Financial Statement Analysis

A Practitioner's Guide

Martin S. Fridson, Fernando Alvarez

• Publisher: Wiley
• Year: 2022
• ISBN:
  9781119457169
• Edition: 5
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

The updated, real-world guide to interpreting and unpacking GAAP and non-GAAP financial statements

In Financial Statement Analysis, 5th Edition, leading investment authority Martin Fridson returns with Fernando Alvarez to provide the analytical framework you need to scrutinize financial statements, whether you're evaluating a company's stock price or determining valuations for a merger or acquisition. Rather than taking financial statements at face value, you'll learn practical and straightforward analytical techniques for uncovering the reality behind the numbers. This fully revised and up-to-date 5th Edition offers fresh information that will help you to evaluate financial statements in today's volatile markets and uncertain economy. The declining connection between GAAP earnings and stock prices has introduced a need to discriminate between instructive and misleading non-GAAP alternatives. This book integrates the alternatives and provides guidance on understanding the extent to which non-GAAP reports, particularly from US companies, may be biased.

Understanding financial statements is an essential skill for business professionals and investors. Most books on the subject proceed from the questionable premise that companies' objective is to present a true picture of their financial condition. A safer assumption is that they seek to minimize the cost of raising capital by portraying themselves in the most favorable light possible. Financial Statement Analysis teaches readers the tricks that companies use to mislead, so readers can more clearly interpret statements.

• Learn how to read and understand financial statements prepared according to GAAP and non-GAAP standards
• Compare CFROI, EVA, Valens, and other non-GAAP methodologies to determine how accurate companies' reports are
• Improve your business decision making, stock valuations, or merger and acquisition strategy
• Develop the essential skill of quickly and accurately gathering and assessing information from financial statements of all types

Professional analysts, investors, and students will gain valuable knowledge from this updated edition of the popular guide. Filled with real-life examples and expert advice, Financial Statement Analysis, 5th Edition, will help you interpret and unpack financial statements.

PART One
Reading Between the Lines

CHAPTER 1
The Adversarial Nature of Financial Reporting

Financial statement analysis is an essential skill in a variety of occupations, including investment management, corporate finance, commercial lending, 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 a 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 professional challenge. Neither will a rote completion of all of the proper standard 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 statements often conceal more than they reveal. To the analyst who embraces 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 supported by the longest row of figures available in the software package. Genuinely 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 beyond 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 standard financial ratios. Comparability, after all, is a cornerstone of generally accepted accounting principles (GAAP). It might therefore seem to follow that financial statements prepared in accordance with GAAP necessarily produce fair and useful indications of relative value.

The corporations that issue financial statements, moreover, would appear to have a natural interest in facilitating convenient, cookie‐cutter analysis. These companies spend heavily to disseminate information about their financial performance. They employ investor‐relations managers, they communicate with existing and potential shareholders via interim financial reports and press releases, and their senior executives participate in lengthy conference calls with securities analysts. Given that companies are so eager to make their financial results known to investors, they should also want it to be easy for analysts to monitor their progress. It follows that they can be expected to report their results in a transparent and straightforward fashion … or so it would seem.

THE PURPOSE OF FINANCIAL REPORTING

Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of financial reporting. Their conceptual error connotes no lack of intelligence, however. Rather, it mirrors the standard accounting textbook's idealistic but irrelevant notion of the purpose of financial reporting. Even the renowned consultant to investment managers and author Howard Schilit, an acerbic critic of financial reporting as it is actually practiced, presents a high‐minded view of the matter:

The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company.¹

Missing from this formulation is an indication of whose primary goal is accurate measurement. Schilit's words are music to the ears of the financial statement users listed in this chapter's first paragraph, but they are not the ones doing the financial reporting. Rather, the issuers are for‐profit companies, generally organized as corporations.²

A corporation exists for the benefit of its shareholders. Its objective is not to educate the public about its financial condition, but to maximize its shareholders' wealth. If it so happens that management can advance that objective through “dissemination of financial statements that accurately measure the profitability and financial condition of the company,” then in principle, management should do so. At most, however, reporting financial results in a transparent and straightforward fashion is a means unto an end.

Management may determine that a more direct method of maximizing shareholder wealth is to reduce the corporation's cost of capital. Simply stated, the lower the interest rate at which a corporation can borrow or the higher the price at which it can sell stock to new investors, the greater the wealth of its shareholders. From this standpoint, the best kind of financial statement is not one that represents the corporation's condition most fully and most fairly, but rather one that produces the highest possible credit rating (see Chapter 13) and price‐earnings multiple (see Chapter 14). If the highest ratings and multiples result from statements that measure profitability and financial condition inaccurately, the logic of fiduciary duty to shareholders obliges management to publish that sort, rather than the type held up as a model in accounting textbooks. The best possible outcome is a cost of capital lower than the corporation deserves on its merits. This admittedly perverse argument can be summarized in the following maxim, presented from the perspective of issuers of financial statements:

The purpose of financial reporting is to obtain cheap capital.

Attentive readers will raise two immediate objections. First, they will say, it is fraudulent to obtain capital at less than a fair rate by presenting an unrealistically bright financial picture. Second, some readers will argue that misleading the users of financial statements is not a sustainable strategy over the long run. Stock market investors who rely on overstated historical profits to project a corporation's future earnings will find that results fail to meet their expectations. Thereafter, they will adjust for the upward bias in the financial statements by projecting lower earnings than the historical results would otherwise justify. The outcome will be a stock valuation no higher than accurate reporting would have produced. Recognizing that the practice would be self‐defeating, corporations will logically refrain from overstating their financial performance. By this reasoning, the users of financial statements can take the numbers at face value, because corporations that act in their self‐interest will report their results honestly.

The inconvenient fact that confounds these arguments is that financial statements do not invariably reflect their issuers' performance faithfully. In lieu of easily understandable and accurate data, users of financial statements often find numbers that conform to GAAP yet convey a misleading impression of profits. Worse yet, companies frequently bend and sometimes break the rules for financial reporting. Not even the analyst's second line of defense, an affirmation by independent auditors that the statements have been prepared in accordance with GAAP, assures that the numbers are reliable. Reported numbers can be invalidated by subsequent revisions, typically, if not always credibly, attributed to honest mistakes.

Alternatively, issuers may emphasize supplementary, non‐GAAP numbers to steer analysts toward a more favorable view of their performance. In fairness, some of the alternative metrics disseminated by issuers increase the clarity of disclosure by addressing genuine shortcomings in the financial reporting rules. The rule makers, after all, have found it challenging to keep accounting standards up to date with changes in the way corporations create wealth. Those changes are a consequence of the shift in the economy from traditional manufacturing to knowledge‐based industries. At the same time, the lack of standardization in non‐GAAP reporting enables issuers that are so inclined to exaggerate their financial performance.

The following case study demonstrates how an overly trusting user of financial statements can be misled.

Mattel's Accounting Games

On August 2, 2019, PricewaterhouseCoopers (PwC), Mattel's outside auditor, received a whistleblower letter suggesting that accounting errors had occurred in earlier periods and questioning whether PwC was truly independent. The toymaker disclosed the letter's receipt on August 8, 2019, and the following day its stock plunged by 15.8 percent while the Standard & Poor's 500 Index registered a minor decline of 0.7 percent. Mattel's board directed the audit committee to investigate the matter.

The investigation found that income tax expense was understated by $109 million in 2017's third quarter and overstated by the same amount in the fourth quarter, resulting in no impact for the full year. Disclosing these findings on October 29, 2019, Mattel pointed out that the errors were noncash and did not affect operating income or EBITDA for 2017. The company acknowledged material weaknesses in its internal control over financial reporting but said that the audit committee concluded that PwC's objectivity and impartiality were unimpaired. Mattel further announced plans to restate its 2018 Form 10‐K to restate 2017's final two quarters and strengthen its internal financial reporting controls.

Details of the findings included the disturbing fact that after the errors came to light they were not disclosed to Mattel's chief executive officer and the audit committee. The internal investigation did not find that management engaged in fraud, instead blaming mishandling of the discovery of the accounting error on “a confluence of one‐time events, management's reliance on the accounting advice sought and received on the error from the lead audit engagement partner of Mattel's outside auditor, and lapses in judgment by management.”³

Mattel's audit committee determined that many of the whistleblower's allegations about PwC's independence were unfounded. In conjunction with a separate investigation by PwC, however, the audit committee concluded that the lead audit partner for Mattel violated Securities and Exchange Commission rules on auditor independence by recommending candidates for the company's senior finance positions and providing feedback on senior finance employees. PwC replaced some members of the audit team assigned to Mattel, including the lead partner, who was placed on administrative leave. (One commentator on accounting issues characterized him as the fall guy in the affair.)⁴

The bland tone of Mattel's disclosure likely reassured investors whose confidence in the company's financial reporting had been shaken by the August 8 revelations. In the following month, however, the Wall Street Journal presented details⁵ of what happened when Mattel's tax team discovered the accounting error in early 2018, several months before the news reached the audit committee.

Brett Whitaker, who was director of tax reporting at the time, said the company's finance team discussed correcting the error and restating earnings, expectin...