fin 2
16. What is the fine line that financial analysts must walk?
They must not lose touch with economic reality and not accept the reality that cheap capital seekers would like them to believe
Other notes on EBITDA
- disregards tax ibligations - not a good proxy for cash flow - doesn't incluse working capital requiements, dividend payments, or capital expenditures (replacement/obsolenscence, growth) - does not pay principal and interest - lends itself to the malleability of accounting rules - poor liquidity measure - assumes long-life long-term assets
Business purpose Doctrine (1935)
- A transaction will not be effective for income tax purposes unless it is intended to achieve a genuine business purpose - If the transaction has no substantial business purpose other than the avoidance or reduction of tax, the IRS will disregard the transaction *A high tax-bracket individual taxpayer contributes an asset to a newly formed C Corporation solely to take advantage of the lower marginal tax rate afforded to corporations on the sale or disposition of assets
Assignment of Income Doctrine ("Fruit and Tree")
- As long as a taxpayer retains control over the source of the income (the tree), he or she will be taxed on the receipt of that income (the fruit) even though he or she has assigned all the rights to the income to someone else * An example is where a self-employed person, who receives a $20,000 check in payment for services rendered on behalf of a client, cannot avoid reporting the $20,000 as income by endorsing the check to his adult son
Step Transaction Doctrine "Piercing the Veil"
- The IRS can collapse a series of apparently unrelated transactions into one transaction to determine the tax consequences - This doctrine is applied in instances when each transaction viewed separately has one overall result but considering the transactions together yields a different result *An example is where a corporation sells property to an unrelated purchaser who subsequently resells the property to a wholly-owned subsidiary of the corporation ("Strongman Transaction") - Transactions that occur more than 12 months apart are presumed to be independent
Substance Over Form ("Smoke and Mirrors")
- The IRS can look through the legal formalities to determine the economic substance (if any) of a transaction - A transaction must be real and bona fide * If the substance differs from the form, the IRS will base the tax consequences of the transaction on reality other than illusion
29. What are some of the issues associated with the size of a company when comparing it to a peer group?
1) Bigger companies enjoy economies of scale and have greater leverage with suppliers 2) A big company can spread the risk of obsolescence and competitive challenges over a wide range of products and customers 3) Particularly vulnerable is a company with just one manufacturing facility 4) Lack of depth in management is another problem commonly associated with smaller companies
21. What are the two approaches to including rent expense for operating leases in the fixed- charge coverage ratio?
1) add the total current-year rental expense from notes to financial statements to both the numerator and denominator of the fixed-charge coverage calculation. 2) Includes one-third of rentals on the theory that one-third of a lease payment typically represents interest that would be paid if the assets had been purchased with borrowed money, and two-thirds is equivalent to principal repayment
14. Under what conditions are the physical wear-and-tear of plant, property and equipment not considered an expense in the calculation of profits?
1. Land, land rights with indefinite lives, site preparation, grading and landscaping 2. excess plant and equipment 3. when an assets salvage value is => the cost of the asset 4. reserve construction equipment 5. PPE in the process of construction until the facility or segment thereof, is replaced in service.
10. What are some of the complications preferred stock introduces in the financial leverage calculations?
1. Preferred stock is equity from a legal standpoint, but in liquidation it is subordinated to debt 2. It must contractually pay a fixed dividend vs. interest on debt 3. Failure to pay a div does not constitute an event of default2 4. PS issuer can omit div but not without omitting Common Stock Div 5. PS div are cumulative which means the issuer must repay all preferred dividends that are in arrears before resuming common stock dividends 6. It may have sinking fund provisions that requires redemption of a substantial portion of the outstanding par amount prior to final maturity vs perpetual preferred stock 7. Exchangeable PS can be converted to debt at issuers option
25. How does this ratio vary with the capital spending cycle?
A company that sharply reduces its capital budget will appear to increase its financial flexibility, but cutting back on capital outlays may impair the company's long-term competitiveness by sacrificing market share or causing the company to fall behind in technological terms
What did Nortel announce on April 28, 2004? Under Canadian Law
A cut in its previously announced earnings of 50% and A delayed reporting its results for Q1 to 2003
27. What does the ratio of capital expenditures to depreciation capture?
A ratio of less than 1.0 over a period of several years raises a red flag, since it suggests that the company is failing to replace its plant and equipment.
9. Regarding non-convertible and convertible debt, what is the ultimate objective of the credit analyst?
Analysts should remember that the ultimate objective is not to calculate ratios but to assess credit risk. Therefore, the best practice is to count convertible debt in total debt but to consider the possibility of conversion when comparing the borrower's leverage with that of its peer group.
What is the treatment of membership refunds under GAAP?
membership fees could not be booked as revenue unitl the refund period was expired. membership fees should be spread throughout the entire period 90 days
15. Why must the simple formula of revenues minus costs not be taken at face value?
Because it is subject to manipulation
6. How can Salsa Meister International show a profit when the franchised restaurants consistently lose money?
Because their income is not determined from the income of the restaurants. Their income comes from franchise fees.
What is "channel stuffing"?
Borrows sales from future periods. Short term cure for a long-term problem
7. How can the riddle of a franchiser's profits and franchisee's losses be resolved?
By cutting through the form of the transactions to the substance of the transactions
8. How can a firm insulate itself from floating interest rate fluctuations?*
By using financial derivatives 1) Interest rate swaps 2) Forward rate agreements 3) Eurodollar CD future market
What is the incentive for "new economy" firms to break free from the focus of after tax earnings as a basis for valuation?
minimal net profits recorded by many "new economy" companies conventionally calculated P/E multiples of such companies, must inconvieniently, make their stocks look expensive
What must financial analysts do to benefit from the insights provided by the careful scrutiny of financial statements?
Disciplinned enough to disbelieve innocent explanations that companies provide for abnormalities
What is one of the most abused features of financial reporting?
Distorting the power of accruals
What did Bristol-Myers executives strenuously deny regarding their accounting policies?
Executives pumped up the bottom line by taking portions of restructuring reserves created in earlier periods into earnings.
1. What do financial statements tell about a borrower's ability and willingness to repay a loan?
Financial statements tell much about a borrower's ability to repay
According to Michael C. Jensen, what two things must one expect when a manager is told he or she will get a bonus when targets are realized?
First, managers will attempt to set easy targets, and second, once these are set, they will do their best to see that they are met even if it damages the company.
18. Profits and resulting cash flow ultimately sustain a company's liquidity and asset values. What are the most commonly used profit margin ratios?
Gross Profit Margin- The amount of sales taking cogs (best for retailers) (particularly important when analyzing retailers) Operating Profit Margin- How much sales is from operating before taxes/capital structure Net profit margin- selects all factors weather undermanagments control or not
19. What aspect of management's effectiveness does each ratio reflect?
Gross margin measures management's skill in buying and selling at advantageous prices. Operating margin shows how well management has run the business a.buying and selling wisely and controlling selling and administrative expenses—before taking into account financial policies (which largely determine interest expense) and the tax rate (which is outside management's control).
How did analyst Steven Tighe derive his estimate for wholesale inventories and what was his conclusion?
He derived his estimate of wholesale inventories of Bristol Myer's 10 major drugs, representing 50% of pharmaceutical revenues, from price and prescription statistics of IMS Health, a vendor of health care data 3rd party vender channel stuffing
What classic red flag did Nortel disclose on March 2004?
IT delayed the filing of its financial reports & a revision of past filing.
When did Nortel finally file its 2003 financial statements?
In January of 2005
What explains the behavior of Freddie Mac's stock price when it announced in January 2003 an unexpected increase in reported earnings?
In some instances it manipulated its earnings to match the Wall Street earnings forecasts.
What was the purpose of Freddie Mac's structuring interest rate swaps with nil net economic benefit?
Interest rates for them would rise and fall at the same time.
12. What is the rational explanation of the phenomenon of an investment increasing in value while generating losses?
It is explained by the Tax Code that allows owners to write off property that essentially overstates wear and tear. no salvage value in tax accounting
31. What are the dangers of attempting to create homogenous peer groups?
It narrows the field to such an extent that ratio comparisons begin to suffer from having too few data points.
32. Do improving or deteriorating financial ratios always have the same implications for different companies?
No. In some cases, a declining trend over several years signals that a company has genuinely fallen to a new, lower level of credit quality. For other companies, negative year-over-year comparisons merely represent the down legs of their normal operating cycles.
8. Why should the astute analyst be troubled by the way Salsa Meister International converts losses into profits?
Merely circulating the same funds does not increase wealth
How did Nortel abused the accrual treatment of contractual liabilities?
Nortel took reserves off the balance sheet without legitimate triggers for doing so and Management overstated reserves to create a bigger cookie jar into which it could dip
6. Why are the calculation of financial leverage ratios less simple than they may appear?
More meaningful compared across time and against peers
12. Accounting rules distinguish between capital and operating leases. Should the user of financial statements be satisfied with this treatment?
No should also take into account off balance sheet liabilites Capital leases must be reflected on BS as Liabilites Take into account operating leases which are reported as rental expenses in the notes of FS
Can most users of financial statements replicate the analysis of Steven Tighe and C.J. Sylvester?
No, because this sort of analysis annual subscription to data is required which can be thousands of dollars.
2. Under what conditions is there a universally agreed upon definition of profit?
Profit = Revenue - Costs
Why were investors unwilling to accept Bally's earnings increases at face value?
Rather than taking upfront membership fees in cash, Bally financed its growing reliance on membership fees.
11. What inspired the attack on the accrual accounting treatment of depreciation?
Real estate because in this industry, private owners aim to minimize reported income by maximizing depreciation expense, thus lowering taxes.
What was central to Kendall Square's difficulties?
Revenue recognition controversies
Was Krispy Kreme a case of massively fictitious earnings?
SEC complaint depicted a process of nickel-and-diming, through a wide range of financial statement items, to beat earnings guidance by $0.01 in every single quarter
In 2003, what did Nortel introduce as a special bonus plan?
Senior Executives bonuses were tied to profits
What disclosures did GM make in March 2006 regarding their classification of cash flows?
Some of their investing activities from mortgages were recorded as operating activites
22. What complications arise in connection with incorporating operating lease payments in the fixed-charge coverage ratio?
The SEC does not require companies to report rental expense in quarterly statements. Retailers in particular often negotiate leases with rents that are semi-fixed, tied in part to revenues of the leased stores.
What classic red flag appeared the day after the SEC launched an investigation of Take-Two accounting practices?
The company's CE resigned
16. What does the liability account "Deferred Income Taxes" represent and what does it reflect?
The cumulative difference between taxes calculated at a stationary rate and taxes actually paid
3. For the analysis of financial statements, what is the most important distinction to understand?
The difference between accounting profits and Bona Fide profits. which costs count now and which costs count later?
26. Why is the ratio of depreciation to Cash Flow from Operations considered forward- looking?
The higher the % of cash flow derived from depreciation the more predictable a company's cash flow and the less dependent its financial flexibility on the vagaries of the marketplace. used as a proxy for replacement capx
24. Why is Cash Flow from Operations to capital expenditures a key ratio to analyze in capital-intensive manufacturers and utilities?
The higher this ratio, the greater the financial flexibility implied.
What pathology did GM illustrate as its fortunes deteriorated in the early 2000s?
They may start to break the rules when earnings don't go their way
33. What are cycle-to-cycle comparisons and why should they be used instead of year-to-year comparisons?
They are used for cyclical companies. Pattern of similar highs and lows did not imply impairment. Deterioration is indicated when a company displayed succesively lower highs and lower lows
35. What are the distinct benefits of quantitative models of credit quality?
a. they are developed by objectively correlating financial variables with events of defaults (EDF). b. the record of quantitative models is excellent from the standpoint of classifying as troubled credits most companies that subsequently defaulted.
Under what circumstances does it make sense for management to delay revenue recognition?
To understate short-term profits and report smooth year-to-year earnings growth that equity investors will reward with high P/E multiples
14. What types of off-balance sheet obligations do SFAS No. 87 and SFAS No. 106 cover?
Under Statement of Financial Accounting Standards (SFAS) 87, balance sheet recognition is now given to pension liabilities related to employees' service to date. Similarly, SFAS 106 requires recognition of postretirement health care benefits as an on-balance-sheet liability.
Is it common to take liberties with booking expenses?
Yes, companies are creative at minimizing and slowing down expenses and speeding up recognition of revenue
What lessons can be learned from Halliburton's case?
a. An auditors seal of approval does not guarantee that a company's financial reporting is reliable b. users of financial statements be complacent just because a prestigious individual has ultimate responsibility for the integrity of the numbers c. If earnings look suspiciously strong during a rough patch for the company's industry, users of financial statements should never automatically rule out the possibility that manipulative accounting explains the disparity.
What lessons can users of financial statements draw from this case?
a. An exceptionally long record of beating guidance or posting year-over-year gains in quarterly earnings is a reason to suspect earnings management. b. related-party transactions and deceptive financial reporting often go hand in hand. c. when management offers an excuse for deteriorating earnings that does no stand up to scrutiny, as Krispy Kreme did by citing the low-carb craze, it may be using financial reporting tricks to try and conceal the true causes. d. does it pass the smell test, ask questions, does this make sense?
What signs began to surface in 2005 that GM's corporate culture had changed?
a. Bond ratings had slid down to the speculative grad rating. b. The SEC was investigating their accounting aspects c. They had to restate earnings d. Changed accounting for retirments e. Credits were erroneously booked
3. What is the most immediate danger faced by a lender and how can this condition arise?
a. Inaquadate cash flow b. Inability to borrow new funds to pay off existing creditiors c. The risk that the borrower will suffer illiquidity
1. What are some of the reasons profits hold such an exalted place in the business world and economic theory?
a. It fosters cost-reducing innovations, which in turn promote the efficient use of scarce resources. b. The profit motive also encourages savings and risk taking, two indispensable elements of economic development. c.profitability is a yardstick by which businesspeople can measure their achievements and justify their claims to compensation.
11. What is the risk when all preferred stock is treated as equity?
a. It would understate financial risk. - The analyst must recognize the heightened level of risk implied by the presence of preferred stock in a company's capital structure
What are some of the ways companies downplay expenses?
a. Liberal assumptions about costs that may be capitalized b. Pile up unjustified accruals c. Dilute expenses with one-time gains, d. booking rebates from suppliers in advance
23. Under what conditions can the use of net interest expense in the denominator of the fixed-charge coverage ratio overstate the level of protection implied by this coverage?
a. Net interest expense is the difference between interest expense and the income derived from interest-bearing assets b. This is only appropriate when a company's strategy is to invest a substantial portion *indefinitely* in marketable securities.
7. From a firm's standpoint, what are the two risks inherent in depending on debt with maturities of less than one year?
a. Potential illiquidity- Substantial debt due at time when lenders are unavailable b. Exposure to interest rate fluctuations
2. What are some of the reasons why analyzing a company's financial statements may not be sufficient to determine its credit quality?
a. The borrowers credit may be supported, formally or informally, by another entity Thorough credit analysis may not include check of subjects past repayments which is not part of financial statments Does not look at competetive environment
5. Why is the Total Debt to Equity ratio important?
a. To gauge how much debt they already owe and the amount of equity they have beneath them (Cushion)
4. Why would a creditor calculate financial leverage ratios?
a. To know how much asset value will be available for liquidation to pay off their claims How much of a buffer is there?
What did the failure of W.T. Grant bankruptcy show?
a. look beyond the cash sources and uses on the income statement b. neither EBITDA nor depreciation + Net Income is a valid proxy for cash flow c. two years prior to bankruptcy, W.T. Grant reported positive net income. d. it also enjoyed a positive and stable cash flow as defined Beaver (traditional cash flow)
What problems are signaled by a surge in accounts receivable?
a. management may be trying to prop up sales by liberalizing credit terms to its existing customers b. a build up in receivables may also be contributed to an extension of credit to new, less creditworthy customers that pay their bill comparatively slowly
What are some after-the-fact explanations for excesses in income reporting?
a. misjudgments b. bookkeeping errors c. deliberate misrepresentation by managers
What happens to firms that spend the minimum on PPE year after year?
a. most companies that spend a minimum on PPE year after year lose their competitive edge b. delaying equipment purchases and repairs for only a couple quarters should not do long term damage
What are some of the reasons that capital spending may exceed depreciation over time?
a. newly acquired equipment may be costlier that the old equipment being written off b. companies expand their productive capacity to accomodate rising demand c. additional outlays are required for the replacement of the obsolete equipment GROWTH d. during a full operating cycle, capital expenditures reported in a company's statement of cash flows are usually at least as great as the depreciation charges shown in the income statement because of the physical wear and tear MAAINTINENCE
28. What needs to be considered even if this ratio consistently exceeds 1.0?
a. persistent inflation means that a nominal dollar spent on plant and equipment today will not buy as much capacity as it did when the depreciating asset was acquired. b. depreciation may be understated with respect either to wear and tear or to obsolescence. c. capital outlays may be too low even if they match in every sense the depreciation of existing plant and equipment.
What happened in the Entrasys Networks' overstating of revenues?
a. revenue booked in wrong periods b. inflated valuations of stock received as payment for products c. expected payments that were booked as revenue but didn't matreralize
What are telltale danger signals?
a. rising levels of accounts receivable, or inventory, relative to sales b. surges in un-billed receivables c. surges in deferred income (offsetting)
According to the Beaver study, what was the dingle best predictor of bankruptcy and how was it calculated?
a. the single best predictor of bankruptcy is a declining trend in the ratio of cash flow to total debt, bankruptcy risk is likely to increase if net income decreases or total debt increases b. operating cash flow / total debt
What did users of financial statements and credit analysts notice in regard to the reports of two companies in the same industry reporting similar income?
a. users of financial statemens discovered that two companies could report similar levels of net income but have substantially different total enterprise values b. credit analysts realized that in a given year, two companies could generate similar levels of income to cover similar levels of interest expense yet represent hgihly dissimilar risks of defaulting on their debt in the future
36. What are some of the problems with quantitative default models?
a.quantitative models tend to classify as troubled credits not only most of the companies that eventually default but also many that do not default. b. The credit analyst must also bear in mind that companies can default for reasons that a model based solely on reported financial data cannot pick up.
What is the assumption that if not-true weakens the argument for favoring the EBITDA based over the EBIT based fixed charge coverage?
adding depreciation to the numerator is appropriate only for the period over which the company can put off a substantial portion of it;s capital spending without impairning its future competitiveness
Explain why a drop in the stock price accompanied the apparent good news of increasing revenues at Wal-Mart?
an accounting change. they were booking layaway sales as soon as it was placed as a layaway and under conservative methods these aren't supposed to be record until cash is received
what is the difference between this abused feature and a payable
an accrued expense is an expense that has been incurred but not yet billed by the vender payable is supported by a received invoice or billing statement
Aside from seasonal variations, what should analysts suspect when inventories or receivables increase materially as a percentage of sales?
analysts should strongly suspect that earnings are overstated, even though management will invariably give a more benign explanation
Why would it be seem paranoid to a novice analyst to consider every company's income statement with suspicion?
are not most people basically honest after all
20. What is SFAS 34 and what refinement in the fixed-charge coverage ratio is required by it
companies may be required to capitalize, rather than expense, a portion of their interest costs. a. Whether it is expensed or capitalized, however, all interest accrued must be covered by earnings and should therefore appear in the denominator of the fixed-charge coverage calculation. b. Do not include capitalized interest in the numerator because this would result in double counting
What were the lessons learned from the wave of LBO-related bond defaults in the 1980's?
depreciation was not, after all, available as a long run source of cash for interest payments
30. How is the line of business used to define a peer group?
different industries have diff financial characteristics, ratio comparisons. Carrying this principal to its logical conclusion, cross-sectional analysis requires a peer group with virtually identical products
13. How does the major risk of analytical error in the reporting of depreciation expense arise?
economic deprecation will exceed reported deprecation
13. Other than operating leases, what are other ways companies try to obtain the benefits of debt without suffering the associated penalties imposed by credit analysts?
enter joint ventures or form partially owned subsidiaries
What role did carb-consciousness play in Krispy Kreme's faltering profits?
excuse- was people having carp-cojsecisonunes diets actual- over expansion
How can rising debt-to-capital ratio confirm an adverse credit trend revealed by operating cash flow?
if a company does not finance the bulge in inventories and receviables by extending its payables or drawing down cash, it must add to its borrowings
How can EBITDA help credit analysts discriminate between two similar looking credit risks?
in credit analysis, as in valuing businesses, EBITDA can discriminate among companies that look similar when judged in terms of EBIT
What did Bernstein's findings reinforce?
instead of seeking an alternative to net income that summaries corporate performance in its entirety, analysts of financial statements should examine a variety of measures to derive maximum insight
Why do companies welcome the migration towards less variable measures of performance?
investors are going to reward stability with higher P/E performance
9. Why and how will the way Salsa Meister International converts losses into profits end?
investors realize that the company will lose its ability to manufacture accounting profits by raising new funds in the stock market. Salsa Meister's stock price will then fall.
What do accounting rules say about setting profits aside?
it must be foreseeable and quantifiable liabilities. GAAP did not give companies discretion to create rainy day funds.
What is the added level of analysis that prompted FASB to prescribe a more comprehensive definition of operating cash flows?
its imperative to investigate whether two balance sheet items, inventories, and accounts receivable, are tying up increasing amounts of cash. if so, it became vital to determine whether the company could generate an offsetting amount of cash by expanding its accounts payable
What accounting practice did the SEC allege Krispy Kreme Doughnuts employed as its store openings stalled?
management was manipulating certain expense accruals to produce EPS at least one penny above the usual and it improperly recorded questionable transactions involving company purchases of franchised stores
17. Regarding the liability account "Deferred Income Taxes," what is the argument many credit analysts make and how do they adjust for this?
net worth is understated by the amount of the deferred tax liability, since it will in all likelihood never come due and is therefore not really a liability at all.
Why would Krispy Kreme try to recover the store-closing costs and overdue interest only to pay it right back?
no scheduled, bit-by-bit write-down would reduce future earnings,on the other hand, when the same dollars come back to Krispy Kreme, they would be recorded as interest income. by taking money out of one pocket and putting it into another
Did Beaver advocate the method that practitioners have institutionalized?
no, he did not conclude that analysts should rely solely on the cash flow to debt ratio, but merely that it was the single best bankruptcy predictor
Explain why net income may or may not be a standard by which every company's value and risk can be compared.
one single financial measure is not enough to capture financial performance comprehensively enough
10. What is depreciation and what is the objection to the relevance of depreciation when calculating earnings?
procedure that recognizes certain types of property decline in value over time due to wear and tear, obsolenceness, or growth. and
what did accounting rules in 2001-2005 state regarding rebates
rebates involved not only current business but were upfront inducements to place larger orders over several years they should be taken into earnings over time rather than immediately
4. What is the litmus test that a calculation of bona fide profits must pass?
see if its owners are wealthier than they were beforehand.
Why was diverting analyst's focus away from traditional fixed charge coverage and toward EBITDA coverage of interest particularly beneficial during the 1980's?
some buyouts were so highly leveraged that projected EBIT would not cover pro forma interest expense even in a good year - EBIT / Interest Expense
What did the SEC charge Take-Two with?
the company accounted improperly for the acquisition of two video game publishers and failed to establish proper reserves for reductions in the retail prices of its games
What did Altman's model demonstrate?
the development of the Aktman z-score and other multivariate models has demonstrated that no single financial ratio predicts bankruptcy as accurately as a properly selected combination of ratios
What were some of the risks associated with Bally's increased reliance on customers who had to borrow in order to join?
the risk with expanding to new customers is high because they are less likely to pay then old members
15. What distinguishes the preceding liabilities from other kinds of hidden liabilities?
these items arise exclusively in furtherance of a business objective (attracting and retaining capable employees), rather than as a surreptitious means of leveraging shareholders' equity.
What did Bristol-Myers offer as an explanation for the sudden drop in projected 2002 earnings?
they gave wholesale discounts to induce them to buy its products much faster than necessary to fill
How is Bally's situation different from the situation at BJ's Wholesale Club?
they get their membership feels up front and they only have .5% customers ask for refunds
5. For financial analysts, what is the practical definition of accounting profit?
whatever the accounting rules say it is.
How can management mask problems related to inventory or receivables?
writing the payables
Are corporate budget systems designed to reward lies and punish the truth?
yes because it forces managers to do whatever it takes
Can companies with similar interest rate coverage have a substantially different default risk?
yes, depreciation, PPE assets and other assets distort default risk
Would a loss of value occur for an apparel manufacturer whose management guesses wrong about the fashion trend and is holding inventory that can be sold, if at all, only at knockdown prices?
yes, selling these would require the company to recognize the loss in value, so management may choose to retain them in their finished goods inventoyr, overstating the amount of usable inventory the company has