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What Every Ratio User Should Know About Assets

Ross, Dianna. Commercial Lending Review 20. 5 (Sep/Oct 2005): 19-24,46-47.Turn on hit highlighting for speaking browsers

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Legitimate reporting choices can contribute variability to the computation of balance-sheetassets. When evaluating ratios, credit analysts must take these potential gray areas into

account. This article provides credit analysts with a review of what reported asset accountsmay legitimately contain, as well as offering comments about related effects on revenues andexpenses. For the financial statement user, the largest risk is that the company will incorrectlyestimate the receivables that will turn out to be not collectible. In addition, most inappropriatereporting of revenue will increase some balance-sheet account other than cash. The reportingof debt and equity investments depends on the type of investment (debt or equity) and, if equity, the degree of control that the equity investment gives the investing company. If

control is not substantial enough to be consolidated, the investing company's intentionregarding holding or selling affects the choice of valuation method.

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Headnote

Financial statement information is subject to legitimate estimates and timing decisions as well

as illegitimate manipulation.

Legitimate reporting choices can contribute variability to the computation of balance-sheet

assets. When evaluating ratios, credit analysts must take these potential gray areas into

account.

Ratio analysis facilitates the process of comparing one company with its own history, with

creditor requirements, with another company and with the relevant industry average on

important issues. But to gain an understanding of creditworthiness from ratio analysis, lenders

must examine the inputs to those ratios: the balance sheet and income statement items that

form the numerators and denominators of financial ratios.

This article provides credit analysts with a review of what reported asset accounts may

legitimately contain, as well as offering comments about related effects on revenues and

expenses.

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Choices and judgments are part of financial reporting. Even businesses that are not engaged

in fraud make financial reporting decisions that can optimize their reported results.

Motive. In a self-fulfilling prophecy, company prosperity and financial health are affected by

how companies are perceived by creditors, investors, customers, employees and regulatory

agencies. Earnings are assessed against analyst forecasts; liabilities are weighed against

assets. Given latitude, why should companies make choices to look worse than need be?

Company decisions are made by managers who as a group tend to be assertive, optimistic,

can-do. After implementing a plan to do well, planners often optimistically assess recent

history as "been there, did well." Business is an extremely complex process with areas that

are primarily gray-not black and white.

Opportunity. In many cases of fraud, companies try to manage their appearance by

inappropriately reporting fictitious revenues and by failing to report expenses as incurred.

Even without such egregious transgressions, companies can take full advantage of two types

of legitimate latitude, operational freedom and reporting freedom. For example, companies

take advantage of the prerogative to make operational choices at year-end in order to make

asset accounts appear better than on any average day.

Without being strictly fraudulent, reporting freedom can be exploited to manage earnings.

Corporate executives are allowed to use judgment to determine amounts reported in accounts

that greatly affect resulting financial ratios. Under U.S. generally accepted accounting

principles (GAAP), companies have:

* the right to choose among different accounting methods;

* the privilege of estimating a multitude of reported items; and

* the freedom of deciding multiple reporting issues that can undermine transparency.

GAAP-sanctioned exercise of judgment, by its nature, results in a wide range of defensible

positions. The 70-year development of GAAP has produced a set of principles, not hard-and-

fast rules, that allow judgment to be exercised when measuring the effects of company

events. The GAAP constraint of conservatism, of course, does direct executives to select

methods and estimates that avoid overstatement of assets, revenue and net income, but this

constraint is also a matter of executive judgment.

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Companies are encouraged by GAAP to disclose to financial statement readers all material

information that would likely affect readers' decisions. Disclosure choices are made from the

entity's point of view, however, not that of the users of financial statements. Different users-

potential and current creditors, shareholders, customers, competitors, regulators, employees-

require different information, have different levels of financial sophistication and have different

goals. Reporting entities cannot necessarily predict the information needs of all users or how

users will use the reported information.

In addition, reporting entities may want to limit the information they disclose. Data, which

may be expensive to collect and analyze, may involve further cost to design its presentation

and explanation so that various users can understand the underlying issues. Concern about

competitors may motivate concealing information, and there is little incentive to disclose more

information than peers and competitors are disclosing.

Companies facing financial and competitive pressure may be tempted to shade the difference

between their situation and the best-case scenario by using legitimate tools to appear to be

closer to the best case. Legitimate timeshifting of revenues and expenses can temporarily

improve reported performance. For example, this year's net income may be on the high side

of a defensible range, but next year the company may have to report a compensating lower

net income. Such time-shifting creates a greater future incentive to manage appearance. This

can be the first step toward an increasing spiral of income manipulation and resulting asset

misstatements.

As this discussion shows, financial statement information is subject to legitimate estimates

and timing decisions as well as illegitimate manipulation. This article looks at assets in order to

show loan officers ways in which ratios may not reflect actual performance and financial

soundness. A danger in balance-sheet amounts is that they may reflect years of statement

and misstatement, and most are stated at values other than fair value.

Below, we will look at common assets and describe how each can be manipulated, affecting

common ratios of liquidity, solvency, asset management and profitability.

Cash and Cash Equivalents

Cash is often considered to be certain in amount and stable in value. But there are some

concerns about cash and equivalents.

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Are they really equivalent? Cash equivalents include various financial instruments considered

to be so highly liquid that they belong in this category. These investments mature soon after

the reporting date and in the meantime are considered low risk. But low risk is not the same

as no risk.

Is cash available to creditors? When a company publishes consolidated reporting, the cash

balance can be the aggregation of the cash of many companies, each of which can have their

cash in a large number of different accounts in different currencies. Consolidated cash does

not imply, of course, that the cash is available to the parent company, an important

consideration for creditors.

Is country risk a factor? Accounts can be in different countries, with different risks of

expropriation and restrictions on repatriation.

Might payments and collections have been timed to maximize reported cash? The reported

balance describes what the company had on the reporting day (a nonrandom closing date).

This provides some cash-management leeway to postpone payments or speed up collections in

order to maximize reported cash.

Has cash on hand changed significantly since the reporting date? The company does not have

the cash reported; it had that much cash on the reporting date.

Recommendations for Analysts

* Read the footnotes. Review the footnotes to learn policies for reporting cash equivalents, for

details supporting the reported balance and for identification of underlying currencies and

risks.

* If the company has provided a cash flow statement using the indirect method, the analyst

may wish to address concerns about cash flow timing by calculating and comparing cash-

versus-accrual ratios across the current and prior year. If the analyst feels confident that the

year-to-year calculation of revenues and expenses was consistent, the ratios of interest might

be (1) cash in from customers divided by sales revenue and (2) cash paid for operations

divided by operational expenses. Significant differences from year to year can then be

discussed with management.

Accounts and Ratios That Can Be Affected

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* If cash is misstated, current assets and total assets will be misstated, with potential effects

on owners' equity.

* Affected ratios include liquidity and solvency (current ratio, quick ratio, debt ratio, debt-

equity ratio) and asset management and profitability (return on assets and other profitability

ratios).

Receivables

For the financial statement user, the largest risk is that the company will (in all good

conscience, negligently or even intentionally) incorrectly estimate the receivables that will turn

out to be not collectible. In addition, most inappropriate reporting of revenue will increase

some balance-sheet account other than cash. Significant increases in receivables, therefore,

may signal an overstatement either of revenue or of the collectibility of resulting receivables.

As receivables must be stated at their net realizable value, it is important for the analyst to

keep in mind the accounting choices that contribute to the reported amount.

How reliable are the reported numbers? In reporting receivables and their related allowance,

management may exercise considerable judgment as to how and how much to disclose,

providing opportunity to affect assets and income.

Has the company changed its method of estimating the allowance for receivables? A reported

change in method (from percentage of sales to percentage of receivables, for instance) orapplication of method (to different management-determined classes of receivables) may have

been the vehicle by which the company significantly altered the allowance amount relative to

gross receivables.

What are the components of the allowance for receivables? Regardless of method, the

company estimated a percentage using information not available to the general financial

statement user. Different percentages probably were used for different classes and ages of

receivables, as an amount long overdue is less likely to be collected than a more recent

amount. Each percentage may have been based on the company's recent history, on industry

averages or on economic forecasts.

Although more information would be helpful, company disclosures should include at least the

following: the amounts of major classes of receivables (trade versus related party, for

instance), the amount of allowance provided, the method used to determine the allowance

amount and description of the factors that influenced management judgment, the policy for

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writing off receivables, significant concentrations of credit risk and the amount of receivables

90 days or more past due.


Read the footnotes. Companies may, but are not required to, disclose various items of interest

to the analyst such as schedules of aged receivables with related percentages allowed,

collected and written off. If considered material, analysts may, of course, request this

information from management, as well as determining whether there has been consistent use

of one method for estimating the allowance. Once obtained, analysts may consider the

implications of annual rates of change in the allowance, the gross receivables and revenues.


* Misstating receivables can lead to misstatements of current and total assets, bad debt

expense, operating income, net income, retained earnings and owner's equity.

* Affected ratios include liquidity and solvency (current, quick, debt ratio, debt-equity,

average collection period) and asset management and profitability (receivables turnover,

return on assets, most profitability ratios).

Investments

The reporting of debt and equity investments depends on the type of investment (debt or

equity) and, if equity, the degree of control that the equity investment gives the investing

company. If control is not substantial enough to be consolidated, the investing company's

intention regarding holding or selling affects the choice of valuation method.

Valuation method is a function of account classification and availability of market value. The

securities that the company must mark to market include equity securities classed as trading

or available-for-sale and any held-to-maturity debt securities that will mature within a year.

With no readily available price, the balance equals cost (for equity securities) or amortized

cost (for debt securities purchased at premium or discount when compared to their face

value). The classification is a matter of management judgment.

The effect on equity is a function of the account classification. The classification will affect how

gains and losses are treated and reported. Unrealized holding gains and losses for trading

securities will be reflected in net income (below income from operations), whereas comparable

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items for available-for-sale securities will bypass the income statement and be reflected

instead in other comprehensive income.

The reporting of investments in derivatives (such as swaps, options, financial forwards and

financial futures) depends on the purposes for which the investment is owned. The asset is

reported at fair value, but there are differences in treatment of any unrealized gain or loss. For

derivatives owned for purposes of speculation, such a gain or loss is reported in income. For

derivatives owned as hedging instruments, however, a further distinction is made between

fair-value hedges (to hedge exposures to changes in the fair value of a reported asset or

liability or of an unrecorded commitment) and cash flow hedges (to hedge exposures to cash

flow risk). The complex area of reporting derivatives, recently addressed by GAAP, is beyond

the scope of this article. Analysts who become familiar with the new accounting rules,

however, will be aided in the analysis task by the detailed disclosures companies are required

to present.


For debt and equity investments, value the portfolio at the analysis date. Whatever the

portfolio fair market value on the reporting date, by the analysis date the makeup of the

portfolio and the value of the original securities can be different. If the portfolio contents are

disclosed in the financial statements or otherwise available from management, the analyst

may wish to consider results if the portfolio contents were reclassified and may in any event

mark the portfolio to market at the analysis date.


* Although investments in securities are reported at market value, their classification has

affected how the change to equity is reported and so may affect net income, retained earnings

and owner's equity.

* Classification of investments and their marking to market can affect profitability ratios. For

instance, assume a company has $800,000 in beginning equity, a $10,000 unrealized loss and

a net income without regard to this loss of $100,000. If this loss is recognized in income,

return on equity would be 10 percent ($90,000/$890,000). If the loss is treated so that it

bypasses income, return on equity is 11 percent ($100,000/$890,000).

Reported Inventory

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Any company's inventory is likely to be unique, so it can be difficult to compare it and ratios

affected by it to those of other companies.

Understand the components of inventory. A single reported balance for inventory can contain

any or all of the following: raw materials inventories for different materials, partially

manufactured inventories (work-in-progress) for many products and finished inventories for

various products.

Understand the valuation method. The components of inventory may have been accounted for

using different costing methods, which can affect the reported cost-of-goods-sold expense and

inventory value. LIFO (last in, first out), of course, maximizes the inventory cost flowing to

cost-ofgoods-sold expense and minimizes net income and the cost remaining in reported

inventory. FIFO (first in, first out) minimizes cost-of-goods-sold expense and therefore

maximizes net income and reported inventory. Were two otherwise identical companies to

report identical inventory balances, the company using LIFO would in fact have a larger

inventory than the company using FIFO.

Understand the measurement period. Individual inventory costs may be tracked periodically

(period-end) or perpetually (every sale). Under LIFO, the difference can be significant. In a

perpetual inventory tracking system, the cost amount removed from inventory and sent to

cost-of-goods-sold expense for any given sale will reference the cost of the most recent

purchases or manufacturing of merchandise. Thus, January sales will consider the cost of the

sale to be cost of January purchases. In a periodic inventory tracking system, the amount

removed from inventory and sent to cost of goods sold in a single entry at year-end will

consider the appropriate costs to be purchases at yearend. Thus, the costs related to sales

from January through December are considered to be the most recent from the perspective of

year-end, that is, all of December purchases, then all of November purchases, etc. In essence,

periodic inventory tracking claims as costs of sales those costs not even incurred at the time

of some of the sales. This timing difference would tend to make cost of goods sold greater

under periodic LIFO than under perpetual LIFO.

How is replacement value determined? Companies are required to report inventory at an

amount less than cost when the utility of goods has fallen below that cost. For most

companies, that means that cost must be compared to replacement value so that permanent

value losses can be reported. Replacement value may be determined by supplier, by product

or by segment, thus creating inconsistencies. Companies are under no obligation to reveal

details of this valuation in their published financial statements.

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Might the company have intentionally structured year-end transactions to affect reported

balances? In times of inflation, entities that use LIFO valuation may stockpile inventory at

year-end in order to increase reported cost of goods sold. Companies may delay

replenishment until the next period. Or they may liquidate inventories in order to bring older

lower LIFO costs into cost of goods sold. Disclosures related to such a LIFO liquidation will

probably include the dollar increase to income and decrease to reported inventory.

Has management been forthcoming in discussing material changes in cost of sales? This

discussion may disclose such changes as dollar amounts or percentages of revenues and may

aid the analyst in determining implications of such changes.

Has management provided useful information in the required disclosures? Company

disclosures should discuss the following: the composition of the inventory (relative mix of raw

materials, work-inprocess and finished goods); the inventory costing method employed; and

the basis for reporting (lower of cost or market, for instance).

Additional disclosures required of companies using LIFO include either the replacement cost of

inventory or the amount of LIFO reserve (which accumulates the annual LIFO effect, the

difference between FIFO and LIFO cost).


* Understand issues related to LIFO and FIFO accounting. Under FIFO, the cost of goods soldcan be understated. Under LIFO, the current inventory balance can be understated, as this

asset contains older costs from many periods ago.

* Use the composition of inventory to assess liquidity and stage of inventory completion.

* Use market value of inventory (if disclosed or otherwise available from management) in

computing ratios based on asset fair value rather than cost.

* Use the annual change in LIFO reserve data in the notes to determine the LIFO effect on

income.

* If the company discloses the inflationary profit from a LIFO liquidation, use this data to

adjust year-over-year comparisons. Also keep in mind that companies may manipulate income

by an intended LIFO liquidation.

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* Unrepresentative inventory misrepresents current assets and total assets, cost of goods

sold, gross profit, operating income, net income, retained earnings and owner's equity.

* Affected ratios include liquidity and solvency (debt ratio, debt-equity, days sales in

inventory, times interest earned) and asset management (inventory turnover, return on

assets) and profitability (most profitability ratios).

Reported Fixed Assets

Reporting of property, plant and equipment balances differs among companies due to real

differences and due to reporting differences. Here are some issues to consider:

* The age of assets, and therefore their efficiency and likely need for replacement, will

probably not be disclosed as companies are not required to report the age of their fixed

assets. A relatively small fixed-asset balance compared to the industry could mean that a

company is relying on older, more depreciated assets.

* The calculations resulting in the reported balances will probably not be disclosed. The

reported balances of depreciable fixed assets (generally all but land) are the results of

management choices about depreciation methods, estimated useful life and salvage value.

* A company should disclose the following: the valuation basis (such as cost), depreciation

expense for the period, balances of major classes of these assets by nature and function,

accumulated depreciation, the method(s) by class and any material impairments. In practice,

however, these disclosures are typically fairly cryptic.


* Determine from disclosures or in discussion with management the extent to which reported

fixed assets are representative of assets used in operations; that is, determine if productive

assets are being leased under arrangements that would not reflect them on the balance sheet.

* If depreciation methods are not adequately disclosed, discuss methods and reasoning with

management. An adequate understanding of depreciation methods and estimates can make

transparent the effects of depreciation choices on reported balances.

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* Discuss with management any material planned capital expenditures. The analyst needs to

assess productive capacity and remaining life. Management should provide forward-looking

information about plans to replace fixed assets to assist the analyst in the prediction of future

cash flow.


* Unrepresentative balances in fixed assets misrepresent total assets. Inaccurate depreciation

expense affects operating income, net income, retained earnings and owner's equity.

* Ratios affected include liquidity and solvency (debt ratio, debt-equity, times interest earned)

and asset management (fixed-asset turnover, return on assets) and profitability (most

profitability ratios).

Natural Resources

Natural resources, such as mineral mines, oil wells and timber stands are recorded at cost and

depleted as benefit is derived. Many of the issues affecting fixed assets are also pertinent to

natural resources.

Lack of qualitative information on natural resources. A relatively small natural resource

balance (compared to industry) could mean that the company's assets are older and more

depleted or that the company owns fewer such resources.

Depletion choices can vary. Depletion choices affect reported balances of depletable natural

resources. Choices include depletion methods, estimated capacity and salvage value.


* Keep in mind that market value can be vastly different from reported depleted cost.

* Investigate depletion methods in order to clarify the effects of depletion choices on reported

balances.

* Gain an understanding of productive capacity and remaining life.

* Require forward-looking information about management plans to purchase future natural

resources that would assist the analyst prediction of future cash flow.

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* Unrepresentative balances in natural resources misstate total assets. Manipulated depletion

expense affects operating income, net income, retained earnings and owner's equity.

* Ratio areas include liquidity and solvency (debt ratio, debt-equity, times interest earned)

and asset management (return on assets) and profitability (most profitability ratios).

Intangible Assets

Valuation issues are also important for intangible assets such as patents, copyrights,

trademarks, franchises and goodwill. Limited-life intangibles are regularly amortized, whereas

indefinite-lived intangibles (such as goodwill, potentially) are not amortized. To determine

reported balances, both classes of intangibles are subject to impairment testing, in which the

asset book value is compared to the fair value. A lower fair value results in an impairment

loss.

For unimpaired amortizable intangible assets, the reported balance is the historic cost less

subsequent amortization of portions of the cost as benefits are consumed. The amounts

amortized are a function of management choices of method and estimates, so judgment is

involved in determining amortization expense (and therefore net income) as well as the asset

balance.

Any goodwill remaining on the balance sheet is management's representation of remaining

future benefit arising from a portion of the amount paid in the past to purchase another

company. The assessment of impairment involves two steps. In step one, a fair-value test on

the (purchased) reporting unit compares unit fair value to carrying value of the net assets. If

fair value is less, the existence of an impairment is determined by comparing the unit's fair

value with its net assets other than goodwill. That difference, if less than goodwill, calls for an

appropriate impairment loss. Note, however, that management chooses the method(s) used to

establish fair value. This management choice provides the opportunity to select the timing of

any reported impairment loss, therefore affecting income and assets.

Required disclosures include amounts (of amortization expense, impairment loss, remaining

goodwill and accumulated amortization by asset class) as well as circumstances resulting in

any impairment.


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For all material intangible assets, the analyst may wish to discuss with management the

nature and extent of expected future benefits from these assets, as well as the methods used

to determine the continued viability of goodwill.


* Misstatement of intangibles misstates total assets. Inaccurate amortization expense and

goodwill impairment misstates net income, retained earnings and owner's equity.

* Affected ratios include liquidity and solvency (debt ratio, debt-equity, times interest earned)

and asset management (return on assets) and most profitability ratios.

Evaluate Inputs to Ratio Analysis

The concerns reviewed in this article represent only a portion of the potential concerns about

company reporting in which a combination of seemingly immaterial amounts can influence the

quality of a prospective borrower's financial reporting.

Lenders using ratios to compare companies to each other or to industry norms should bear in

mind the following:

* The extent to which the numbers can be manipulated within the freedom provided by GAAP

* The management choices that underlie the reported numbers

* The likelihood that reported numbers reflect the company's true financial picture

* The extent to which the effect on a given ratio matters to the decision being made.

Sidebar

GAAP-sanct/oned exercise of judgment, by its nature, results in a wide range of defensible

positions.

AuthorAffiliation

Dicmna Ross is an Associate Professor at St. Mary's University, San Antonio, Texas. She can

be reached at [email protected].

Copyright Aspen Publishers, Inc. Sep/Oct 2005

Word count: 4100

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Indexing (details)

Cite SubjectCredit analysis;Commercial credit;

Assets;Financial ratios;Financial statement analysis;Guidelines;Ratio analysisLocationUnited States--USClassification9190: United States, 8110: Commercial banking services, 9150: GuidelinesTitleWhat Every Ratio User Should Know About AssetsAuthorRoss, DiannaPublication title

Commercial Lending ReviewVolume20Issue5Pages19-24,46-47Number of pages8Publication year2005Publication dateSep/Oct 2005Year

2005PublisherCCH INCORPORATEDPlace of publicationRiverwoodsCountry of publicationUnited StatesJournal subjectBusiness And Economics--Banking And FinanceISSN08868204Source typeTrade JournalsLanguage of publication

EnglishDocument typeFeatureSubfileAssets, Credit analysis, Financial ratios, Financial statement analysis, Commercial credit, Ratioanalysis, GuidelinesProQuest document ID229589431

Document URLhttp://search.proquest.com/docview/229589431?accountid=132449

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CopyrightCopyright Aspen Publishers, Inc. Sep/Oct 2005

Last updated2010-06-10DatabaseABI/INFORM Complete

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