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 aslong 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 liberalalternative is available. (see Summary ofAccounting Policies in financial statements)

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

• Stable earnings relative to the industry (gimmickseventually 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 fewfootnotes and comments.

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

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

• Check auditors reputation unknown accounting firmmay 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 expensesfor 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 - setsup 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 somemaximum of earnings or ROE

• Transfer some earnings to next year when bonusmay increase.

REVENUE GIMMICKS

BY RECOGNITION METHOD

installment - book earnings when paid - offerdiscounts 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 inaccounts 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 statementif 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 troubleif 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 managementcan 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.