Post on 22-Dec-2015
Alexander Motola, 2013 1
Balance Sheet AnalysisAlexander Motola, CFA
Alexander Motola, 2013 2
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?
Alexander Motola, 2013 3
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
Alexander Motola, 2013 4
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
Alexander Motola, 2013 5
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?
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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
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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?
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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…
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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
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Accounts ReceivableAllowance for Doubtful Accounts
Look at the trend◦It’s not seasonal◦It probably impacted A/R, DSO, and
EPS
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Accounts ReceivableExample of ADA T-Account
◦You can see the income statement impact
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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
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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
Alexander Motola, 2013 14
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
Alexander Motola, 2013 15
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
Alexander Motola, 2013 16
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?
Alexander Motola, 2013 17
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?
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InventoryMost companies report 3
“buckets” of inventory ◦Raw Materials◦WIP (Work in Progress)◦Finished Goods◦It obviously depends on the business
model
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InventoryHere’s an example of a footnote
◦All three categories are there◦They also have the LIFO/FIFO adj
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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…
Alexander Motola, 2013 21
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”
Alexander Motola, 2013 22
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
Alexander Motola, 2013 23
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
Alexander Motola, 2013 24
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
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Inventory
Alexander Motola, 2013 26
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
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Inventory
Alexander Motola, 2013 28
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
Alexander Motola, 2013 29
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
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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