than revenue, there might be a problem. 16

17 Recording Revenue Too Soon (Example) Q2, 3/99 Q2, 3/98 CFO Net income CFO Net income (9.5) 1.1 CFO/Net income 13% 113% 17

18 Recording Revenue Too Soon (Example) Q4, 9/99 Q3, 6/99 Q2, 3/99 Q1, 12/98 Q4, 9/98 Revenue Current billed receivables Unbilled receivables L-T installment receivables Total receivables

19 Shifting Current Expenses to a Later or Earlier Period Five techniques used to boost profits by excluding expenses: 1. Capitalizing normal operating costs, particularly if the company recently changed from expensing it 2. Changing accounting policies and shifting current expenses to an earlier period 3. Amortizing costs too slowly 4. Failing to write down or write off impaired assets 5. Reducing asset reserves 19

20 Shifting Current Expenses to a Later or Earlier Period Normal business costs fall into two categories: 1. Costs that provide short-term benefits. These costs must be expensed immediately. 2. Costs that provide long-term benefits (inventory, long-term assets). These costs can be expensed over longer periods. 20

21 Shifting Current Expenses to a Later or Earlier Period Capitalizing Normal Operating Costs Marketing and sollicitation costs Landfill and interest costs Software and research and development costs Repair and maintenance costs 21

22 Shifting Current Expenses to a Later or Earlier Period Amortizing Costs Too Slowly Question companies that depreciate assets too slowly Watch for a change to a longer depreciation or amortization period Watch for slow amortization of inventory costs (e.g. film industry) 22