Financial Statement Analysis : A Practitioner’s Guide

Available in our e-library on M&A at IMAA!

Authors: Martin S. Fridson, Fernando Alvarez

Publisher: John Wiley

Year: 2011, July

ISBN: 978-0-470-63560-5

Content

Praise for Financial Statement Analysis FOURTH EDITION

“I love this book. It helps to develop the questioning mind—the mind of a financial detective. It teaches the art of skepticism and critical thinking. Readers go beyond definition and calculation and learn interpretation.”
—Philip L. Cooley, PhD, Prassel Distinguished Professor of Business, Trinity University

“Over my decades of involvement with high-yield bonds, Marty Fridson has been the leading speaker of truth. As he so accurately states in Financial Statement Analysis, the credit investor is required to engage in a game of cat-and-mouse with company management’s intent on minimizing their cost of capital by putting a positive gloss on their financial statements. The Fourth Edition of Marty’s terrific book is the bible on how to detect and deal with these efforts.”
—Howard Marks, Chairman, Oaktree Capital Management

“Financial Statement Analysis is a unique text; it combines great academic work with numerous real-life examples to form a highly useful reference for equity investors, debt holders, and investors who straddle both asset classes. Whether you are an investor, an investment advisor, or a teacher, Financial Statement Analysis will prove very valuable.”
—Margaret M. Cannella, former head of Global Credit Research, J.P. Morgan and Adjunct Professor, Columbia Business School

“Marty has seen it all! He has had a front-row seat to see the birth, death, and rebirth of the high-yield bond market . . . several times over! In the Fourth Edition of Financial Statement Analysis, Marty clearly demonstrates that despite the enactment of Sarbanes-Oxley in 2002, and other attempts to curtail abuse of the system, one needs a critical analytical eye to be certain that management is not trying to obfuscate the truth. The case studies provide excellent and timely examples of some of the techniques that companies have used to mislead investors.”
—Edward Z. Emmer, former global head of Corporate and Government Ratings and Equity Research, Standard & Poor’s

“Those who read financial statements without understanding the strategic context in which they are written will land on the losing end of the gripping episodes with which bond-market legend Marty Fridson illustrates in the Fourth Edition of his classic reference, Financial Statement Analysis. And all of us who depend on the markets sending capital to its best use should hope that investors read this book first.”
—David Musto, Professor of Finance, the Wharton School of the University of Pennsylvania

“This book rightly urges resolute skepticism when inspecting financial statements. Its great value, though, is in the plain-spoken stripping down of real-world and illustrative examples that show how to see past the numbers to the practicalities and incentives behind them—and so help analysts and journalists alike ask the right questions.”
—Richard Beales, Assistant Editor, Reuters Breakingviews

Table of Contents

Preface to Fourth Edition xi

Acknowledgments xv

PART ONE – Reading between the Lines

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 TWO – The Basic Financial Statements

CHAPTER 2 – The Balance Sheet 29

The Value Problem 30

Comparability Problems in the Valuation of Financial Assets 32

Instantaneous Wipeout of Value 34

How Good Is Goodwill? 35

Losing Value the Old-Fashioned Way 38

True Equity Is Elusive 40

Pros and Cons of a Market-Based Equity Figure 41

The Common Form Balance Sheet 43

Conclusion 45

CHAPTER 3 – The Income Statement 47

Making the Numbers Talk 47

How Real Are the Numbers? 52

Conclusion 77

CHAPTER 4 – The Statement of Cash Flows 79

The Cash Flow Statement and the

Leveraged Buyout 81

Analytical Applications 86

Cash Flow and the Company Life Cycle 87

The Concept of Financial Flexibility 99

In Defense of Slack 104

Conclusion 106

PART THREE – A Closer Look at Profits

CHAPTER 5 – What Is Profit? 111

Bona Fide Profits versus Accounting Profits 111

What Is Revenue? 112

Which Costs Count? 114

How Far Can the Concept Be Stretched? 116

Conclusion 117

CHAPTER 6 – Revenue Recognition 119

Channel-Stuffing in the Drug Business 119

A Second Take on Earnings 123

Astray on Layaway 127

Recognizing Membership Fees 128

A Potpourri of Liberal Revenue

Recognition Techniques 131

Fattening Earnings with Empty Calories 132

Tardy Disclosure at Halliburton 138

Managing Earnings with Rainy Day Reserves 141

Fudging the Numbers: A Systematic Problem 143

Conclusion 147

CHAPTER 7 – Expense Recognition 149

Nortel’s Deferred Profit Plan 149

Grasping for Earnings at General Motors 154

Time-Shifting at Freddie Mac 157

Conclusion 159

CHAPTER 8 – The Applications and Limitations of EBITDA 161

EBIT, EBITDA, and Total Enterprise Value 162

The Role of EBITDA in Credit Analysis 166

Abusing EBITDA 169

A More Comprehensive Cash Flow Measure 171

Working Capital Adds Punch to Cash

Flow Analysis 174

Conclusion 176

CHAPTER 9 – The Reliability of Disclosure and Audits 179

An Artful Deal 180

Death Duties 183

Systematic Problems in Auditing 184

Conclusion 189

CHAPTER 10 – Mergers-and-Acquisitions Accounting 191

Maximizing Post-acquisition Reported Earnings 191

Managing Acquisition Dates and Avoiding Restatements 195

Conclusion 197

CHAPTER 11 – Is Fraud Detectable? 199

Telltale Signs of Manipulation 199

Fraudsters Know Few Limits 201

Enron: A Media Sensation 201

HealthSouth’s Excruciating Ordeal 210

Milk and Other Liquid Assets 217

Conclusion 221

PART FOUR – Forecasts and Security Analysis

CHAPTER 12 – Forecasting Financial Statements 225

A Typical One-Year Projection 225

Sensitivity Analysis with Projected Financial Statements 237

Projecting Financial Flexibility 242

Pro Forma Financial Statements 245

Pro Forma Statements for Acquisitions 246

Multiyear Projections 253

Conclusion 263

CHAPTER 13 – Credit Analysis 265

Balance Sheet Ratios 266

Income Statement Ratios 275

Statement of Cash Flows Ratios 280

Combination Ratios 283

Relating Ratios to Credit Risk 290

Conclusion 304

CHAPTER 14 – Equity Analysis 307

The Dividend Discount Model 308

The Price-Earnings Ratio 313

Why P/E Multiples Vary 316

The Du Pont Formula 324

Valuation through Restructuring Potential 328

Conclusion 334

APPENDIX – Explanation of Pro Forma Adjustments for Hertz Global Holdings, Inc./DTG 335

Notes 341

Glossary 353

Bibliography 367

About the Authors 369

Index 371