basic statements fridson alvarez
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Financial Statement Analysis
Reporting & Basic Statements: Balance Sheet & Income Statement
based on M. Fridson, F. Alvarez: Financial Statement Analysis (2011)
Piotr Winiewski, Ph.D.
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Purpose of financial reporting?
Source: Psalm 118 (2011)
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Cheap financing for corporates
Purpose of financial reporting
Source: Access Brokers (2011)
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Why smooth earnings?
Source: MS Windows (2011)
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Because
Volatility is perceived as a risk factor.
Source: Options Playbook (2011)
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How is the smoothing done?
Source: Out of Comfort Zone (2011)
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Thats how Lags and leads in recording accounting events. Incentives to business parties to speed up revenues, slow down expenses to prop up incomes
Source: 21 Ace (2011)
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Why earnings revised up often?
Source: Traders Narrative (2011)
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Cos
Good news spreads faster than bad news. Ever heard of people who brag?
Source: Martina Schonfeld (2011)
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Why do big baths make sense?
Source: Interior Exterior Designs (2011)
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Because
Empirically, investors have tended to react similarly to hyper-bloodbaths as to mega-bloodbaths. The blood is spilled (bad news share price slumps) and cest ca!
Source:The Fathomless Master (2011)
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What is done during bloodbaths?
Source: The Angry Dome (2011)
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During bloodbaths
Dramatic write-offs of obsolete assets, contingencies made to create space for longer-term stable income streams
Source: Cartell (2011)
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Why wont auditors complain?
Source: Listentomywords (2011)
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Pressure groups Accounting standards are worked out by the FASB during a bargaining process involving accountants, issuers (companies) and users (everyone else) of financial statements.
Source: Suite Life (2011)
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Whats the agency problem?
Source: Buyer's Broker (2011)
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Conflicts of interests
[..]between a companys shareholders and hired managers. Can arise from performance related incentive schemes and other disequilibria. Digression: private equity managers bonuses.
Source: CADRE (2011)
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What if owners = managers?
Source: EOS (2011)
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When owners = managers
Even worse for the analyst. Harder to find out what they are up to. Things swept under the carpet more consistently and without major traces
Source: You Talk Like a Banjo (2011)
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Why managers fight to keep earnings growth on track?
Source: National Guard Counterdrug Program (2011)
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Because Broken dreams are mercilessly avenged: the company ceases to be perceived as a rising star and is now valued on a stable cash flow pattern Digression: DCF valuation.
Source: The Zombies Layer (2011)
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What are natural limits to growth?
Source: Random Musings of a Curious Mind (2011)
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1 of 4 Saturation. People get fed up
Source: Dreamstime (2011)
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2 of 4 Entry of competition. Copycats, knockoffs.
Source: Luxury Watches Reviews (2011). Note that this is a genuine Patek Philippe picture.
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3 of 4 Macro limitations. One product cannot fully substitute others
Source: ?
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4 of 4 Limits to growth in the market in which the company operates A company cannot control 200% of a market.
Source: World of Monopoly (2011)
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Any excuses to slow-downs?
Source: Sustainable Living for Dummies (2011)
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1 of 3 Objective, short-term distortions. Bad weather. Logistic problems due to rampant sales. Y2Ks. Prices of raw materials temporarily out of line
Source: ?
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2 of 3 Diversification away from mature markets. Conglomerate discounts. Examples from various countries.
Source: Cartoon Stock (2011)
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3 of 3
Revolutionary products/services. Unfortunately high mortality rate.
Source: Manny The Movie Guy (2011)
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Legal hazards nightmares waiting to happen?
Source: MWG Blog (2011)
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Yes! Why?
An unquantifiable risk factor. How can we account for something immeasurable?
Source: Hazelnut Films (2011)
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Why no provisions made in advance?
Source: SPL UK (2011)
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Reasons
1. Vested interest in non-disclosure.
2. Conflicts of interests vis-a-vis current shareholders.
3. Lack of expertise in crisis detection and management.
Source: Anirundh Sethi Report (2011)
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How share issues are sold?
Source: Your Money Dictionary (2011)
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Stories, pampering
1. Hyped up stories thrown at retail investors. Mind-boggling forecasts.
2. More sophisticated appetizers for institutional buyers. Catering to their greed. Nature of portfolio management
Source: Experience Days (2011)
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Why is credit evaluation abnormal?
Source: Free Credit Report (2011)
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Optimum business scale
Because it makes a fair amount of sense to be sustaining a certain amount of losses in order to maximize gains at aggregate (portfolio) level.
Source: Families.com (2011)
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Why do managers want a quick buck?
Source: Dribbble (2011)
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Conflicting horizons
Maybe they are about to leave quickly. Retirement. Job changes. Other motifs?
Source: Art.com (2011)
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Is human capital on balance sheets?
Source: Bret L. Simmons (2011)
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No, no one knows how to price it! One of the principal challenges of contemporary accounting and finance world-wide
Source: On Product Management (2011)
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Examples of distorted balance sheets
Source: The Inspiration Room (2011)
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OK, here they are
The overwhelming majority of intangible assents unaccounted for until acquisition/sale.
Liabilities not updated for market interest changes.
Assets/liabilities unique to a companys operations (irreplacable).
Source: Jangle Pop Boutique (2011)
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Did ratings respond to .com boom?
Source: Silicon Angle (2011)
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Surprisingly to some
Not substantially. The credit agencies tended to ignore most of the elusive intangibles, notably: goodwill. Thus, goodwill wipeouts went largely unnoticed
Digression: risk profiles: equity/debt investors
Source: The Risk Management Guide (2011)
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What can goodwill be good for?
Source: Baja Greenawalt's Cozy Book Nook (2011)
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E.g
Beefing up a companys balance sheet total. Artificial de-leveraging.
Source: MyLot (2011)
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How to engineer goodwill easily?
Source: India Talkies (2011)
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Stock-for-stock M&A Both parties to the process happy: book-values get an instant boost. With speculative pre-M&A stock-price growth: a real dream factory.
Source: ChristieTaylorOnline (2011)
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Why is goodwill no good to lenders?
Source: Wearenogood (2011)
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Reason
Goodwill is hard to monetize. One cannot sell it and lease it back (like real estate), thereby no cash implications.
Source: Ehow (2011)
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Can stable EPS destroy value?
Source: Tulum Second Line Lot (2011)
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Yes
If it consistently fails to catch up with the going rate of return in the industry, then resources perhaps ought to be realocated. Opportunity cost of capital. Digression: the crowding-out effect of high real interest rates.
Source: Intermediate English (2011)
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What benchmarks to use?
Source: Archithings (2011)
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When comparing
Whilst comparing a companys productivity/profitability/cash generation, we should look at its peer group same industry, ideally, similar size
Source: CSL Cartoonstock (2011)
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What a leveraged recap can do?
Source: Cool Science Projects (2011)
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Effects
Up stock market valuation. Reconcile vying shareholders groups see previous. Fend off hostile take-overs
Source: Biotech Investment Paradigm (2011)
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Pros of Market Cap valuation
Source: Seeking Alpha (2011)
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Here they are
Ease of calculation.
Timeliness.
Large number of analysts.
Source: Music Teachers Helper (2011)
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Drawbacks of Market Cap?
Source: HubPages (2011)
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Quite a few
No reliable proxy for unquoted companies.
Volatility.
Behavioral finance asymmetries to information.
Going-concern assumptions
Source: Darwin's Game Closet (2011)
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What about derivatives under GAAP?
Source: Financial Pipeline (2011)
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Now Either capitalized (shown as assets) or written to debt (show as liabilities) at fair value. Hedging set-offs possible.
Source: CSL Cartoonstock (2011)
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Why is % balance sheet useful?
Source: Mississauga Real Estate (2011)
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Reasons
Because it shows individual assets as %s of total assets and individual liabilities and equity components as %s of (total liabilities + shareholders equity). Easier to see trends on each item!
Source: All Spammed Up (2011)
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Which industries are susceptible to interest rate volatility?
Source: ETF Trends (2011)
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The financial sector
Why? Because it often lives off borrowed capital.
Source: The World Bank Group (2011)
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Which sectors do not care so much?
Source: Auto Under $20K (2011)
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Traditional Retailers, traditional industries
Source: MPR News (2011)
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Should consultants be retained?
Source: TheNewLead (2011)
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Sometimes yes In industries demanding highly specialized know-how and in high-profile transactions it might be justified to retain a sectoral consultant.
Source: Innowacyjny Sklep Internetowy (2011)
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Why are some sales bogus?
Source: Deep Bajaj (2011)
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Sales propping
Longer payment periods, laxer credit standards, discounts for early order placement
Source: Behavior Advisor (2011)
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How to detect them?
Source: Deadline (2011)
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Answers
Talk to the companys managers. Look into its industry. Compare what competitors are doing
Source: ?
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How to see depreciation gimmickry?
Source: Cartoonstock (2011)
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Simple Look where the competitors depreciation ratios stand. Uderreported depreciation might be a way to pump up profitability.
Source: OAI (2011)
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What rhetoric is used?
Source: With Friendship (2011)
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To
To approximate industry norms closer. Subjective. Ultimately checked by an auditor.
Source: Financing Tips (2011)
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When are depreciation methods switched?
Source: Memphis Invest (2011)
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When Profits are desperately needed. E.g. a company is using straight-line, demand ebbs, so supposedly to reflect real asset use the company begins to depreciate as per the activity based rule. Lower charges, but part of a more general problem.
Source: Bear Manor Media (2011)
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How extraordinary are some items?
Source: Animalamigo (2011)
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Depends Sometimes a smokescreen to hide recent problems and convince weakness was temporary
Source: Arts & Sciences College Forum (2011)
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Position of extraordinaries?
Source: Saint Paul Public Schools (2011)
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After-tax
Below the bottom line: income/loss!
Source: Cotton Incorporated (2011)
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Rules for extraordinaries?
Source: Caribbean Stud Online (2011)
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Guidelines
GAAP: unusual nature - anomaly. Infrequency.
Source: DeviantArt (2011)
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Did 9/11 qualify?
Source: September 11 News (2011)
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Surprisingly NO!
Not even for airlines, which suffered an external shock to their financial standing. Why? By then they had been struggling; inability to separate the 9/11 impact from other, prior woes
Source: ETF Trends (2011)
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What do companies do to stretch the definition?
Source: Juiced Muscle (2011)
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Examples
Non-GAAP, yet compelling expressions such as: non-recurring, unusual, restructuring
Source: Home Buying/Selling (2011)
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Why restructure?
Source: Cartoonstock (2011)
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CEO succession A companys new CEO wants to have a clean slate and a big bath attributed to his predecessor (so a turn-around can now be possible)
Source: Brookeswords (2011)
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Are there tireless restructurers out there?
Source: The Free Dictionary (2011)
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Yes Procter & Gambles example. Restructured for 7 consecutive years
Source: Nappy Headed Black Girl (2011)
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What are pro forma results?
Source: Plannersweb (2011)
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Spin-mastery Protected and promulgated under freedom-of-the-press laws, non-GAAP information, oftentimes a manipulation.
Source: Pardio Wars (2011)
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Why examine SEC filings?
Source: Sitepoint (2011)
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Because
Less susceptible to manipulation
Source: Greek Shares (2011)
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What is a quick revenue booster?
Source: Asia Ru (2011)
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M&A
Consolidation of take-overs.
Source: Grants for New Business (2011)
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Which is better: internal/extenal growth?
Source: Spread Shirt (2011)
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Internal/external growth Internal - hard-earned. Usually more profitable/cash favorable.
External OK if synergies, economies/opportunities of scale, vertical/horizontal integrations materialize (oftentimes mere wishful thinking).
Source: Dreamstime (2011)
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Fixed vs. variable costs: easy distinction?
Source: Lucy Learns (2011)
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No
Hard to find in corporate financials. If found, very useful. Enables break-even calculations pre-and post-M&A.
Variable-biased (in relation to sales) cost structures usually more flexible, i.e. secure.
Source: Dr. Pinna (2011)
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How do P/Es get pumped up?
Source: Skateboard Australia (2011)
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E.g
Series of acquisitions of low-multiple (e.g. unlisted) targets.
Source: Meredith's in Brasilia (2011)
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Earnings manipulation: early warnings
Source: Dating After Forty Eight (2011)
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According to M. D. Beneish
1. Receivables collection decelerating.
2. Eroding gross margins.
3. Falling depreciation rates.
4. Non-current, non-PPE assets value soaring.
5. Sales growth.
Source: I keeps it (2011)