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
