Financial Statement Analysis

[Pages:413]Financial Statement Analysis

John Wiley & Sons

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Financial Statement

analysis

A Practitioner's Guide

Third Edition

MARTIN FRIDSON FERNANDO ALVAREZ

John Wiley & Sons, Inc.

Copyright ? 2002 by Martin Fridson and Fernando Alvarez. All rights reserved.

Published by John Wiley & Sons, Inc.

No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: PERMREQ@.

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This title is also available in print as ISBN 0-471-40915-4. Some content that appears in the print version of this book may not be available in this electronic edition.

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In memory of my father, Harry Yale Fridson, who introduced me to accounting, economics, and logic, as well as the fourth discipline essential to the creation of this book--hard work!

M. F.

For Shari, Virginia, and Armando.

F. A.

ADDITIONAL PRAISE FOR FINANCIAL STATEMENT ANALYSIS, THIRD EDITION

"With a solid understanding of accepted accounting standards, one must peel through the fog generated by audited accounting numbers to get a clear picture of any company's financial health. Certainly, Fridson and Alvarez show us how to do just that. What I like best about the book is the authors' ability to provide examples of real-life debacles discussed in the business press that could have been foreseen using the techniques explained in the book and having a healthy dose of skepticism. Their approach to analyzing financial statements should be commended."

--Ivan Brick Professor and Chair, Finance and Economics Department, Rutgers Business School

"This book should be required reading for the seasoned investor and novice alike. Fridson and Alvarez show, in a very readable format, that diligent analysis still can make a difference. Finally a book that covers not just the basics, but all the subtleties and everything that management doesn't want you to know."

--Robert S. Franklin, CFA Portfolio Manager, Neuberger Berman, LLC

"Read it, digest it, and review it frequently. Fridson and Alvarez take you through financial statement analysis with many salient examples that expose hidden agendas and help with assessing the true value of securities."

--Ron Habakus Director of High Yield Investments, Brown Brothers Harriman

"Fridson and Alvarez clearly show why the most successful financial analysts approach their jobs with healthy doses of cynicism. Well written, insightful, and with numerable real life war stories, this book is required reading for all high yield bond analysts at AIG."

--Gordon Massie Managing Director, High Yield Bonds American International Group Global Investment Advisors

"Fridson and Alvarez give financial analysts, accountants, investors, auditors and all other finance professionals something to chew over. They succeed in illustrating the use of financial statement analysis with many astonishing real life examples. This book starts where others stop. Clearly, a must read that brings the reader beyond the pure number crunching!"

--Marc J.K. De Ceuster Professor at the University of Antwerp (Belgium) and Director of Risk Management at Deloitte & Touche

"Alvarez and Fridson have a real gift for expressing the concepts of finance in down-toearth, understandable ways. The situations they choose, and the skillful way they lay out each example, make all the subtle relationships come to. They are real artists with spreadsheets that are easy for the reader to follow, and easy to adapt to new situations. For instant financial empowerment, buy this book and let Alvarez and Fridson ramp up your financial modeling skills."

--John Edmunds Director of the Stephen D. Cutler Investment Management Center at Babson College

preface to third edition

This third edition of Financial Statement Analysis, like its predecessors, seeks to equip its readers for practical challenges of contemporary business. Once again, the intention is to acquaint readers who have already acquired basic accounting skills with the complications that arise in applying textbook-derived knowledge to the real world of extending credit and investing in securities. Just as a swiftly changing environment necessitated extensive revisions and additions in the second edition, new concerns and challenges for users of financial statements have accompanied the dawn of the twenty-first century.

For one thing, corporations have shifted their executive compensation plans increasingly toward rewarding senior managers for "enhancing shareholder value." This lofty-sounding concept has a dark side. Chief executive officers who are under growing pressure to boost their corporations' share prices can no longer increase their bonuses by goosing reported earnings through financial reporting tricks that are transparent to the stock market. They must instead devise more insidious methods that gull investors into believing that the reported earnings gains are real. In response to this trend, we have expanded our survey of revenue recognition gimmicks designed to deceive the unwary.

Another innovation that demands increased vigilance by financial analysts is the conversion of stock market proceeds into revenues. In terms of accounting theory, this kind of transformation is the equivalent of alchemy. Companies generate revenue by selling goods or services, not by selling their own shares to the public.

During the Internet stock boom of the late 1990s, however, clever operators found a way around that constraint. Companies took the money they raised in initial public offerings, bought advertising on one another's websites, and recorded the shuttling of dollars as sales. Customers were superfluous to the revenue recognition process. In another variation on the theme, franchisers sold stock, lent the proceeds to franchisees, then immediately had the cash returned under the rubric of fees. By going out for a short stroll and coming back, the proceeds of a financing mutated into revenues.

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