Financial Statement Analysis

PRAISE FOR FINANCIAL STATEMENT ANALYSIS, FIFTH EDITION
"Anyone can get lucky in the short term, but to succeed in the long term requires expert financial skills. There is no better guide than Marty Fridson." -John Paulson, President, Paulson & Co. "Read Financial Statement Analysis and avoid getting duped by financial shenanigans. This book will protect you and your investments." - Wesley R. Gray, PhD, CEO of Alpha Architect, and co-author of Quantitative Value and Quantitative Momentum "Financial Statement Analysis is an almost indispensable book for portfolio managers, securities analysts, and businessmen who want deep insights into how financial statements can be misleading and how they can be helpful in understanding the true strengths and weaknesses of companies. The book should be required reading for all students interested in careers in finance or general business." - Edgar Wachenheim III, CEO, founder, and chairman of Greenhaven Associates; author of Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor "Once again, Fridson and Alvarez provide analysts and investors with the necessary, but all too often overlooked truth about how to approach financial statement and corporate profit analysis. Anyone who wants to understand business should study the lessons in this book." -David Trainer, CEO, New Constructs "Most financial analysis books are written by academics with limited to no real-life experience. This book is unique since it clearly reflects the extensive practical experience of the authors, along with their knowledge of relevant research. I particularly liked the chapters on data reliability, M&As, fraud, forecasting, and credit analysis. This book is at the top of financial analysis books available, to be used as a text in university financial analysis courses, as well as a source of knowledge to investment professionals." - Baruch Lev, Philip Bardes Professor of Accounting and Finance, New York University; author of The End of Accounting and the Path Forward for Investors and Managers "Over my decades of involvement with high-yield bonds, Marty Fridson has been the leading speaker of truth. As he so accurately states in Financial Statement Analysis, the credit investor is required to engage in a game of cat-and-mouse with company's management intent on minimizing their cost of capital by putting a positive gloss on their financial statements. The Fifth Edition of Marty's terrific book is the bible on how to detect and deal with these efforts." -Howard Marks, Co-Chairman, Oaktree Capital Management

Preface to Fifth Edition xi
Acknowledgments xv
  Part One
Reading Between the Lines 1
Chapter 1
The Adversarial Nature of Financial Reporting 3
The Purpose of Financial Reporting 4
The Flaws in the Reasoning 8
Small Profits and Big Baths 12
Maximizing Growth Expectations 13
Downplaying Contingencies 20
The Importance of Being Skeptical 23
Conclusion 27
Part Two
The Basic Financial Statements 31
Chapter 2
The Balance Sheet 33
The Value Problem 34
Comparability Problems in the Valuation of Financial Assets 36
Instantaneous Wipeout of Value 38
How Good Is Goodwill? 40
Losing Value the Old-Fashioned Way 44
True Equity Is Elusive 45
Book Value May Overstate Reality 46
Pros and Cons of a Market-Based Equity Figure 49
The Common Form Balance Sheet 51
Conclusion 53
Chapter 3
The Income Statement 55
Making the Numbers Talk 55
How Real Are the Numbers? 61
Conclusion 85
Chapter 4
The Statement of Cash Flows 87
The Cash Flow Statement and the Leveraged Buyout 89
Analytical Applications 95
In Defense of Slack 121
Conclusion 123
Part Three
A Closer Look at Profits 125
Chapter 5
What Is Profit? 127
Bona Fide Profits versus Accounting Profits 127
Which Costs Count? 130
Conclusion 134
Chapter 6
Revenue Recognition 135
Making It Up at Gowex 135
Globo's Foreseen Fall from Grace 139
Channel-Stuffing in the Drug Business 143
A Second Take on Earnings 146
Making the Numbers at M/A-Com 149
Astray on Layaway 151
Recognizing Membership Fees 152
A Potpourri of Liberal Revenue Recognition Techniques 155
Fattening Earnings with Empty Calories 156
Tardy Disclosure at Halliburton 162
Managing Earnings with Rainy Day Reserves 165
Fudging the Numbers: A Systematic Problem 168
Conclusion 171
Chapter 7
Expense Recognition 173
Diamond Foods's Movable Expenses 173
Nortel's Deferred Profit Plan 176
Grasping for Earnings at General Motors 181
Time-Shifting at Freddie Mac 184
Conclusion 186
Chapter 8
The Applications and Limitations of EBITDA 187
EBIT, EBITDA, and Total Enterprise Value 188
The Role of EBITDA in Credit Analysis 193
Abusing EBITDA 196
A More Comprehensive Cash Flow Measure 198
Working Capital Adds Punch to Cash Flow Analysis 201
Conclusion 203
Chapter 9
The Reliability of Disclosure and Audits 205
Where Was the Cash? 206
Sloppiness Can Be a Red Flag 210
How Manipulation Evades Detection 214
Systematic Problems in Auditing 215
Conclusion 220
Chapter 10
Mergers-and-Acquisitions Accounting 221
Goodwill Goes Bad 223
Double Trouble 224
Conclusion 227
Chapter 11
Is Fraud Detectable? 229
Telltale Signs of Manipulation 230
Fraudsters Know Few Limits 233
Enron: A Media Sensation 233
HealthSouth's Excruciating Ordeal 242
Milk and Other Liquid Assets 249
Trouble Was Brewing at Luckin 252
Conclusion 254
Part Four
Forecasts and Security Analysis 255
Chapter 12
Forecasting Financial Statements 257
A Typical One-Year Projection 257
Sensitivity Analysis with Projected Financial Statements 270
Projecting Financial Flexibility 276
Pro Forma Financial Statements 279
Multiyear Projections 285
Conclusion 299
Chapter 13
Credit Analysis 301
Balance Sheet Ratios 302
Income Statement Ratios 311
Statement of Cash Flows Ratios 316
Combination Ratios 318
Relating Ratios to Credit Risk 326
Conclusion 342
Chapter 14
Equity Analysis 343
The Dividend Discount Model 344
The Price-Earnings Ratio 350
The Du Pont Formula 360
Valuation through Restructuring Potential 364
Advanced Equity Analysis 370
Conclusion 373
Notes 375
Glossary 387
Further Reading 405
About the Authors 407
Index 409