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FINANCIAL RATIOS

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					         FINANCIAL RATIOS

FOUR BASIC TYPES

    List the most commonly used in each category


LIQUIDITY


•      Current ratio = Current Assets / Current Liabilities,

•      Quick ratio = (Current Assets - Inventory) / Current
                                             Liabilities,
•      Cash ratio = Cash / Current Liabilities
MANAGEMENT SKILL


•   Total Asset Turnover = Sales / Total Assets,

•   Fixed Asset Turnover = Sales / Fixed Assets

•   Inventory Turnover = Sales / Inventory

•   Working Capital Turnover = Sales / (Accounts
                       Receivable + Inventory)

•   Capital Spending Rate = Capital Spending / Sales,
PROFITABILITY


•    Return on Equity = Net Income/Equity

•    Return on Assets = Net Income/Assets or
                                 EBIT/Assets,

•    Operating profit margin = Operating Profit/Sales,

•    Net Profit Margin = Net Income/Sales,
FINANCIAL RISK


•    Debt to Equity = Debt / Equity,

•    Debt Ratio = Debt / Assets

•    Debt / Capital where Capital = Long-Term Debt +
                                               Equity

•    Times Interest Earned = Net Operating Income /
                                  Interest Expense
DUPONT ANALYSIS - ANALYZING ROE

ROE    = (Net Income/Pretax Income) x
               (Pretax Income/EBIT) x (EBIT/Sales)x
               (Sales/Total Assets) x (Total Assets/Equity)


       = (Tax Burden) x (Interest Burden) x
        (Return on Sales) x (Total Asset Turnover)x
        (Financial Leverage)


Note that to get the net effect of debt on ROE we use
       (interest burden) x (financial leverage)
THE RELATIONSHIP BETWEEN ROE AND ROA

 ROE
  = (1 - tax rate)[ROA + (ROA - Interest rate)Debt / Equity]

 IMPICATIONS

 •      High debt firms have positive leverage on ROE as
        long as their ROA exceeds the interest rate paid on
        debt, otherwise, debt creates negative leverage.

 •      This negative leverage effect is what drove many
        high debt firms into bankruptcy in the recession.

 Example of Ratio Analysis using Reuters.com
In the next section we will discuss some of the ways
companies may manipulate their accounting to mislead
investors.
GENERALLY ACCEPTED ACCOUNTING PRINCIPALS (GAAP)

  BASIC PREMISES

  •     Going Concern

  •     Historical Costs - reduce judgment

  •     Consistency - similar transactions treated similarly

  •     Matching - match cost with cost-caused revenues

  •     Conservatism - when uncertain, report lowest figure
               for income or assets.

  •     Disclose Fully - all relevant information.
       QUALITY OF EARNINGS


NO GENERALLY ACCEPTED DEFINITION



FASB definition: normal, recurring, cash flow generating
                earnings from operations, reflecting the
                need to replace depreciating assets.
SIMPLE, OUTWARD INDICATORS OF QUALITY

•    Choice of conservative policy when a liberal
     alternative is available. (see Summary of
     Accounting Policies in financial statements)

•    Stable policies (look for frequent changes reported
                             in footnotes)

•    Stable earnings relative to the industry (gimmicks
     eventually run out and earnings drop).

•    Stable dividends - same as above

•    Stable debt levels through time.
•   No large changes in “Other Accounts”

•   Simple and clear financial reports with few
    footnotes and comments.

•   Short bland audit report long, wordy ones
    mentioning material uncertainties mean trouble.

•   Check date - reports dated later than usual mean
                   accountants / management disagree.

•   Check auditors reputation unknown accounting firm
    may mean trouble
CATEGORIZING GIMMICKS - 3 BASIC WAYS

  REPORTED INCOME = REVENUES - EXPENSES +
                      (TAX BENEFIT)

  •    REALIZE REVENUES FASTER / SLOWER
       should be booked when high probability of
       payment but managers have some discretion.

  •    REALIZE COSTS SLOWER / FASTER -SAME
            some avoid proper write-offs

  •    TAX RELATED - increase / decrease expenses
       for tax books but not for financial statements to
       shareholders. - lower taxes - higher income.
    WHY MIGHT MANAGERS WANT TO REDUCE
            REPORTED INCOME?

•      Keep reserve to cover mistakes made in the future

•      New CEO takes a bath - blames earlier CEO - sets
       up good results in future - Daimler Benz
       (conversely, retiring CEO may artificially boost
       earnings in his last year to look good)

•      Incentive compensation paid only to some
       maximum of earnings or ROE

•      Transfer some earnings to next year when bonus
       may increase.
        REVENUE GIMMICKS
BY RECOGNITION METHOD

    installment - book earnings when paid - offer
    discounts for fast payment

    shipping - book earnings at shipment - ship faster

    production method - when produced - produce faster

    completed contract and percent completed contract-
    when contract (or %) completed - speed completion

    Such manipulation shows up in increases in
    accounts receivable and inventories.
BOGUS REVENUE
• Grossing up – Priceline resells tickets and counts the
full price as their revenue even though they don’t buy
the ticket from the airline until it is sold.
• Exchanges of overvalued products – side agreement
to buy at high price if seller buys from you at high price
– cell phone companies buy each others unused lines.
• Exchange of same product at higher prices to boost
end consumers’ sale price – electric companies sold
each other the same electricity, boosting price each
time and then sold to customers who pay based upon
average price of electricity sold.
• Lend a customer the money to buy your product when
there is little chance the customer will repay.
SELL PRODUCT TO UNCONSOLIDATED SUBSIDIARY
            AT INFLATED PRICES
  Sell receivables to subsidiary to cover bad credit sales and
  late payment. Usually, 50% ownership in subsidiary
  requires consolidation so this does not have an effect for
  consolidated subsidiaries. But if subsidiaries is judged to be
  very different than parent then consolidation is not required
  e.g., Ford , GM, GE, finance subsidiaries. Accounted for in
  one line by the equity method, proportionate share of value
  of unconsolidated subsidiary appears under Investments
  account on the balance sheet and proportionate share of
  income appears in Equity in Income from Non-
  Consolidated Subsidiary account on income statement
          if subsidiary has a loss then Investments account is
  written down and Equity in Income is negative.This tactic
  obscures the loss- makes it look like subsidiary's problem.
•Sell assets to realize one-time gains at low capital gains tax
rates – or take gain on early debt retirement

       GE - you will know the company is in trouble
       if it has large loss - they would smooth it otherwise


•Receives large dividend payment from subsidiary (assumes
cost method of accounts)


•Control sales versus lease of product to control sales (look
at sales breakout).
•Hides revenues by taking unwarranted bad debt expenses
or reserves for product repair.

      German and Japanese accounting system encourage


•Merges and sells off assets      whose    book   value
underestimates market value.
            COST GIMMICKS
CAPITALIZING EXPENSES

     Increase unfunded pension liabilities - don't have to
     fully fund pensions. Federal pension insurance
     agency covers defaults.

     Many expenses can be capitalized if management
     can explain how the expense provides benefits in
     future periods.

     for example, utilities - interest on construction/
      new firms - start up costs / marketing expenses/
                     increase intangible assets.
•REDUCE MANAGED COSTS

advertising / investment in plant & equipment / research
and development / Avoid taking reserves for expected loss
in future on sales now, e.g., warrantee costs, provision for
bad loans etc. (do reverse to hide income to add in future
periods through reversals of charges) / reduce inventories
and avoid payables / reduce maintenance - same effect as
reducing assets life.

•CHANGE DEPRECIATION METHOD OR LENGTHEN
ASSET LIFE ASSUMPTION - reduces depreciation
expense reported to shareholders - inflates earnings - keep
tax depreciation the same - usually accelerated.
•USE FIFO INSTEAD OF LIFO - inflates earnings in
                               inflationary period.

•IF YOU USE LIFO - let inventory rundown to get to older,
                                   cheaper inventory.

•REDUCE PENSION EXPENSES - assume higher return/
     reduce contribution for past employees (retirees)
     that have not been funded previously/ unfunded
     pension 10% of equity (bad), 40% (worst).

•FLOW THROUGH TAX CREDIT - reduces tax expense
     now / more conservative to defer some credit -
     spread over life of equipment purchased.
•MANIPULATE TAX LOSS CARRY FORWARD (5
YEARS) OR BACKWARD (3 YEARS)


•STATEMENT OF CASH FLOWS CAN HELP FIND
PROBLEMS - it shows where cash is coming from and
where it goes.

• See Enron’s 2000 10K filed 4/2001 for example
• See American International Group 10K filed 2/28/2008
You can’t rely on Wall Street analysts as much as
you might think.

				
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