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. Financial 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: [email protected]. 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. ADDITIONAL 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 T his third edition of Financial Statement Analysis, like its predecessors, 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 typein 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 Preface to Third Edition ix of cash flows. Under close scrutiny, terms such as valueandincomebegin 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. MARTINFRIDSON FERNANDOALVAREZ