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- Financial Statement Analysis
- John Wiley & Sons
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- 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
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- 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
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