Financial Statement Analysis


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Table of Contents

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

About the Author

MARTIN S. FRIDSON is Chief Investment Officer at Lehmann Livian Fridson Advisors, a New York-based investment management firm founded on fundamental security analysis. He is past President of the Fixed Income Analysts Society.

FERNANDO ALVAREZ has been a faculty member at Babson College, Rutgers University School of Business, NYU-Stern, and Columbia Business School. His research interests include the interaction of strategy, financial statement analysis, valuation models, and stock market reactions to business decisions.

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