2. Financial Statement Analysis

See Bernstein, Leopold and Wild, John (1998), Financial Statement Analysis, Theory, Application, and Interpretation, 6th edition, Irwin McGraw-Hill. Also, White, Gerald, Sondhi, Ashwinpaul, and Fried, Dov (1997), The Analysis and Use of Financial Statements, 2nd edition, John Wiley and Sons; Kimmel, Weygandt, Kieso, and Trenholm (2009), “Financial Accounting, Tools for Business and Decision Making”, 4th Canadian ed., John Wiley and Sons.

Fridson, Martin, and Alvarez, Fernando (2011), Financial Statement Analysis, A Practitioner’s Guide, 4th ed. John Wiley & Sons Inc. In Chap. 1, the authors discuss “the importance of being skeptical”. This theme carries through the rest of this book, an indispensable resource for credit analysts and for first-time users of financial statements. This book looks at some of the biggest financial scandals in recent times, such as Enron, WorldCom, and Nortel Networks.

Chartered professional accountants provide three types of financial statements. (1) Audited Engagement: It provides the highest assurance that the financial statements are free of material misstatement and are fairly presented based upon the application of generally accepted accounting principles (GAAP). The assurance is supported by testing procedures performed in the compilation of the figures. (2) Review Engagement: It provides only limited or reasonable assurance on a company’s financial statements. (3) Compilation Engagement: They provide no assurance on a company’s financial statements. The accountants merely compile them in a financial statement format that complies with generally accepted accounting principles without any testing performed.

International Financial Reporting Standards (IFRS), the reporting rules for making company accounts understandable and comparable across international boundaries, are issued by the International Accounting Standards Board (IASB) of the International Accounting Standards Committee (IASC). The IASC has no authority to require international compliance, but many countries including Australia, Brazil, Canada, and the European Union have adopted the accounting standards. The financial statements of publicly traded companies in these jurisdictions are prepared in accordance with IAS. The Financial Accounting Standards Board (FASB) of the United States establishes and communicates standards of financial accounting and reporting, known as generally accepted accounting principles (GAAP). The United States has not adopted IFRS, but the FASB also requires the reporting of comprehensive income.

Arthur Andersen LLP was the public accounting firm that audited Enron Corp. The firm cofounded as Andersen, DeLany & Co. in 1913 by Arthur E. Andersen, no longer exists. On June 15, 2002, Arthur Andersen was found guilty of obstructing justice (shredding evidence) in the Enron scandal, and lost its licence to engage in public accounting.

Such data are available from various business services companies. Sources include Risk Management Association (RMA). Banks use RMA Annual Statement Studies as a standard source to evaluate businesses applying for financing. Another source is online web access to Dun & Bradstreet’s Key Business Ratios to benchmarking data. A third source is Wolters Kluwer’s Almanac of Business and Industrial Financial Ratios for 199 industries in all of North America (Canada, the United States, and Mexico).

The widely used variable reduction techniques are Principal Components Analysis and Factor Analysis. The procedures partition a smaller number of metrics from the larger multivariate data set. The result is a subset whose ratios have zero correlation with each other but are strongly correlated with the excluded ratios. The zero or low correlation ensures maximum information or explanatory power is achieved. The strong correlation ensures that the ratios of the subset capture information in the excluded ratios. Bernstein & Wild, op. cit. Lists 48 financial ratios in the front cover; and there are as many as 100 as stated in White, Sondhi, and Fried, op. cit. Page 192.

Sathye, M. V. James, and B. Raymond (2013), Credit Analysis and Lending Management, 3rd Edition, Tilde University Press. Refer to Chapter 2, page 81. The authors list ten ratios that loan officers consider important.

Herbert A. Simon coined the word satisficing by combining “satisfy” and “suffice” to explain the behaviour of decision-makers working with limited information. In such a situation, he argued that an optimal solution is indeterminate. He referred his satisficing theory of the firm as bounded rationality in contrast with unbounded rationality that underpins the classical theory, which assumes that the firm knows with certainty its demand and cost function and can therefore maximise profit. Herbert Simon received the Nobel Memorial Prize in Economics “for his pioneering research into the decision-making process within economic organizations” in 1978.

See online data prepared by Aswath Damodaran, NYU Stern School of Business, Operating and Net Margins by Industry Sector. Data of last update: January 5, 2017. http://​people.​stern.​nyu.​edu/​adamodar/​New_​Home_​Page/​datacurrent.​html. See also Grocery Stores Industry Profitability on CSI Market. Web site: http://​csimarket.​com

See Ganguin, B., J. Bilardello (2005), op. cit., page 99 where the authors examine the pros and cons of using EBITDA; and Martin Fridson & Fernando Alvarez (2011) op. cit., Chapter 8.

Refer to Aswath Damodaran, op. cit. The average for 163 global firms in the industry was 1.92% as of January 2017. Data from CSI Market show that average the Net Income margin for US firms was 2.35% in 2016 and 2.13% in 2015.

Koopmans, Tjalling C., ed. (1951), Activity Analysis of Production and Allocation. New York: Wiley. Koopmans’ notion of technical efficiency is that an input–output vector is technically efficient if, and only if, increasing any output or decreasing any input is possible only by decreasing some other output or increasing some other input.

White, Sondhi, and Fried, op. cit. on methods to adjust leverage ratios to include various off-balance sheet liabilities. In particular, this chapter shows how to capitalise operating leases. Also, Moody’s, “Guideline Rent Expense Multiples for Use with Moody’s Global Standard Adjustment to Capitalize Operating Leases”, Revised March 2006. Refer to Chapter 11.

The general formula for WACC is: \( \mathrm{WACC}=\frac{\sum_{j=1}^N\ {r}_j{V}_j}{\sum_{j=1}^N{V}_j} \) where N is the number of sources of capital, r is the required rate of return for security j, and V is the market value of all outstanding securities j. Applying the formula to two securities, equity and debt, \( \mathrm{WACC}=\frac{E}{E+D}\ {r}_e+\frac{D}{E+D}\ \left(1-t\right){r}_d \) where E is the market value of equity, D is the market value of debt, and t is the marginal tax rate.

Moody’s Investors Services (2015), Announcement: Moody’s updates its global methodology for financial statement adjustments. The methodology is provided in the publication June 2015 article, Financial Statement Adjustments in the Analysis of Non-Financial Corporations. Before the recent revision, the sector multiples ranged from 5× to 8×.

There are numerous readings on financial manipulation. The reader may wish to look up these sources: (1) Martin Fridson and Fernando Alvarez, ibid., Chapter 9, The Reliability of Disclosure and Audits; (2) Roman Weil and Michael Mahler, Handbook of Cost Management, 2nd Edition, John Wiley & Sons, 2005, Chapter 31, Section 41.4, Specific Methods to Manipulate Financial reports; (3) Al Rosen and Mark Rosen, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Third Edition Hardcover, May 5, 2010.