balance sheet analysis alexander motola, cfa alexander motola, 20131

Alexander Motola, 2013 1

Balance Sheet AnalysisAlexander Motola, CFA


Quality of Earnings, Chapter 8Two Key Ratios: Accounts Receivable and Inventories“…the best method I have ever discovered to predict future downwards earnings revisions by Wall Street security analysts – is a careful analysis of accounts receivable and inventories.” (QoE, pg. 107)Was is predicting future

downwards earnings revisions important?

Is A/R and inventory analysis difficult?


Quality of Earnings, Ch. 8All of the examples are 30 years

old – are they still relevant today?◦Those business are (largely) gone◦Mgmt and investor psychology

remain◦Accounting standards have evolved,

but not too much◦2000-2002 market “event” was a

repeat of the 1984-1985 debaucle


Quality of Earnings, Ch. 8In most financial analysis, we are

less concerned with the absolute (actual) numbers, and more concern with the change in the pattern◦You need a lot of data

Many periods of numbers Competitor/Industry data where

applicable◦You need to understand what the

numbers mean, and how they might be derived


Accounts ReceivableCompanies sell goods to

customers – this is revenueCustomers either pay cash or use

credit (usually 30 days)If the customers don’t pay at the

time of the transaction (revenue), then A/R is created

Credit is a normal part of business; it removes a transactional barrier

What can we learn from credit?


Accounts ReceivableThink about your job – what does

your company do? How soon do customers pay?

There is normally an “appropriate” amount of credit, relative to sales, for most businesses

Calculations◦ EOP (easiest): AR/Rev*#days◦ AVE: [(Current period AR + Last Period

AR)/2]/Rev*#ofdays (91.25)◦ 4Q Average: (5 AR [ave])/cumulative

sales * #days


Accounts ReceivableWhat A/R is on the balance

sheet?◦What does “Net” mean?◦What does “Gross” mean?◦What is ADA?◦Which # makes more sense, Net or

Gross?◦If Wall Street focuses on Net A/R,

what does that mean?


Accounts ReceivableWhat is a “DSO”?

◦It is an average◦It approximates the number of days –

on average – that it takes a company to turn a sale (revenue) into cash

◦Lower is better, but it depends on the business cycle

◦The faster you grow, the more working capital you need…


Accounts ReceivableI like Gross

◦It *IS* the amount of money owed the company

◦The reserve does matter, it is estimated by the company based on their “experience” If the reserve changes a lot, either the

company is manipulating earnings, A/R, or their “experience” has changed – any one of these are important


Accounts ReceivableAllowance for Doubtful Accounts

Look at the trend◦It’s not seasonal◦It probably impacted A/R, DSO, and

EPS


Accounts ReceivableExample of ADA T-Account

◦You can see the income statement impact


Accounts ReceivableDSO trend - ramps suddenly

Why are DSOs up?◦ Economy weakening◦ Regulatory changes◦ More credit extension – financing

customers, channel stuffing, stealing from future revenues

◦ Customers can’t/won’t pay


Accounts ReceivableSome companies will disclose their

“Aging” in a footnoteAging is more detail of the total A/R

by different buckets based on how long “past due” or current they are

Sometimes just a few customers skew the DSO upwards because they can’t or won’t pay

Companies HAVE to disclose if they have 1 or more customers that make up 10%+ of sales or A/R in any reported period


Accounts ReceivableThe dirty little secret – FactoringRamping DSO is seen as a collection

issue, analysts understand earnings quality declines as DSO goes up

Companies can sell A/R to finance companies for X cents on the dollar◦A/R down◦Cash up◦No tell tale on the SCF, either◦It’s no economic for most companies, it’s

purely cosmetic, and comes at a cost


Accounts ReceivableIs there a way to discover if a

company is factoring?◦ Not really◦ Most companies will tell you if you ask◦ You can delve into their banking

relationships, but you aren’t likely to get very far

If you want to learn more, a good next step is to read either◦ What’s Behind the Numbers? Del

Vecchio and Jacobs◦ Financial Shenanigans – Schilit


InventoryThis reflects the value add

created by the company on the balance sheet at the product level

It is a direct input into COGSShould a company have a lot of

inventory?What questions should we ask

about a company’s inventory?


InventoryLike A/R, we can look at the

absolute level as well as the amount of inventory relative to sales

“Relative to sales” means DIO◦Days of Inventory Outstanding◦Is it really relative to

Sales/Revenues?◦Basic calculation is: Inv/COGS*#days

Why?◦What does DIO tell us as analysts?


InventoryMost companies report 3

“buckets” of inventory ◦Raw Materials◦WIP (Work in Progress)◦Finished Goods◦It obviously depends on the business

model


InventoryHere’s an example of a footnote

◦All three categories are there◦They also have the LIFO/FIFO adj


InventoryWhat does a lot of Finished

Goods tell us (as a mix of inventory)?

What does a lot of Raw Materials tell us?

These are both examples which would cause Inventory $ and DIOs to go up, but the conclusions are different…


InventoryDIO exampleONNN has a long history of DIO

around 80 days

But then there’s this move of +40 days◦Big acquisition (SANYO)◦Not really worrying if they can “work it

down”


InventoryDIO exampleONNN has a long history of DIO around

80 days

But then there’s this move of +40 days◦ Big acquisition (SANYO)◦ Not really worrying if they can “work it

down” – which they were obviously able to do


InventoryDIO exampleONNN has a long history of DIO around

80 days

But then there’s this move of +40 days◦ Big acquisition (AMI Semi)◦ Not really worrying if they can “work it

down” – which they were obviously able to do


InventorySometimes there is just a

problem…UTSI grew > 75% each of the

first two quarters of 2003…Having accelerated from the

previous year (around the 30-40% range)

With the help of some acquisitions…

And the stock had been awesome as the revenue acceleration happened


Inventory


Inventory

• Inventories go nuts, up to $1b in 2Q03, equating to 374 days• The inventories come down, but we later learn they’ve tried

to move them “OBS” (the # in row 264).• UTSI – after clearing mgmt house – conducted a series of self

investigations regarding their accounting and business practices, and much mischief was found


Inventory


Other “Cookie Jars”“A disingenuous accounting practice in

which periods of good financial results are used to create reserves that shore up profits in lean years. “Cookie jar accounting” is used by a company to smooth out volatility in its financial results, thus giving investors the misleading impression that it is consistently meeting earnings targets.” - Investopedia

You can analyze DDR, or days of deferred revenue, on a similar basis

Warranties are another place to store expenses


Other “Cookie Jars”“One of the best-known cases of cookie jar accounting in recent years was that of computer giant Dell, which in July 2010 agreed to pay a $100 million penalty to the Securities and Exchange Commission (SEC) to settle SEC allegations that it used cookie jar reserves. The SEC maintained that Dell would have missed analysts’ earnings estimates in every quarter between 2002 and 2006 had it not dipped into these reserves to cover shortfalls in its operating results. The cookie jar reserves were created through undisclosed payments that Dell received from chip giant Intel in return for agreeing to use Intel’s CPU chips exclusively in its computers. (Intel made these payments to Dell to lock out rival chipmaker Advanced Micro Devices from Dell computers.)” - Investopedia


SummaryEarnings (EPS) isn’t just a

number – you need to evaluate what’s behind it

Most of the information necessary to determine Earnings Quality is available

The larger your sample (more periods), the more insightful you can be

Everything has context; the numbers are clues, but you still need to piece together what they are saying

balance sheet analysis alexander motola, cfa alexander motola, 20131

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