Sunday, August 09, 2009

The Numbers Game: How To Read Financial Statements (The Balance Sheet)

We have seen how once-high-flying companies were brought down to their knees during the market meltdown beginning in March 2000. No sector lost more money for investors than telecommunications. Some $2 trillion in shareholders' wealth and 400,000 jobs were wiped out in an eighteen-month stretch. One of these companies was Global Crossing, a fiber-optic cable company. As late as November 2001, the CEO was still telling shareholders that he expected the company to improve its operating results as it cut expenses and benefitted from strong growth in certain business lines. Three months later, Global Crossing was the forth-largest bankrupt company in U.S. history.

Were there any danger signs? They were staring right in the investors' face. Global Crossing's had reported eight straight quarters of losses dating back to 1999. Total debt as a percentage of its capital grew from 24 percent in September 2000 to 41 percent the next year. Too many investors were in fact not paying attention to the fundamentals of the business. Reading and understanding 10ks or annual report may appears to be a daunting task. But it isn't as difficult or complicated as you think it is. There are some common accounting tricks that management often play. You can be their own watchdog if you are aware of it.

The 10k or annual report is where company must disclose everything that might affect its future performance, be it a lawsuit, a shrinking market share, or pending expiration of a key patent. The 10k is also where you will find the company's financial statements. Here we will try to examine the various sections of the statements and also some of the commonly used methods companies use to make their accounts more rosier than they are. Many companies, including blue-chip firms, have all played the numbers game. Unfortunately, even investing in high-quality blue-chip firms do not protect you from accounting trickery. It is hard for companies to be completely immune from the pressure from cutting corners. Many on Wall Street or corporations would have you believe that you need an accounting degree to understand financial statements - it is far from the truth. As you will see, with a bit of work, you'll be able to determine by yourself how well a company is really doing and even make an educated guess about its future performance.

All financial statements must contain three sections: the balance sheet; the income statement and; the cash flow statement. Let's start with the balance sheet.

The balance sheet provides a snapshot of the company's overall financial health - same as a doctor report you will get for a health checkup. It tells you if the company is growing internally or using debt to pump up results. The balance sheet lists the assets such as cash and equipment, and also the liabilities such as obligations like debt and accounts payable, at a specified point in time. The difference between the assets and liabilities is the shareholders' equity. Shareholder's equity includes any investment by the company's owners plus any retained profits that have been reinvested in the business rather than paid out as dividends to the shareholders.

Current assets are listed first on the balance sheet - items include cash, accounts receivable, short-term investments and inventories. Noncurrent assets are listed next. This includes medium and long-term investments, real estates, goodwill, patents, copyrights, plant and equipment. Many of these assets must either be depreciated (for tangible assets such as plant and equipment) or amortized (for intangible assets such as patents and copyrights) to comply with the general accepted accounting principles (or GAAP). Depreciating an assets means allocating its cost as an expense over the period the company uses the asset to generate revenue - a management judgement for the life span of the asset. Depreciable assets are shown on the balance sheet at its original price, offset by the depreciation accumulated over the years. Depreciation has an effect of reducing earnings in the income statement since it is an expense.

Amortization is also similar to depreciation. It recognizes that an intangible asset has a limited useful life and thus a portion of the intangible asset's cost is recorded as an expense each year. GAAP used to require intangible assets to be amortized over a maximum of forty years. However, in 2001, the FASB, which determines GAAP, eliminated any maximum life over which intangible assets must be amortized and instead required companies to write down the assets when they lose value.

Listed after assets are the company's liabilities and then the shareholders' equity. Total assets must be equal to total liabilities and shareholders' equity. Liabilities, like assets, are classified as current and noncurrent. Current liabilities - which generally must be paid within a year - include items such as account payable, short-term notes, the current portion of any long-term debt, and income taxes not yet paid. Noncurrent liabilities include long-term debt, mortgages, and capital leases. Liabilities and equity are listed in the general order in which they are expected to be paid in case of bankruptcy or liquidation. Money owed to suppliers are first in line, while common shareholders are last in line.

An item in the shareholders' equity of interest is retained earnings. This is the amount of a company's earnings that was not distributed to shareholders as dividends. This does not mean that the money is in the bank or available to be distributed back to the shareholders. Instead, the earnings are most likely to be reinvested in the business, for example to expand the company's product line, build a new manufacturing plant or to acquire new businesses.

That's the balance sheet in a nutshell. So, what clues should investors look for? A simple way is to get a feel of the company's health by checking on the inventories and receivables. If either one is growing a lot faster than sales on the income statement, then trouble may be brewing.
  • If inventories are rising faster than sales, the company may be having trouble selling as much as it forecasted - i.e. demand is not as rosy as the company thought. Some questions come to mind: If demand is weakening, could it be that the company's products have lost customer acceptance in the marketplace?; Has technology changed and thus make its inventories obsolete?; Has a new competition entered the market?; Is a general economic softness hurting the company?
  • If account receivable are growing faster than sales, has the company induced customers to buy more goods than customers really need by offering discounts or easy cancellation terms? Channel stuffing is one such trick used to gross up reportable income. It happens when a company ships products to customers, such as retailers and distributors, loading them up with, or "stuffing," their shelves with excess inventory. This practice is often accompanied by company offers of discounts, below-market financing, and other inducements to get customers to buy products ahead of time. These buyers often delay payment for shipments, thus pushing up the accounts receivable. Rising receivables may signal a change in a company's credit policy. Some firms will lower their credit standards by accepting, say, payment in ninety days rather than sixty days, so as to boost anemic sales. All these help management to cover up a bad quarter so that it meets analyst's expectations, while robbing revenue from future quarters with such hurry-up sales. For example, Bristol-Myers Squibb paid $15o million to settle a SEC charge in August 2004.
When inventories are written down in value, investors should ask what was the root cause: Did the company overestimate what it could sell?; Is this a sign of poor sales forecasting, order management, or production quality controls? Under GAAP, temporary reduction in revenues and profits normally do not result in assets write-down. Instead, write-downs are typically caused by longer-term or permanent reductions in sales value. A write-down means a company does not expect to fully recover the money it invested in the inventories. Companies are required to explain these changes in trends, and their expected effect on the future operations of the company in an important section of the company's financial reports called "Management's discussion and analysis."

Write-off inventory is rarely a onetime event that analysts and corporate executives would want you to believe in. Rather, a write-down could indicate problems with the business strategy, product development, or marketing channels. More importantly, it could be a distress signal about the company's future stock price.

Some companies write off inventories as worthless, without disposing it. Why would a company incur the cost of maintaining and warehousing what it has declared as worthless inventory? One reason is that the company may intend to use the inventory - either by selling it or using it in a production process. As a result, only the lower, written-off cost gets expensed under "cost of sales" in the income statement in the future, thus, making the future earnings appearing rosier than they really are. Dubious it is but unlike channel stuffing which is an accounting fraud, there is no rule that says a company cannot use or sell written off inventories. But written-off inventory has allowed companies to goose up earnings and boost gross margins. Cisco Systems wrote off over $2 billion inventory in 2001, helping to lessen the loss in future quarter - only to report a loss of $268 million which otherwise would be more had it not been for the use of written off inventory in the first quarter of 2002, about 10 months after the write off.

What does a "strong balance sheet" really means? Usually, it refers to the level of debt. By itself debt is not a bad thing. However, if a company cannot generate sufficient income to pay or service its debts, then it's asking for trouble. The reason why so many companies failed is because they took on a mountain of debt. For example, the telecom companies in the late 1990s took on huge debts to finance the building of fiber-optic networks, only to see it failed when the technology bubble burst and demand for network capacity withered. Telecom companies had laid miles and miles of cables but had too few paying customers. This not only affected them but also their equipment suppliers who found that the inventory were piling up in their warehouses. As a result, bankruptcies soon followed as the telecoms and equipment suppliers were unable to meet their debt obligations. On the other hand, companies that had less debt in the high-flying 1990s were able to weather the storm - pretty much like what it is today in the automotive sector.

A way to measure debt is to look at the ratio of long-term debt to the company's total invested capital. In the balance sheet, find the amount of long-term debt. Then, divide that figure by the total amount of capital (capital equals equity plus debt). A ratio of 20 percent is considered high.

If the debt-to-capital ratio seems complicated, a simpler way is to size up the balance sheet. Here's how: Just compare the amount of cash to the amount of debt. Enron's balance sheet is instructive. At the end of 2000, it listed $1.4 billion in cash, while it carried $10.2 billion in debt. Such a wide gap between the two is a strong indicator that something is amiss.


Daniel M. Ryan said...

Thanks for the point about rising accounts receivable. I needed the reminder.

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Penny Stocks said...

Financial statements can be very confusing to the novice.