by Chuck Kremer, CPA, and Randall Chun
Outline
A. Introduction
B. About the Need for Using
Financial-Statement Information in Business – Restating the
Obvious
C. So Why Isn’t Using
Financial-Statement
Information in Business Working Better?
D. But Can’t We Rely
on Profit? Apparently Not.
E. Need for Analyzing
Dollars and Ratios Both –
The
Power of Trend Analysis and Competitor Analysis
F. Need for Reality Check – Cash
Flow
G. Need for Three Bottom Lines –
One
for Each Financial Statement
H. Summary
A. Introduction
Chuck’s entire professional career has involved helping non-financial businesspeople understand and use financial-statement information for intelligent analysis, in order to make better decisions that put more money into their companies’ bank account over the long term, he feels compelled to speak to the daily attacks against relying on financial-statement information to understand the health and value of a company.
First we should address several questions you may be asking. We must begin by stating that we do not have all the answers to this dilemma; still you should find the advice herein valuable, practical and irrefutable from a common-sense perspective.
Also, you may read this article wondering whether the advice applies from an investor’s or a manager’s perspective. Granted that these two users have many needs that are different. But we suggest that following the advice will prove invaluable for either user.
Finally, the intent of this paper is to provide some tools to examine financial statements along with a roadmap to the question underlying assumptions upon which any business person can make a better assessment of a company’s health and well-being.
B. About the Need for Using Financial-Statement Information in Business – Restating the Obvious
Although we would argue that making money should not be the only business goal, any company that doesn’t include making money (also known as financial performance) as one of its goals will likely have a difficult time surviving and thriving in bad economic times and good.
Unlike other business goals, making money is a measurable goal. This means targets can be determined, progress can be tracked and decision makers can agree.
Ignore financial-statement measures at your own peril.
C. In This High Tech Age Of Computers, More MBA Graduates And Reportedly Tighter Accounting Rules, Why Isn’t Using Financial-Statement Information in Business Working Better?
In fact it probably is. However, with the fast-paced environment of the New Economy coupled with the ability to generate incredibly huge amounts of money by dramatic rises in stock prices, the potential for abuse is enormous because the near-term financial rewards are so massive. Witness the tragically colossal saga of Enron arguably measures on a scale that none of us in business have ever experienced before.
At the same time, Enron implications help us recall plenty of other bizarre business stories from the past few years.
Waste Management Company also used Arthur Andersen for consulting and auditing. The company first published financial statements that included the write-off of repainting its entire fleet with a new image as an extraordinary expense, which it told analysts to ignore when it reported its earnings. This overstated current-year earnings. And since Waste Management chose not to depreciate the repainting, subsequent year profits were also overstated. This scenario was one of the reasons that caused the court to fine the auditing firm approximately $7 million.
Sunbeam Corporation, manufacturer of small appliances, hired “Chainsaw Al Dunlap” as CEO to turn it around. Dunlap was later accused of telling his people that they must do whatever it took to meet revenue targets. They complied by shipping millions of product to customers who never ordered what was shipped. Receivables and even Inventories were significantly overstated so profit looked healthy, as first reported. But Sunbeam subsequently restated its profit significantly downward and then filed for bankruptcy. Dunlap and his co-executives recently agreed to pay a $15 million settlement to investors who had sued.
Leslie Fay, manufacturer of women’s apparel, showed an acceptable profit in the early ‘90s, but subsequently had to restate its financials and then filed for bankruptcy. Its CFO has recently been sentenced to nine-year prison term.
We could go on, but fraud happens, even at high levels in business!
D. But Can’t We Rely on Profit? Apparently Not.
A new trend in reporting earnings has arisen where most companies and most analysts focus on a surrogate for measuring earnings that is not based an GAAP, and is more forgiving than GAPP earnings. A number of variations are found (i.e. EBITDA, pro-forma earnings), but all variations amount to earnings before the bad stuff.
Historically GAAP has perpetually tried to find a satisfactory way to deal with extraordinary items, but was never able to find a way that appeased all business leaders. As for September 11, FASB announced that the financial results of terrorism do not qualify as “extraordinary,” as amazing as this may seem. Recently Robert Willens, an accounting expert at Lehman Brothers, Inc. stated “I don’t know anyone who uses GAAP net income anymore for anything.”
Obviously, much of the resistance to focusing on net income according to GAAP is self serving by business leaders who want higher earnings to drive higher stock prices. Recent trends in increased performance compensation (including increase in the use of stock options) based on healthy stock price have made leaders more creative in announcing earnings that include (or not) those transactions they choose to report.
Another timely development is FASB’s decision to eliminate Goodwill Amortization, beginning with the year 2002. Tangible property, plant and equipment always had to be depreciated (written off) over their estimated useful life. Similarly, intangibles (i.e. patents and goodwill) had to be written off over their estimated useful life. (For Goodwill, this life could not exceed 39 years.) But now, in response to ongoing pressure from business leaders, FASB requires that Goodwill remain on the books of the acquiring company at the initial amount booked at acquisition. However, when Goodwill is deemed to be no longer worth the amount stated on the Balance Sheet, it must be written down to its estimated value as soon as determinable, which reduces earnings for that period. This new ruling will have a huge impact on stated financial performance.
E. Need for Analyzing Dollars and Ratios Both –
The Power of Trend Analysis and Competitor Analysis
So far we have endorsed measuring Net Income as a dollar amount, and we have given it due respect as the bottom line of the Income Statement. But measuring in dollars does not allow for comparisons, so Net Income also needs to be measured as a ratio.
Some options are obvious, Return on Sales; Return on Assets; Return on Equity. Our choice is Return on Assets, the bottom line for the Balance Sheet, which shows how well the company is implementing SEA logic (effective management of Sales, Expense and Assets; nothing more; nothing less).
In calculating ROA, some companies use beginning Assets; some use Ending Assets; some use Average Assets. The choice doesn’t matter, but once the choice is made what matters is consistency.
While ROA should get bottom-line emphasis, don’t stop here. Use the full DuPont Power-Analysis Tool, which follows:
- ROS
- x Asset Turnover
- = ROA
- x Financial Leverage (or Assets / Equity)
- = ROE
- x Price / Earnings
- = Market / Book
The DuPont Tool for Power Analysis can then be used for comparing the company’s latest financial performance against the latest financial performance for its industry. It can also be used for trend analysis, in other words for comparing the company with itself. Using analysis with these linked ratios helps spot both the strengths and weaknesses, at least from a financial perspective.
F. Need for Reality Check – Cash Flow
Investors did not need to wait to sell their stock until Jeffrey Skilling left Enron for unexplained personal reasons in August, 2001. If they had been watching Net Cash Flow Generated from Operating Activities (OCF) they would have noticed that Enron went from positive OCF to negative in the first calendar quarter of 2001 ($464 million), and year-to-date OCF has consistently shown negative ever since. (But Net Income for the first quarter showed positive at $425 million and did not turn negative until the third quarter of 2001.) So astute investors watching cash flow would have started asking questions six months earlier than investors who relied totally on profit for clues.
OCF is an early warning indicator, as we have seen happen in other important situations and again with Enron.
The Income Statement leaves a lot of room for creative accounting, some of which is questionable (booking phantom revenue) and some of which is completely legal and ethical (choice of method for depreciation). But it is much harder to be creative with the Cash-Flow Statement, because the cash-flow rules leave less gray area. Furthermore, most people understand cash when they see it, even auditors. Cash is not a theoretical measure; it is money that can be used for buying and selling goods and services.
OCF does not care whether some cash flow is extraordinary or not. If a tobacco company is required by judgment to pay a large settlement, extraordinary as the judgment might be, OCF is reduced in the period the cash is paid out.
Currently where many companies took on high debt loads in good economic times and now are trying to survive high leverage in bad economic times, some CFOs are urging management to refocus its financial-performance measurement from the Income Statement to the Cash-Flow Statement,
It is important to acknowledge that some percentage of business leaders have not supported clear cash-flow reporting, however. Some leaders still use the Income-Statement to measure cash flow.
Here comes another bizarre story about financial statements. Back in 1987 when Financial Accounting Standards Board (FASB) first mandated the inclusion of Cash-Flow Statements, it recommended a direct calculation of OCF that separately listed Cash Received from Customers versus Cash Paid Out to Suppliers and Employees, on the basis that this clarity was needed for managers and investors alike. However, many leaders protested this direct calculation as requiring excessive calculation cost in favor of an indirect calculation that begins with the Income Statement and then reconciles differences to get to OCF. Unfortunately the indirect calculation is the general business practice today.
Chuck was once on a panel speaking to business-school graduate students, and he was followed by an unnamed CEO of a famous high-growth start-up company. The CEO said his company would never use the direct calculation for cash-flow reporting because it was too revealing, and implied that he always avoided unnecessary clarity for investors in every way possible. Our close associates have tried consistently since 1987 to influence for the direct calculation. The situation in today’s bizarre business world makes the need for a direct calculation of OCF more important than ever before.
But what can you as a individual business person do about this problem? Well at least when you are obtaining financial-statement information from a financial professional, tell him / her you want a direct calculation of OCF. And hopefully, after enough business people state their preference for a direct calculation of OCF, the accounting rules will require the direct calculation instead of allowing it as an option.
G. Need for Three Bottom Lines –
One for Each Financial Statement
Our general advice for using financial-statement information intelligently is to track the bottom line of each of the three financial statements :
· OCF for the Cash-Flow Statement
· Net Income for the Income Statement
· Return on Assets for the Balance Sheet
But what about companies that prefer to track some other version of cash flow, profit and return on …? Some companies internally prefer tracking Free Cash Flow, which seems to be good enough. Some service companies prefer internally tracking Return on Sales, which at least focuses on a ratio that can be used for benchmarking against competition, even though it does not cover tight asset management as a focus. Some companies prefer internally tracking EBITDA in order to hold operating managers accountable only for what they can control.
At first glance, these surrogate bottom lines seem adequate, but with an important caveat. Since some business leaders try to focus attention away from “extraordinary expense,” always watch Net Income even if you also watch EBITDA.
H. Summary- four rules for using financial-statement information in today’s bizarre business world
The following 4 rules are always worthwhile. But in today’s world of increasing bizarre business news, these rules take on even greater value.
Rule # 1: Never rely on just one measure of financial performance. Instead, use a three-bottom-line approach, which provides for checking performance from various perspectives.
Rule # 2: Accept the press releases with Earnings before the Bad Stuff only if you also track Net Income according to GAAP.
Rule # 3: Track dollar amounts, but also track profitability ratios like ROA, for both trend analysis and for competitor analysis.
Rule # 4: Compare OCF to Net Earnings, and when they don’t
support each other, place more confidence in OCF for a reality check.
About the authors
Chuck Kremer, CPA, is Senior Consultant,
Business Literacy for a division of Novations VMS, a performance-improvement
training and development company serving Fortune 1000 companies.
His email address is ckremer@novations.com.
His website is www.novationsvms.com.
Randall Chun has spent nearly 20 years managing
and controlling telecommunications operating and capital costs
for various Internet Service Providers and backbone providers
for both US and global networks. He is currently developing
a business plan for a Voice over IP network for an international
consortium. His email address is randychun@yahoo.com.
“Trends in Financial Management,” by Alan Levinsohn, Strategic Finance, February, 2002, pp.63 through 64.
“Cash Flow Management in a Leveraged Environment,” by Marty Moore, CPA, Strategic Finance, January, 2002, pp 31 through 33.
Value Line Ratings and Reports defines Cash Flow as “Net Profit plus Depreciation and Amortization.”
Telecommunication companies generally define cash flow as EBITDA (Earnings before Depreciation, Amortization, Interest and Other), which practices have been questioned or challenged by Wall Street Journal reporters such as Jonathan Weil; also “Warning;
Use of EBITDA May Be Dangerous to your Career,” by Alfred King, Strategic Finance, September, 2001, pp. 35 through 37.
The wisdom for pursuing the indirect calculation is attacked “Fast
Track to Direct Cash Flow Reporting,” by Paul B. W. Miller, CPA and Paul R. Bahnson, CPA, Strategic Finance, February 2002, pp. 51 though 55.
Chuck’s master teacher, the late Louis R. Mobley, testified repeatedly before FASB for requiring a direct cash-flow statement, as he and Kate McKeown explain, Beyond
IBM, Enter Publishing, NY, NY, 1989. (Lou later expressed that watering down cash-flow statements with an indirect calculation of OCF defeated most of the cash-flow clarity that FASB almost accomplished.)
Managing by The Numbers, by Kremer; Rizzuto; Case, Perseus
Books, Cambridge MA, 2000
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