Financial Statement Analysis A Practitioner’s Guide – Martin Fridson, Fernando Alvarez

An updated guide to the essential discipline of financial statement analysis

In Financial Statement Analysis, Fourth 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.

This fully revised and up-to-date Fourth Edition offers fresh information that will help you to evaluate financial statements in today’s volatile markets and uncertain economy, and allow you to get past the sometimes biased portrait of a company’s performance.

• Reflects changes in the financial reporting landscape, including issues related to the financial crisis of 2008-2009
• Provides guidelines on how to interpret balance sheets, income statements, and cash flow statements
• Offers information for maximizing the accuracy of forecasts and a structured approach to credit and equity evaluation

Filled with real-life examples and expert advice, Financial Statement Analysis, Fourth Edition will help you gain a firm understanding of the techniques that will help you interpret financial statements, which are designed to conceal more than reveal.

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 Postacquisition 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

AUTHOR INFORMATION

MARTIN FRIDSON is Global Credit Strategist at BNP Paribas Investment Partners, one of the world’s largest asset managers. Over a twenty-five-year span with brokerage firms including Salomon Brothers, Morgan Stanley, and Merrill Lynch, he became known for his innovative work in credit analysis and investment strategy. Fridson has served as president of the Fixed Income Analysts Society, governor of the Association for Investment Management and Research (now CFA Institute), and director of the New York Society of Security Analysts.

FERNANDO ALVAREZ is currently an Adjunct Associate Professor of Finance and Economics at the Columbia University Graduate Business School, where he teaches entrepreneurship finance. From 2003 until 2008, he was associate professor in the Finance and Economics Department and director of entrepreneurship programs at Rutgers Business School, Newark and New Brunswick. Alvarez has taught at New York University’s Stern School of Business where he was associate professor on innovation and entrepreneurship, and Babson College where he was assistant professor of finance.

REVIEWS

“Financial Statement Analysis: A Practitioner’s Guide is a well-organized, thorough exploration of the challenges facing practitioners who rely on financial statements to make investment and lending decisions. Reference books about accounting, while valuable for their insights, are seldom this enjoyable to read. This book is different because the authors seamlessly integrate fascinating real-life examples and instructive fictional scenarios into each chapter to illustrate their points. For anyone with a passing interest in the subject, or for new analysts learning the trade, Financial Statement Analysis is an amazing resource.”
—Christopher Shayne, CFA, Director of Product Operations for Enterprise Risk Solutions at Moody’s Analytics

“Any book that reaches its 4th edition (updated to 2011) should be good. That’s true in spades for Financial Statement Analysis. Fridson and Alvarez have written a classic. It should be required reading and a constant reference source on the bookshelf of any investor intending to buy individual company stocks or bonds.”
—Canadian Financial DIY blog

“In the 1990s, Benjamin Graham’s Security Analysis served as [Value Partners’] reference book, but since then they have been using Martin Fridson’s Financial Statement Analysis: A Practioner’s Guide.”
—excerpt from The Value Investors: Lessons from the World’s Top Fund Managers by Ronald Chan, Bruce C. N. Greenwald (Foreword)