FOUR BASIC TYPES
List the most commonly used in each category
• Current ratio = Current Assets / Current Liabilities,
• Quick ratio = (Current Assets - Inventory) / Current
• Cash ratio = Cash / Current Liabilities
• 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,
• Return on Equity = Net Income/Equity
• Return on Assets = Net Income/Assets or
• Operating profit margin = Operating Profit/Sales,
• Net Profit Margin = Net Income/Sales,
• Debt to Equity = Debt / Equity,
• Debt Ratio = Debt / Assets
• Debt / Capital where Capital = Long-Term Debt +
• Times Interest Earned = Net Operating Income /
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
Note that to get the net effect of debt on ROE we use
(interest burden) x (financial leverage)
THE RELATIONSHIP BETWEEN ROE AND ROA
= (1 - tax rate)[ROA + (ROA - Interest rate)Debt / Equity]
• 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
GENERALLY ACCEPTED ACCOUNTING PRINCIPALS (GAAP)
• 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
• 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 +
• 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
• 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
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.
• 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.
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
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
•IF YOU USE LIFO - let inventory rundown to get to older,
•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.